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Secure Income

Introduction  

This briefing sets out the two ways in which an individual can receive a secure income - either through a scheme pension or a lifetime annuity.  

Core considerations 

  • Annuities are purchased from defined contributions schemes.  
  • When purchasing an annuity the individual may choose various options, such as protection from inflation, guarantees and beneficiaries annuities.
  • Scheme pensions are generally provided by defined benefit schemes, but may also be provided by some defined contribution schemes.  
  •  Scheme pensions generally provide some inflation protection and dependant’s benefits. 
  • Income from a scheme pension or an annuity will be subject to income tax and paid under PAYE.
     

Contents

 

Lifetime annuities

A lifetime annuity allows an individual to use their pensions funds to provide a secure income paid for the rest of their life. Usually, the member will take 25% of their funds as a tax-free cash lump sum and then use the rest of the funds to buy an annuity with their chosen annuity provider.  

A lifetime annuity removes the investment risk from the individual and passes that to the insurance company they purchase the annuity from. However, there is then very limited flexibility and limited opportunity to benefit from potential investment returns such as with a drawdown plan. 

The amount of income from a lifetime annuity will depend on the value of the fund used to buy the annuity, the annuity rate available (which is often linked to long term gilt yields) and the options chosen by the individual. The annuity rate will depend on the individual’s age, life expectancy and the interest rates at the time of purchase. Adding options such as increases with inflation will usually reduce the initial income from the annuity. 

Individuals are able to ‘shop around’ to find the best quote i.e. the highest level of secured income for their fund value.   

Some individuals may be able to purchase an impaired life annuity or an enhanced annuity which will give them a higher starting income because they are deemed to have a shorter life expectancy. Examples include those with long term health issues, and lifestyle choices such as smoking.  

An annuity must be paid at least annually but most will be paid monthly.  

Before 6 April 2015 income from an annuity could generally only stay level or increase. It could only decrease in very limited circumstances. Since then, it is possible to have a more flexible annuity however, there has been very limited interest from providers in offering such annuities.  
 

Lifetime annuity options

Lifetime annuities can be set up with a number of options which are selected at outset, and only rarely can they ever be selected once the annuity is already in payment.
 

Pension increases

The member can choose for their income to increase each year, either by a fixed percentage or linked to inflation. The greater the chosen increase the lower the starting income will be.  
 

Pension guarantees 

Clients can select a guarantee period. This means that the payments will continue to be paid until the end of the chosen guarantee period even if the member dies before the end of the period. There are no longer caps to the duration of the guaranteed period, though providers may only offer guarantees of up to 10, 20 or 30 years. A longer guarantee period will reduce the annuity rate offered.
 

Value/Annuity protection  

This option provides a lump sum payment on death equal to the difference between the amount paid for the annuity and the income paid out before death. Some providers allow you to choose to protect a specified percentage of the amount paid for the annuity, rather than all of the value. Including this protection will generally reduce the annuity rate offered.  


Dependants or nominee’s annuity  

This allows the income payments to continue to a dependant or nominee following the individual’s death, commonly referred to as a joint-life annuity. This will usually be at a reduced percentage such as 50% of the member’s initial income. The dependant or nominee’s annuity can be selected to start alongside a continuing payment under the guarantee period, referred to as overlap, or can be set to start paying after the end of a guarantee period. 
 

Lifetime annuity taxation

Income from the lifetime annuity will be subject to income tax at the client’s marginal rate. The income payments will be paid by the provider under PAYE. If no tax-free cash was taken when the annuity is purchased, then this option will be lost. 

If the member dies under the age of 75 any dependant or nominee annuity will be paid free of income tax. If the member died aged 75 or over, then the dependants or nominees annuity will be subject to income tax at their marginal rate.  

An annuity protection lump sum death benefit (available with value/annuity protection) is tested against the clients lump sum and death benefit allowance (LSDBA). If the LSDBA is not exceeded it will be paid tax free on death before age 75, if the LSDBA is exceeded the excess is subject to income tax at the recipient’s marginal rate. On death after age 75 the lump sum is always subject to income tax. 
 

Scheme pensions

A scheme pension is a regular income paid for the lifetime of the member directly from the pension scheme or it can be secured with an insurance company selected by the scheme. It must be paid at least annually but will usually be paid monthly. Where secured with an insurance company the scheme pension may be in the name of the scheme trustees, in which case it will usually be paid to scheme trustees and then to the member. Or, the scheme pension may be held in the name of the member, in which case the payments may go direct from the insurance company to the member.   

On the death of the member the scheme will usually pay a specified proportion of the pension to a dependant of the member.  

Defined benefit schemes and collective money purchase arrangements can only pay benefits in the form of a scheme pension. Scheme pensions may also be provided from money purchase schemes but very few do, and members must first be offered the chance to purchase a lifetime annuity.   

Unlike other retirement benefit options such as income drawdown or an annuity, scheme pensions can’t be nominated to individuals selected by the member.  

The level of scheme pension will be determined by the scheme rules. Typical rules set out the accrual rate at which benefits are built up. A typical scheme might for example pay 1/60th of the final salary for each year of service. 

Example  

Emma is in a final salary scheme with an accrual rate of 1/60th. She retires at the scheme’s normal retirement age of 65 with 30 years of service. Her final salary is £50,000. Emma’s initial scheme pension will be 30/60ths of £50,000 i.e. £25,000 a year.  


Normally, a scheme pension must be payable for life, but in specific circumstances the annual rate of a scheme pension payable to a member may be reduced or stopped, such as where: 

  • A scheme pension paid on the grounds of ill health stops as the client recovers. 
     
  • A pension sharing order reduces the member benefits. 
     
  • The scheme pension is a bridging pension that is being reduced in a prescribed manner. 

 

Scheme pension options

The scheme rules will set out the benefits provided meaning the member will usually only have limited options to shape their benefits.  


Tax-free cash entitlement 

Some schemes, particularly the older public sector schemes will provide an automatic entitlement to a pension commencement lump sum e.g. three times the initial pension. However, many will offer tax-free cash via commutation i.e. the member can choose to give up part of their pension for some tax-free cash. The scheme will set the commutation factor, and these vary widely. 

Example 

Brendan is entitled to an annual pension of £20,000. His commutation factor is 15.1. He could take for example £30,000 of tax-free cash but this will mean his initial annual pension would reduce by £2,000 to £18,000. 


Pension increases

The scheme rules will set out any annual pension increases, this may include members having the option to forgo or reduce any increases in exchange for a higher initial pension. Unless offered by the scheme there will rarely be other options to tailor the scheme pension.
 

Dependant’s scheme pensions

The scheme rules will set out what level of dependent’s pension will be paid. This will typically be a percentage of the member’s pension such as 50%. The dependents pensions will be paid for the rest of the dependant’s life. 


Pension guarantee  

Scheme pensions can include a guarantee period of up to 10 years, meaning that even if the member dies sooner payments will continue up to the end of the guaranteed period. Scheme rules will determine the guarantee period (if any) that is available.  
 

Pension protection 

Where a member starts receiving a scheme pension from a defined benefit arrangement they may be able to select a guarantee that a set amount of pension will be provided.  If the member dies before the guaranteed amount of pension has been paid, the balance can be paid as a pension protection lump sum death benefit. Some schemes may include such protection as standard without it being an option. Other schemes may include separate lump sum death benefits in addition to any ongoing scheme pension. 
 

Scheme pension taxation

Scheme pensions are subject to income tax at the member’s marginal rates. The scheme will make the payments under PAYE. 

A dependant's scheme pension is also subject to income tax at their marginal rate regardless of the members age when they die. 

Pension protection lump sums are tested against the clients lump sum and death benefit allowance (LSDBA). If the LSDBA is not exceeded it will be paid tax free on death before age 75, if the LSDBA is exceeded the excess is subject to income tax against the recipient. On death after age 75 the lump sum is always subject to income tax. 

 

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