What is an Unsecured Pension?

Unsecured Pension (UP) replaced pension drawdown when the new rules for pensions simplification came into force in April 2006. An Unsecured Pension allows you to make income withdrawals from your pension fund until age 75 instead of buying an annuity.

After the age of 75 you must either buy an annuity or transfer to an Alternatively Secured Pension.

 

The Advantages

Drawdown has many advantages but the most important are; income flexibility, investment control and choice of death benefit

• Income Flexibility
  • Each year the amount of income taken can be varied between the minimum and maximum limits. Income can also be taken monthly, quarterly, half yearly or annually.
• Control over investments
  • If drawdown is set up through a Self Invested Personal Pension there is a wide range of investment options available.
• Choice of death benefits
  • Unlike standard annuities where the only death benefits are available from a joint life annuity, drawdown offers a choice of death benefits.

The Disadvantages

The basic rules for drawdown are simple, but it is a complex option because of the risks involved. When you buy an annuity you give up control of your pension fund in return for a secure income. With drawdown you maintain control of the pension fund but your income will not be secure and so it is a much more risky option than buying an annuity.

• The value of investments may fall in value
• Annuity rates might fall
• No benefit from mortality cross subsidy

Unsecured Pension (Drawdown) - Income Limits

GAD limits to income

The amount of income that can be paid from an Unsecured Pension fund is determined by reference to tables produced by the Government Actuary's Department (GAD). The maximum income in any one year is roughly equal to a single life annuity and there is no minimum income requirement.

Income limits from the Government Actuaries Department (GAD)

To ensure that the income limits from drawdown are in line with annuities the limits are calculated by reference to current gilt yields. GAD produces a set of special tables based on a range of interest rates.

Calculate your maximum drawdown limit

Go to our drawdown income calculator

5 Yearly Reviews

There is a compulsory review every five years to ensure that the pension fund can sustain future income payments. At the review the minimum and maximum income limits are set for the next 5 years..

Income flexibility

Income can be varied each year so long as it is kept within the GAD limits.

Income withdrawals can be paid monthly, quarterly, half yearly or annually and can be in advance or arrears.

One of the main attractions of drawdown is that if the policholder dies before the age of 75 there is achoice of death benefits, whereas with an annuity the capital is lost on death unless there is a joint life option or income guarantee.

On the death of the policyholder there are three options:

Lump Sum Death Benefit

• A surviving spouse or dependant may take the remaining pension fund as a capital sum, less a 35% tax charge.
• The lump sum payment will be free of IHT, providing the correct trust has been established.

Continued Drawdown

• A surviving spouse or dependant may continue making income withdrawals

Annuity Purchase

• A single life annuity can be purchased for the spouse or dependant without a guarantee period or value protection.

Mortality Drag

Annuities pay income for life and drawdown has a lump sum death benefit

One of the main attractions of drawdown is that if the policholder dies before the age of 75 any remaining fund can be paid to the family less 35% tax, whereas with an annuity the capital is lost on death.

The comparison between drawdown and annuities is more complex than it seems because there is an invisible force at work called mortality drag.

When you buy an annuity you benefit from a mortality cross subsidy but this is not present in drawdown and the effect is known as mortality drag.

Mortality cross subsidy

Annuities are based on the principle of mortality cross subsidy where those who die before their normal life expectancy subsidise those who live longer than expected.

Drawdown results in the deferral of annuity purchase and so the investor does not benefit from the mortality cross subsidy.

This means that in order for a drawdown fund to provide the same income as an annuity there has to be an extra investment return each year to compensate for the absence of this subsidy.

The effect of mortality drag

The chart below shows the investment growth required year on year in order that the drawdown could purchase the same level of annuity income.

The chart shows that the older you are the greater the impact of mortality drag and means that the risk of drawdown increases with age. This is often used to justify the concept of "phased annuities" where segments of drawdown are converting into annuities at regular intervals in oder to reduce the effects of mortality drag.