FAQs - Unsecured and alternatively secured pensions

The government's A-day pensions simplification legislation, which came into force in April 2006, created unsecured pensions.

An unsecured pension is an alternative to buying an annuity. It allows the customer to draw an income from their pension fund while leaving their fund invested. A customer under 75 can take out an unsecured pension and either draw an income by using income withdrawal (also known as pension fund withdrawal or pension drawdown), or by using a 'short-term annuity'. An unsecured pension will stop at age 75. By that time, customers must secure an income from their pension funds, which generally means buying a lifetime annuity, or an Alternatively Secured Pension (see below).

Alternatively Secured Pensions (ASPs) were also created in April 2006 and they work in a similar way to unsecured pensions, but have different rules. They are available to people reaching age 75 who do not want to buy an annuity with their pension fund.

When first introduced, ASPs had no minimum income withdrawal requirement. And it was possible to pass any remaining funds on the member’s death to the pension funds of other members of the same scheme if the member had no dependants.

However, the Government has indicated that ASPs are intended to provide an income in retirement for scheme members and their dependants, rather than be used as a device to pass on tax‑privileged pension funds. Therefore a minimum income level has been introduced. Also, any lump sum death benefits passed to other scheme members will be taxed at up to 70% and could also be subject to inheritance tax.

The FSA requires authorised firms and advisers to keep themselves up to date about potential changes in the law, and to take those changes into account when advising their clients to buy, sell or exercise their rights under, a regulated investment. That means that you must have regard to, and give appropriate warnings about, material risks that might have an adverse effect on a client if the client takes, or refrains from taking, your advice.

Anyone being recommended to enter into an ASP should have the potential tax consequences explained clearly to them by their adviser. And that the Government has said that it might remove access to ASPs altogether if there is evidence of continued use to provide capital sums after age 75. The changes to ASP taxation announced on 6 December 2006 can be found in PBR Note 13 on the HMRC website in the 2006 Pre-Budget Report.

An unsecured pension, using income withdrawal or using short term annuities, is complex and is not suitable for everyone. It is riskier than an annuity as the income received is not guaranteed and will vary depending on the value and performance of underlying assets. Advisers need to make sure their customer is aware of the risks unsecured pensions poses to them. The customer is exposed to similar risks if the unsecured pension uses short term annuities.

This is also true for alternatively secured pensions. The followings risks identified for unsecured pensions will also apply for alternatively secured pensions.

The customer will be taking an income from a fund that remains invested in the stock market or from an asset which is subject to market conditions. Dependent on the levels of drawdown (or amount of the short term annuity) and charges (which tend to be high for income withdrawal plans), a high-risk investment strategy may be necessary to ensure that:

• the required levels of income are sustained; and
• the value of the income generating fund, or asset, continues to be sufficient to secure adequate levels of income.
  

The customer's personal and financial circumstances should be considered carefully, in particular:

• the customer's investment objectives. For example, does the customer need tax free cash, or the customer's state of health;
• current and future income requirements, existing pension assets and the relative importance of the plan, given the customer's financial circumstances; and
• attitude to risk, ensuring that any difference between their attitude to risk relating to unsecured pension arrangements, and that in relation to other investments is clearly explained.

See COBS 9.3.3G.

As well as sticking to the FSA's Principles for Business, in particular Principle 6, "Customer's interests" and Principle 9, "Customer's: relationships of trust", advisers should ensure that in addition, suitability letters explain:

• the purpose of the contract for the customer;
• the relative importance of the contract, given the customer's financial circumstances;
• the customer's attitude to risk; and
• the risk factors involved in entering into income withdrawal or purchase of a short-term annuity, including:
  
  • taking withdrawals may erode the value of the remaining fund, especially if the investment returns are poor and a high level of income is taken. This could result in a lower income for the customer in the future;
  • the investment returns may be less than those shown in the illustrations;
  • annuity rates may be at a worse level in the future;
  • when maximum withdrawals are taken, or the maximum short term annuity is purchased, high levels of income may not be sustainable; and
  • the maximum income that can be withdrawn under an alternatively secured pension after age 75 is less than the maximum that applies before age 75.
  • The potential for significant tax charges on lump sum death benefits under alternatively secured pensions.

See COBS 9.4.10G.