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Secure income overview

Lifetime annuities and scheme pensions are both types of secure pension, providing individuals with a known amount of regular income, usually for their lifetime.

While there's usually no flexibility to vary the levels of income, market risk and investment decisions are removed.

This contrasts with flexible access pensions where individuals leave their pension invested and take on all of the investment risk, but can choose how much of their money to withdraw and when to take it.

Lifetime annuities

These secure a retirement income by using a money purchase fund (after any tax free cash has been taken) to buy an annuity contract from an insurance company.

It doesn't have to be purchased from the same company that runs the pension scheme. Individuals may be able to secure a better annuity rate from another company - this is known as an 'open market option'.

Lifetime annuities can be used to provide pensions for the original member and/or their survivors. They can also be bought with either uncrystallised funds or drawdown funds.

The amount of lifetime annuity provided will depend on the fund value available to buy the annuity, the pension options chosen and the current annuity rates available from the chosen annuity provider.

The annuity rates will typically be determined based on prevailing interest rates and the pensioner's age and life expectancy (probably using pooled mortality tables, unless perhaps an impaired life annuity is required). Some providers' annuity rates differ depending on where the annuitant lives, with lower rates available to those living in wealthier areas (because their life expectancy will generally be higher) and higher rates available for those living in poorer areas.

Options

HMRC allow annuities to be purchased with several options or features, although pension scheme trustees and providers may not offer them all:

• Payment frequency - the flexibility to decide how often pension payments are made. They must be paid at least once a year but, other than this, there are no restrictions on the payment frequency. So they could be paid weekly, fortnightly, monthly, quarterly or yearly.
  
  The pension payments can be made in advance or in arrears. For example, if a monthly pension starts on 1 May the pension payment for May could be made on 1 May (payment in advance) or 31 May (payment in arrears).
• Pension increases/decreases - the pension can be set up to increase every year, to help protect the pension's real buying power against the effects of price inflation. Since 6 April 2015, lifetime annuities are also allowed to decrease - however, this could affect future pension funding.
• Survivors' pensions - pension payments (or a proportion of them) continue to be paid to survivors on the member's death. Since 6 April 2015, survivors' pensions are no longer restricted to dependants; any individual can be nominated to receive a survivor's pension.
• Pension guarantee - the member can buy their annuity with a guarantee period, so the regular payments will continue to be paid until the end of that period even if the member dies sooner. Since April 2015, the guarantee period is no longer limited to 10 years. A beneficiary inheriting a fund on death cannot buy a guarantee period with their annuity.
• Value protection - a value protected annuity can provide a lump sum death benefit if chosen. This is also sometimes referred to as annuity protection. The maximum benefit will broadly be the difference between annuity purchase price and total payments made up to the date of death.

The pensioner can normally choose which options to build into the pension. Of course, all of these have a cost and the options chosen will affect (reduce) the starting level of pension.

Some individuals may be able to buy an impaired life annuity or an enhanced annuity which will give a higher starting pension due to a lower life expectancy. These are available to individuals with particular medical conditions (such as heart disease or cancer) or lifestyles (for example, smokers).

Taxation

Income Tax

A lifetime annuity for the original pension scheme member is taxed as earned income. The scheme administrator is responsible for deducting any income tax due under the usual PAYE procedures and accounting for that tax to HMRC.

A lifetime annuity paid to a beneficiary (or the remaining payments due under a guarantee period) will also be subject to income tax at the beneficiary’s marginal rate unless:

• income payments started after 5 April 2015, and
• the date of death was after 2 December 2014, and
• the deceased died under age 75

in which case it will be paid tax-free.

Lump sum allowance (LSA) & lump sum and death benefit allowance (LSDBA)

Following the removal of the lifetime allowance, funds used to purchase an annuity no longer have to be tested against an allowance. However, any tax-free cash taken when the annuity was purchased will count towards both the LSA and LSDBA.

Where a member dies before age 75 and a lump sum is paid as a result of value protection, the lump sum paid will be tested against the deceased’s available LSDBA. Any excess above the available LSDBA is subject to income tax at the beneficiary’s marginal rate, as is any lump sum from value protection on death after reaching age 75.

Inheritance tax

IHT may be an issue if any payments are made to a beneficiary under a guarantee period. The current market value of the remaining payments (i.e. what a purchaser might reasonably pay for the rights to those payments) will form part of the member's estate and potentially be subject to IHT unless they're left to the member's spouse or civil partner. The member's will, or the intestacy rules, determine who is entitled to the payments.

The rules

There are safeguards to ensure that a lifetime annuity contract provides a stable and predictable source of income. To qualify as a lifetime annuity, the annuity contract must:

• be bought from an insurance company
• be paid for the member's life
• be paid at least once a year (either in advance or in arrears)
• not allow the payment of a capital sum on the member's death, except from under annuity protection or by commuting the remaining guarantee payments under the trivial commutation rules, and
• not be capable of being assigned or surrendered, except in the following circumstances:
  
  
  • to give effect to a pension sharing order, or
  • if the annuity is guaranteed for a set period, it can be assigned during that period either to give effect to the terms of the member's will, or to meet the legal personal representatives' obligations in distributing the member's estate.

Before 6 April 2015, there was also a requirement that the amount of pension income normally had to either stay level or increase each year - only in limited circumstances could the amount go down.

However, since 6 April 2015, lifetime annuities can decrease. This could, for example, allow a reduction when the pensioner reaches State Pension age.

But when an individual first receives a payment from an annuity capable of reducing (other than in prescribed circumstances) they'll trigger the £10,000 money purchase annual allowance. This would limit the potential for future funding.

Investor protection is provided under the Financial Services Compensation Scheme (FSCS).

Scheme pensions

A scheme pension is also a type of secured pension. It's simply a promise made by a registered pension scheme to pay an individual a given level of income.

This can either be to the original member, or on death, to their dependants. They can't be paid to the wider class of beneficiaries open to a lifetime annuity.

Defined benefit schemes

Pensions paid from defined benefit schemes can only ever be provided in the form of scheme pensions.

The scheme rules will determine the amount of scheme pension provided and the options included.

Money purchase schemes

Scheme pensions may also be provided from money purchase schemes, but this is not common practice.

• Where a scheme pension is paid direct from money purchase funds, the amount of pension paid will be calculated by the scheme actuary. This will represent the actuary's best estimate of what level of scheme pension represents fair value for the amount of fund given up in return for the promised scheme pension. The calculations will consider the pensioner's age and estimates of life expectancy and future investment returns.
  
  If the fund performs badly, or the pensioner simply lives too long, the scheme administrator carries the risk of having to find more money to pay the promised scheme pension.
• Sometimes scheme pensions from money purchase funds will be secured by buying an annuity with an insurance company - this removes this risk. The level of scheme pension provided will depend on the fund value and the current annuity rates available from the chosen provider.

Options 

Where scheme pensions under defined benefit schemes are concerned, the scheme design will dictate what options are provided and the pensioner won't normally have any choice over them.

For money purchase schemes, the scheme trustees are not obliged to offer all the options permitted, so members should check what's available with their own scheme trustees/administrators.

The main options are:

• Payment frequency - the flexibility to decide how often pension payments are made. They must be paid at least once a year but, other than this, there are no restrictions on the payment frequency. So they could be paid weekly, fortnightly, monthly, quarterly or yearly.
  
  The pension payments can be made in advance or in arrears. For example, if a monthly pension starts on 1 May the pension payment for May could be made on 1 May (payment in advance) or 31 May (payment in arrears).
  
  
• Pension increases - the pension can be set up to increase every year, to help protect the pension's real buying power against the effects of price inflation. Unlike flexible lifetime annuities, scheme pensions can only decrease in limited circumstances.
  
  
• Survivors' pensions - pension payments (or a proportion of them) will continue to be paid to survivors on the member's death. Survivors' scheme pensions can only be paid to dependants.
  
  
• Pension guarantee - a guarantee that the pension will be paid for a fixed period of up to 10 years maximum, even if the member dies sooner. The guarantee can be paid to anyone, but can't be included on a scheme pension provided for a dependant.
  
  
• Value protection - to provide better value for money by releasing a lump sum death benefit should the member die early. This is also sometimes referred to as pension protection. The maximum benefit will broadly be the difference between the original crystallisation value and the total payments made up to the date of death.

Taxation 

Income tax

Scheme pension is taxed on the member as earned income. The scheme administrator is responsible for deducting any income tax under PAYE.

A dependant's pension is also subject to income tax under PAYE, even where the member died before age 75. This is in contrast to a beneficiary entitled to drawdown income or a lifetime annuity who would receive their income tax free if the member died before age 75.

Payments made for the remainder of any guarantee period are taxed as the beneficiary's income, even if they are commuted for a lump sum under the triviality rules (the trivial commutation limit is currently £30,000), and whatever the age of the member on death.

Lump sum death benefits from value protection are, however, paid tax free if the member dies before age 75. Otherwise they are taxed as the income of the recipient.

Lump sum allowance (LSA) & lump sum and death benefit allowance (LSDBA)

Following the removal of the lifetime allowance, funds used to purchase a scheme pension no longer have to be tested against an allowance. However, any tax-free cash taken when the scheme pension is set up will count towards both the LSA and LSDBA.

On death before age 75, lump sum death benefits from value protection will be tested against the deceased’s available LSDBA. Any excess above the available LSDBA is subject to income tax at the beneficiary’s marginal rate, as is any lump sum from value protection on death after reaching age 75.

Inheritance tax

IHT may be an issue if any payments are made to a beneficiary under a guarantee period.

If the guaranteed payments made after the death are paid to the estate or at the direction of the deceased the value of those payments forms part of the estate.

If the continuing payments are made to a beneficiary at the discretion of the scheme pension trustees/administrators, then they're free of IHT.

If the payments are included in the estate of the member, the value is the current market value of the remaining payments (i.e. what a purchaser might reasonably pay for the rights to those payments). HMRC provide a calculator to help determine the present value of the future payments.

The rules 

A scheme pension must:

• Be paid by the scheme administrator (or by an insurance company chosen by the scheme administrator)
• Be paid at least once a year
• Be paid for the life of the member (so there is a commitment of payment)
• Not reduce, except in limited circumstances. These include a reduction due to a pension sharing order, or where the annual allowance tax charge is paid by the scheme. A reduction is also allowed if it is applied to all members based on actuarial advice
• Only provide survivors' pensions for dependants
• Comply with the regulations and responsibilities of a defined benefit scheme if the scheme pension is provided directly from money purchase fund investments

Defined benefit scheme pensions are protected separately by the Pension Protection Fund (PPF).