02: Defined contribution arrangements

If you are a member of a defined contribution arrangement, at retirement you can draw part of your fund as tax-free cash and use the balance to provide an income for yourself and, if you wish, your dependants.

Cash

The normal rule is that the maximum tax-free cash you can draw is 25% of your pension arrangement’s value, although this may be higher for some employer schemes. In theory you cannot draw cash without taking an income, but in practice it may be possible to do so by using pension fund withdrawal (see below).

It will usually make sense to take the maximum cash available, unless you have chosen phased retirement or your pension arrangement incorporates guaranteed annuity rates. The advantage of cash is that it is tax-free, whereas any income you take is taxable.

Income options

There is a variety of ways in which income can be taken from a pension plan. However, most plans do not offer all the options, so you may need to transfer to take advantage of a particular income route. The main choices are:

Lifetime annuity

A lifetime annuity is purchased from an insurance company and can be payable throughout your life or that of yourself and your partner. Annuity payments can be fixed (level), increase at a pre-determined rate or RPI-linked. A rising annuity offers protection against inflation, but your initial income will be lower than from a fixed pension. For example, at the time of writing the initial payment under an RPI-linked pension for a man aged 60 is 42% lower than for a fixed pension.

Some companies also offer annuities on a with profits or unit-linked basis. Such annuities offer potentially higher returns, but the income can go down as well as up according to investment performance.

Annuity payments can be guaranteed for a period of up to ten years, regardless of whether you (or your partner) are alive.  Alternatively, annuity protection can pay a lump sum payment on death before age 75 of the original pension value, less gross income payments made and less a 35% tax charge.

Scheme pensions

Scheme pensions are very similar to lifetime annuities, but much less common. The major difference is that they are paid by your current pension provider.

Pension fund withdrawal

As the name suggests, under this option your income is provided by withdrawals from your pension fund. The maximum initial annual withdrawal is approximately 120% of what a fixed annuity would provide. There is no minimum withdrawal, hence the possibility of taking cash at retirement (or before) but no immediate income.

The maximum level of withdrawals is normally reviewed every five years, based on your then age, prevailing interest rates and the value of your remaining fund. Your income can therefore go down as well as up, although a handful of schemes do offer income guarantees. At any time up to age 75 you can stop withdrawals and buy an annuity, but at age 75 fund withdrawals must end. You then have the option of buying an annuity or switching to an alternatively secured pension (ASP), which is a more restrictive form of withdrawal.

If you die before age 75, your remaining fund can be used to provide benefits for your chosen beneficiaries. The benefits can include a lump sum, which is subject to a flat 35% tax charge, but is normally free of inheritance tax. After age 75, the death benefits under ASP are limited to dependants’ pensions, a lump sum payable to a charity or a transfer of the remaining fund to another member of your pension scheme (which could include your child or grandchild). Inheritance tax and tax penalties (typically at a rate of 70%) will apply on any fund transfer, making this a relatively unattractive option.

Phased retirement

Under phased retirement, each year you use part of your pension plan’s fund to provide cash and buy an annuity. Your ‘income’ thus consists of tax-free and taxable lifetime annuity. Initially the bulk of the ‘income’ will be cash, but as the accrued annuity grows, the cash component shrinks. At age 75 the process must stop and the remaining funds must be used to buy a final annuity, scheme pension or an ASP.

On death before age 75, the full value of your remaining pension fund is payable as a lump sum, usually free of inheritance tax. In addition any death benefits under the annuities would also be paid.Last Updated