Capped Drawdown | A Guide To Capped Drawdown

 


Last updated: 27/03/2014



Below is our guide to Capped Drawdown.


It is intended to provide basic details of the rules relating to Capped Drawdown, its advantages and disadvantages and the death benefit options available to a spouse / dependants.

Also included are a few factors to consider when choosing a suitable provider, some reasons why a person might choose Capped Drawdown for their retirement income provision instead of one of the alternatives and highlight the need and importance of advice.

ARTICLE SECTIONS:

WHAT IS CAPPED DRAWDOWN?
CAPPED DRAWDOWN MAXIMUM INCOME EXAMPLES
HOW IS CAPPED DRAWDOWN INCOME TAXED?
CAPPED DRAWDOWN SUITABILITY
SOME REASONS FOR CHOOSING CAPPED DRAWDOWN
CAPPED DRAWDOWN: DEATH BENEFITS & SPOUSE / DEPENDANTS’ OPTIONS
SOME ADVANTAGES OF CAPPED DRAWDOWN
SOME DISADVANTAGES OF CAPPED DRAWDOWN
CAPPED DRAWDOWN: THE COSTS
CHOOSING A CAPPED DRAWDOWN PROVIDER
THE NEED FOR CAPPED DRAWDOWN ANNUAL / REGULAR REVIEWS
CAPPED DRAWDOWN RELATED JARGON EXPLAINED
CAPPED DRAWDOWN: CRITICAL YIELD
CAPPED DRAWDOWN: MORTALITY CROSS SUBSIDY & MORTALITY DRAG
CAPPED DRAWDOWN: GAD DRAWDOWN TABLES
CAPPED DRAWDOWN: GAD INTEREST RATE / GILT YIELD

Capped Drawdown is an alternative way of taking a retirement income from personal pension funds.

Instead of taking the conventional route of buying a Lifetime Annuity, with Capped Drawdown a retiree’s pension funds remain invested in a personal pension plan and they withdraw some of their pension funds as an income.

Note:

Some existing pension plans may not allow Capped Drawdown to take place, so you might have to transfer your pension funds into another type of pension plan either with your existing pension provider or a different one.

There is a maximum limit placed on how much income that can be withdrawn each year.

When a retiree first starts using Capped Drawdown, their pension provider will work out the maximum allowable income by using a special set of tables provided to HM Revenue & Customs by the Government Actuary's Department (GAD). The tables currently take into account the retiree’s age and also prevailing 15 year gilt yields (see GAD Interest Rate / Gilt Yield).

The initial maximum income limit then remains in place for three years. On the third anniversary it is recalculated and every three years thereafter (called a Triennial Review) until age 75 when the reviews then take place each year.

The maximum income limit is intended to be roughly equivalent to the income that would be available to the particular retiree from a single life annuity at the time that income review is carried out (using their specific pension fund value at that time).

The minimum limit is currently zero.

As mentioned above, with Capped Drawdown the retiree’s pension funds remain invested and under their control. Their value will rise and fall in line with the investment performance of the investment funds selected by the retiree. As a consequence, any future income is not guaranteed and can also fluctuate. 

If the pension funds perform poorly and too much income is withdrawn, the Capped Drawdown income could reduce or even cease over time (if the pension funds are entirely depleted).

Capped Drawdown can begin from age 55 and there is currently no upper age limit (either for when it starts or ceases although each insurance company’s have their own rules).


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The following table shows a range of Capped Drawdown maximum income examples for men and women of various ages.

The figures are for illustrative purposes only and have been calculated using the 2011 HMRC Drawdown Pension Tables (150% Max GAD), the Gilt Yield/GAD Rate that applies for this month and a pension pot of £100,000.

The income figures shown are gross. Although we have made every effort to ensure that the figures are accurate, you should not rely upon them solely to make financial decisions. For more precise figures you should obtain an illustration from a Capped Drawdown provider or financial adviser.

If you want to calculate some income examples based on your own age and a specific pension fund value, try using our Capped Drawdown Income Calculator.


AGE MAXIMUM ANNUAL
CAPPED DRAWDOWN INCOME
55 £6,150.00
60 £6,900.00
65 £7,950.00
70 £9,300.00
75 £11,550.00
80 £15,150.00
85 £21,000.00


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The income withdrawals will be taxed under the Pay As You Earn (PAYE) system and are therefore subject to Income Tax.

However, no National Insurance contributions are payable on Capped Drawdown income and any Income Tax paid can be claimed back from HM Revenue & Customs by those eligible to do so.


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Capped Drawdown isn’t suitable for everyone.

When compared to a conventional Lifetime Annuity, Capped Drawdown is a complex and risky way to take a retirement income.

Future income levels are not guaranteed and will fluctuate.

Unlike with a conventional Lifetime Annuity, there is a real possibility that the income could cease altogether if the invested pension funds perform poorly and too much income is withdrawn.

Anyone using Capped Drawdown needs to be sure that they both understand and are content with the risks that they are taking with their future retirement income.

Some may be happy to accept the possibility that their pension income could rise in the future if the stockmarket goes up but how would they feel if the stockmarket plummeted like it did when the ‘Credit Crunch’ hit a few years ago and, as a result, their pension income fell by 30% or more when their income limit is reviewed?

The FSA usually recommends that if a person wishes to use Capped Drawdown, that they should have a minimum ‘going in’ fund value of at least £100,000 (after tax free cash is taken).  They also recommend that other capital should be available that can be used as a backup in case the Capped Drawdown plan fails to perform as expected. 

However, it is possible to enter Capped Drawdown with a much lower fund value than this and there are perfectly legitimate reasons why a person might wish to do so.


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There are many reasons why a person might wish to choose Capped Drawdown instead of buying a Lifetime Annuity.

For example, say a person has pension funds invested but just wishes to access their tax-free cash lump sum entitlement. They can use Capped Drawdown to achieve this aim without the need to take an income.

They can take their tax-free cash lump sum entitlement and leave the remaining funds invested for income purposes at a later date. They can also continue to make further pension contributions into a pension plan should they wish to do so (usual eligibility rules / limits apply).

They may want a flexible or temporary income. Capped Drawdown allows a retiree to start and stop their income whereas a conventional Lifetime Annuity does not.

They may want to retain control over their pension funds and in particular want to leave their pension funds behind after their death for their dependants or beneficiaries to use as they think fit.

This is an alternative to a Lifetime Annuity where death benefits have to be chosen upfront and cannot be changed at a later date. Depending on the annuity options chosen at outset, it is entirely possible for all the income from a conventional Lifetime Annuity to cease when a retiree dies (even if it is just one day after the annuity starts!) and for the annuity provider to reap the benefit from the retiree’s pension funds rather than the retiree’s family/beneficiaries.

Their pension funds may not constitute a significant proportion of their assets and they are happy to take high income withdrawals knowing that they have other capital assets that they can call upon if their Capped Drawdown pension fund fails to grow according to plan and/or is depleted.

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If a person dies whilst taking an income via Capped Drawdown, what death benefits / options are there for any surviving spouse or dependants?

The death benefits available from pension funds invested in a Capped Drawdown pension arrangement vary depending on the retiree’s age, whether their pension funds are crystallised or uncrystallised (see definitions below), their personal circumstances and  final wishes at the time of their death.

Note:

Capped Drawdown related death benefits are subject to HM Customs & Excise (HMRC) taxation rules and the following represents our understanding of the rules. Do not rely upon this information to make decisions about your pension funds without first checking out the facts with HMRC, or a pensions or legal adviser!

Before Reading Further, A Few Important Definitions

For most people, crystallised pension funds are those that have already been accessed for the provision of an income and/or a Pension Commencement Lump Sum.

Uncrystallised pension funds are those that have not already been accessed for the provision of an income or a Pension Commencement Lump Sum.

A Pension Commencement Lump Sum is the proper name for a tax-free cash lump sum entitlement.

See: List of Benefit Crystallisation Events for more information.

 

Benefits / Choices Available On Death (At Any Age) For Crystallised Pension Funds

 

Lump Sum Option

The remaining pension funds can be taken as a lump sum.

With this option, a tax charge of 55% is payable.

Alternatively, and subject to certain conditions being met, the remaining fund can be paid free of tax to a nominated charity.

 

Income Options

A Spouse/Civil Partner or qualifying dependant can use the remaining pension funds to provide an income via a Lifetime Annuity, a Short Term Annuity or Capped Drawdown Pension Plan (or a mixture, if there are sufficient pension funds remaining).

If they satisfy the Minimum Income Requirement test in their own right, they may also use Flexible Drawdown.

Please note that age limits may apply to some of these options.

 

Benefits / Choices Available On Death (Before Age 75) For Uncrystallised Pension Funds

 

Lump Sum Option

The remaining pension funds can be taken as a lump sum.

Currently, any lump sum paid will not be taxed (subject to a Lifetime Allowance test).

If the lump sum option is taken and the fund value exceeds the Lifetime Allowance the excess will be subject to a 55% recovery charge.

 

Income Options

A Spouse/Civil Partner or qualifying dependant can use the remaining pension funds to provide an income via a Lifetime Annuity, a Short Term Annuity or Capped Drawdown Pension Plan (or a mixture, if there are sufficient pension funds remaining).

If they satisfy the Minimum Income Requirement test in their own right, they may also use Flexible Drawdown.

Please note that age limits may apply to some of these options.

 

Benefits / Choices Available On Death (Age 75 and over) For Uncrystallised Pension Funds

 

Lump Sum Option

The remaining pension funds can be taken as a lump sum.

With this option, a tax charge of 55% is payable.

Alternatively, and subject to certain conditions being met, the remaining fund can be paid free of tax to a nominated charity.

 

Income Options

A Spouse/Civil Partner or qualifying dependant can use the remaining pension funds to provide an income via a Lifetime Annuity, a Short Term Annuity or Capped Drawdown Pension Plan (or a mixture, if there are sufficient pension funds remaining).

If they satisfy the Minimum Income Requirement test in their own right, they may also use Flexible Drawdown.

Please note that age limits may apply to some of these options.

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Below are some of the advantages of a Capped Drawdown Plan.

A tax-free lump sum can be taken without the requirement to take an income.

The income can be stopped and started to suit the retiree’s needs (subject to an annual maximum).

Annuity purchase can be deferred indefinitely or until needed.

No requirement to specify any spouse’s or dependents benefits or any of the other options normally associated with annuity purchase.

The pension fund is not given up / lost as it is with annuity purchase and remains under the retiree’s control.

The pension fund can be passed on to any chosen beneficiaries after the retiree’s death.

The pension fund continues to remain invested and the retiree can choose which assets to invest them in.

If investment returns are good the future Capped Drawdown income could go up.


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Below are some of the disadvantages of a Capped Drawdown Plan.

If Capped Drawdown is being used to defer annuity purchase there is no guarantee that future annuity rates will be higher when annuity purchase finally takes place.

The ongoing income is not guaranteed and could go down because of either poor investment returns or other factors such as changes to GAD interest rates or HMRC Capped Drawdown regulations.

Capped Drawdown plans need to be regularly reviewed and monitored (preferably on an annual basis). This could mean extra costs if professional guidance is needed.

Capped Drawdown plan charges are higher than those for annuity purchase and they could also increase over time.

There is no Mortality Cross-Subsidy.

As the value of a Capped Drawdown pension pot is liable to get smaller each time an income is drawn, the growth on the chosen investments will need to be consistently higher as the retiree gets older in order to compensate for the lack of Mortality Cross Subsidy. If the invested funds do not perform as well as expected the decision not to buy a comparative annuity at the start may prove to be a costly mistake over the longer term.

If the growth on the invested funds is poor the value of the pension fund may be eroded or depleted and lost altogether. This is particularly so if high levels of income are taken over an extended period.

As the pension fund stays actively invested, there is a risk that the chosen investments/funds may not perform as anticipated. In addition, it is highly likely that higher risk funds will need to be selected in order to maintain the same level of income that was available from a conventional Lifetime Annuity at the outset.

Over time, inflation can eat into the buying power of Capped Drawdown income payments. A Capped Drawdown plan doesn’t have any income indexation options to help combat this.


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A Capped Drawdown plan is a sophisticated investment product and as such it carries additional costs such as management and investment charges.

The total amount and types of charges varies from provider to provider.

In general, a typical plan will have initial charges, annual charges, fund management charges, ad hoc charges (possibly for income withdrawals and other routine events) and possibly some pre-agreed ongoing adviser charges (for setting up costs and/or annual review fees).

Overall, the total effect of these charges can amount to between 3% and 6% (or more in some cases) per annum depending upon which plan provider and investment funds are chosen.

An exit penalty may also apply if a plan is discontinued during the first five years.

In contrast, the charges for setting up and maintaining a Lifetime Annuity (typically a one off charge of 1% to 1.5% of the fund value) is taken out at the start and no further costs are involved.


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When choosing a suitable Capped Drawdown provider a retiree may wish to consider some of the following factors:

The Minimum Pension Fund Transfer Value

A retiree may need to transfer their pension fund from their existing pension provider or pension plan to another in order to start taking a Capped Drawdown income.

If so, the Capped Drawdown provider will usually have a minimum acceptable pension fund value, for example, £20,000 or £50,000 (although for many Capped Drawdown pension providers, it is much higher).

Their choice of Capped Drawdown providers may therefore be limited by the pension fund value.

The Level Of Regular Charges Applied To The Plan

How much are the provider’s standard annual management charges? This is important because they will consistently erode the value of the invested pension funds.

The Level Of Ad-Hoc Charges Applied To The Plan

Other charges may be applied from time to time for a whole variety of reasons. For example, a charge might be made every time a retiree makes an income withdrawal or they switch funds. These charges can really add up over time if the retiree is planning on making regular income withdrawals and/or investment fund switches.

The Quantity / Quality Of Investment Funds Available For Retirees

If a retiree’s pension funds are to remain invested to benefit from future growth potential, they will need to have access to a decent selection of investment funds, which allow them to invest, not just in shares but also in other assets such as property.

Some may also wish to invest their pension funds in different parts of the world such as North America, Latin America, Japan, Russia, India and/or China.

Retiree’s need to ensure that the Capped Drawdown provider that they choose has a range of top performing funds in all the areas and asset classes that they wish to invest in.

Online Client Fund Management Facilities Availability

Some retirees might be happy to receive a pension fund valuation statement just once a year and once selected not review or ever change their investment funds while others like to keep a regular eye on what’s happening to the value of their pension funds and switch funds around if they are not performing as expected.

Some, but not all, Capped Drawdown providers have online systems that allow retiree’s to get up to date valuations, perform fund research, reallocate their pension funds to different investment funds and make requests to withdraw income.

The Administrative Efficiency Of The Provider

We’ve all had cause to contact big companies sometime in our lives and know that their administrative systems can be a nightmare. They can lose paperwork and take forever to deal with enquiries etc. Insurance companies are no different and problems like these can result in lost income and time trying to sort out any problems.

Care should be taken to choose a Capped Drawdown provider that has good administrative systems in place in order to increase the chances that any new Capped Drawdown plan is set up promptly and run efficiently and accurately.

The easiest way to find the best Capped Drawdown provider is to talk to a financial adviser.

They have access to software, which can search for a suitable Capped Drawdown provider based on a retiree’s exact requirements.

If required, an adviser can also provide advice regarding the investment funds to choose and how much to allocate to each fund.

They can also carry regular reviews (see below) of a Capped Drawdown plan and provide confirmation whether or not the performance of the chosen investment funds is in keeping with expectations.

Another benefit of getting advice is that it is covered by the Financial Services Act. This means that a retiree will be entitled to compensation if the advice received later turns out to have been unsuitable for their circumstances at the time.


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Unlike with the steady, guaranteed income available from a non-invested Lifetime Annuity, with Capped Drawdown a retiree’s pension funds continue to remain invested and so remain prone to fluctuations in their value.

Depending on how much income that is withdrawn each year and how the chosen investment funds perform, there is a real danger that the value of the pension fund could be significantly reduced over time or even reduce to zero. If this does happen, the level of income that can be withdrawn each year is also likely to fall or even stop altogether.

This is one of the main reasons why annual / regular reviews of Capped Drawdown Plans are recommended.

In addition to regular reviews of income withdrawal levels and investment fund performance, it is just as important for retiree’s using Capped Drawdown to conduct a more in-depth review of their entire financial circumstances, at the very least, every two or three years to ensure that Capped Drawdown remains the most suitable retirement income product for their personal circumstances.

This is particularly important the older that they become. See the section below about Mortality Drag.


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When a retiree receives a Capped Drawdown illustration it will contain two Critical Yield figures. Types A & B.

Critical Yield Type A

Critical Yield Type A is the rate of investment growth needed to provide and maintain an income equal to that of a comparative ordinary Lifetime Annuity, which could have been purchased with the pension funds at the time of entering into Capped Drawdown.

Critical Yield Type B

Critical Yield Type B is the rate of investment growth needed to maintain a chosen or specific level of Capped Drawdown income throughout life or to a specific future date.

Critical yield figures may differ from provider to provider as they are based on each providers own plan charges and the annuity rate that they refer to when they make their calculations.


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When a retiree buys a Lifetime annuity, the insurance company works out their expected life expectancy (how long they have left to live) and uses this calculation to decide the level of annuity income it will pay them.

The longer that they are expected to live, the lower the income will be and the shorter they are expected to live, the higher the income will be.

Although most people will die at around the expected age, there are those who will live longer and shorter lives than expected.

The insurance company makes a profit from those who die earlier than expected and a loss on those who live longer than expected.

In simple terms, Mortality Cross-Subsidy is these losses and profits being used to cancel each other out and make the whole system work.

With Capped Drawdown there is no Mortality Cross Subsidy because annuity purchase does not take place.

To make up for this (and to keep pace with a comparative Lifetime Annuity income available over the longer term), a Capped Drawdown plan needs to generate an extra investment return each year.

This extra investment return is called Mortality Drag.

Mortality Drag increases as a person ages.

For example, for a male age 70 the cost of Mortality Drag is around 1% per annum, which means that his investment fund has to produce 1% extra growth if he wants his income to keep pace with that available from a Lifetime Annuity.

At age 90 it is over 8% per annum!

Clearly, as retiree’s get older, they have to consider whether or not the benefits gained from using Capped Drawdown outweigh the downside of increased Mortality Drag.

This also highlights the need to regularly review a Capped Drawdown plan and keep an eye on the ongoing performance of the selected investment funds.


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GAD Drawdown Tables are issued by the Government Actuary's Department (GAD) and are prepared for HM Revenue & Customs (HMRC). They are used for the calculation of the annual income limit for Capped Drawdown pension arrangements.

The tables, together with instructions, can be found at http://www.hmrc.gov.uk/pensionschemes/gad-tables.htm.


In order to use the GAD Drawdown Tables, the appropriate GAD Interest Rate / Gilt Yield must be used.

The GAD Interest Rate / Gilt Yield can be different each month as it is based on 15 year Gilt yields.

For the current GAD Interest Rate / Gilt Yield see our Historic GAD Rate Table.

Our Capped Drawdown Income Calculator automatically uses the current rate applicable.


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