Finance Bill to remove pension annuity requirement

Measures in the Finance Bill will remove the requirement that members of defined-contribution pension schemes must secure an annuity by the time that they reach age 75. Those with an annual income of £20,000 will be able to withdraw the balance of their funds whenever they choose.

On this page:
Proposed revisions
Inheritance issues
Minimum income requirement
Understanding risks
Views on these changes.

From 6 April 2011, new legislation will permit certain individuals who are members of a registered DC pension scheme to continue to make use of an income drawdown arrangement even after they have reached age 75. The measures in the Finance Bill 2011 will remove the existing legislation that has required members of registered pension schemes to secure an income, usually by means of buying an annuity from an insurance company (although a certain amount of flexibility was introduced by Regulations (on the legislation.gov website) in 2006 permitting annuities that vary in line with freely marketable assets).

The coalition Government's intention was announced in its first Budget and involves repealing the relevant provisions in the Finance Act 2004. Shortly afterwards the Treasury published a consultation paper, "Removing the Requirement to Annuitise by Age 75" (on HM Treasury website).

Proposed revisions

A summary of the consultation responses was published that also set out the Government's policy decisions. The proposed changes are now included in the draft legislation that will become the Finance Bill 2011. The overall objective is to remove, with effect from 6 April 2011, the requirement to secure a pension by the time the scheme member has reached age 75. The current alternatively secured pension rules will be repealed for both new and existing pensioners, thereby removing the requirement that pensioners must buy an annuity before age 75.

In any individual case the maximum income that a pensioner may withdraw from most pension funds will be capped at 100% of the equivalent annuity, which is the single-life level annuity that could have been bought by the member's pension fund based on annuity rates set by the Government Actuary, and this will apply for as long as an individual retains the fund. The requirement for a minimum annual withdrawal amount from age 75 is abolished. The maximum (capped) amount that may be withdrawn is to be determined at least every three years until the end of the year in which the member reaches age 75, after which these reviews will be carried out annually.

Individuals using income drawdown who have in place a lifetime pension income of at least £20,000 per year will be allowed to access the whole of their funds as pension income without any limit on annual withdrawal. However, this must also be permitted by the pension provider's own rules.

Any new pension savings for individuals whose application to access the whole of their drawdown pension fund has been accepted will be liable to the annual allowance charge on all new pension savings. Individuals who make a withdrawal from a drawdown pension fund during a period when they are resident outside the UK for a period of less than five full years will be liable for UK income tax on that withdrawal for the tax year in which they once again become resident.

Most of the rules preventing registered pension schemes from paying lump-sum benefits after the member has reached age 75 are to be removed. The tax rate for all but one of the lump-sum death benefits is to be set at 55%. The exception is that of death benefits for those who die before age 75 without having taken a pension; these will remain free of tax. Unused drawdown pension funds of a member who dies with no living dependants may be donated tax free to a charity.

All these proposed provisions will also apply to members of non-UK pension schemes who have received either tax relief on contributions or funds that have been transferred from registered pension schemes.

Inheritance issues

In relation to inheritance tax issues, there are four proposed changes made in the document. The first is that with effect from 6 April 2011 inheritance tax will not generally apply to drawdown pension funds remaining under a registered pension scheme, including when the individual dies after reaching age 75. Secondly, from the same date, the inheritance tax anti-avoidance charges that apply to registered pension schemes and qualifying non-UK pension schemes (QNUPs) where the scheme member omits to take his or her retirement entitlements will be removed.

The third change, however, is that inheritance tax charges that arise where the trustees of a pension scheme have no discretion in relation to the payment of lump sums after the death of members and where amounts must be paid to the estate will remain subject to inheritance tax. Finally, inheritance tax will continue to apply to all the other lump sums, ie those payable by a non-registered pension scheme or a "non-QNUP".

The Government states that in light of various considerations, including the expected proportion of pension funds that is comprised of tax relief and inheritance tax avoidance issues, it remains of the view that 55% is the appropriate level of recovery charge for death benefits.

Minimum income requirement

The key element of the new legislation is the introduction of a minimum income requirement (MIR) to avoid the scheme member falling on the public purse.

In the response document, the Government recognised respondents' concerns about the potential complexity of an age-related MIR. Consequently, in order to maintain simplicity and flexibility, the Government will allow flexible drawdown from age 55 onwards, with a single level of MIR applicable at all ages.

The Government has also recognised that it is impossible for any realistic level of the MIR to eliminate entirely the possibility of an individual using flexible drawdown falling back on the state. The Government acknowledges that few individuals would enter flexible drawdown intentionally to exhaust their money and claim state benefits.

Detailed assumptions were used to determine an appropriate level for the MIR. Nevertheless, the response document states: "Since the calculations are highly sensitive to all the parameters involved, any analytical estimate of the MIR is approximate and the Government must exercise a significant degree of judgment in choosing the level. Informed by these calculations and other views submitted as part of the consultation process, the Government believes that an appropriate annual level for the MIR is £20,000."

Although the Government understands that most purchased life annuities are currently sold without surrender rights, their different tax treatment would make it possible to sell such a purchased life annuity that could be cashed in on request. The paper states: "A purchased life annuity could then be purchased for a short period of time solely for the purposes of satisfying the MIR, violating the principle that income used to satisfy the MIR must be guaranteed for life." For this reason, purchased life annuities will not be allowed to count towards the MIR.

Understanding risks

The Government recognises the concerns raised about individuals entering drawdown without a full understanding of the risks involved. The Treasury response document states that it is right that individuals who wish to benefit from the flexibility offered by capped drawdown pensions are able to do so but also makes the point that this product inevitably carries exposure to investment risk that annuities do not. The associated risk of depleting funds prematurely cannot be entirely mitigated without imposing undesirably restrictive withdrawal limits that would undermine the flexibility that drawdown arrangements provide.

The document also states that the Government recognises that some individuals who would previously have purchased an annuity at age 75 will now choose to stay in drawdown arrangements from 6 April 2011. It further states: "Giving individuals the flexibility to make choices appropriate to their individual circumstances is one of the key objectives of the new rules. However, purchasing an annuity will continue to be the best option for many individuals to provide an income in retirement. Individuals wishing to access flexible drawdown will need to satisfy an MIR of £20,000, in many cases by purchasing an annuity as part of this requirement. The Government believes that these factors mitigate the risk of large falls in demand for annuities."

Views on these changes

Saga's director-general Dr Ros Altmann points out that, under the new regime coming into force on 6 April, individuals with large pension funds can access their money whenever they wish once they have secured the MIR of £20,000 per year. This might involve buying an annuity with around £250,000 of their pension fund, but then they would be free to do what they like with the rest, and pay only income tax rates - or if they are not resident in the UK the income is tax free. The removal of the requirement at age 75 will therefore benefit those who want to remain in an income drawdown arrangement and those who do not annuitise by age 75 will benefit from "a huge tax cut" when passing on unused pension funds. She states: "Currently, the tax rate is 82% (70% on the pension plus 12% inheritance tax) but from 6 April this year this rate is cut to 55%."

On the other hand Craig Fazzini-Jones of MGM Advantage points out that one of the arguments for ending compulsory annuitisation at age 75 is that, if a person dies earlier than expected, that person can leave their pension fund in their estate, but he notes that only around 12% of 60-year-old men today will die before they are aged 75 and this is likely to reduce further. He says: "So for many, it is a big gamble to trade a lifetime income for the probability of dying early." He cites a person who buys an asset-backed annuity: the value of the mortality cross-subsidy becomes apparent as it is added as a bonus each year. For a 77-year-old, this annual bonus could be as much as 2%. If instead the investment is made in, say, an income drawdown product, it would mean that the underlying investment would have to work 2% harder in drawdown than it would in the asset-backed annuity.

This feature is based primarily on the Treasury's paper "Removing the Requirement to Annuitise by Age 75", but also on the draft clauses for the Finance Bill, their accompanying explanatory notes and the press releases issued by Saga and MGM.