I listened to Blackrock’s Larry Fink speak at the National Association of Pension Funds conference in Edinburgh this week. He was very clear that everyone must save more; that his industry must somehow “communicate the urgency to save today”; and that anyone who didn’t act on this urgency would face a “miserable future”.
*At the moment everyone gets relief at their marginal rate of income tax, be that 20%, 40% or 45%.
You might think this is something of a statement of the obvious. But it isn’t. There is actually a large group of people who, far from under-saving into their pensions, are dangerously over-saving.
Pensions legislation incorporates something called the ‘Lifetime Allowance (LTA)’. It was introduced eight years ago and has fluctuated all over the place since then. It started at £1.4m, went to £1.8m and then fell back to £1.5m. And it’s about to change again.
From 6 April it will be £1.25m. You can apply to have your limit frozen at £1.5m, but assuming you don’t, if on the day of your retirement you have more than £1.25m in your pension pot, you will be taxed on the excess at a rate that could hit 55% plus (55% on anything you take as a lump sum and 25% plus your normal income-tax rate on whatever income is generated by the excess).
You might think this is of no relevance to you whatsoever – you haven’t put £1.25m in your pension account, and you don’t ever expect to. But you are missing two points.
The first is that, while the LTA sounds like a contribution limit, it isn’t. It doesn’t refer to how much money you can put into your pension. It refers to how much you may have in your pension when you finally retire.
The second is the magic of compounding. £1.25m sounds like a lot. But add in investment returns, inflation and time and it’s nothing.
Let’s look at it in terms of investment returns only. Over the last 50 years or so, the stock market has given us an average real return of about 5.5% a year. Go back further and it comes out at more like 7%. Let’s take 6% for the sake of argument (I’m using US numbers here just because the data goes back further).
Then let’s use as an example a 38 year-old man with £250, 000 in his pension. He probably hasn’t even noticed the change in the lifetime limit, given that his current savings come in at a million less than it does.
But guess how much he will have in his account in 27 years (when he is 65) even if he stops saving right now? £1.2m. He’s effectively almost at the limit already. What if he invests really well and makes 7% a year? £1.55m. And what if he keeps contributing to his account to the tune of £500 a month until he retires? £2m.
I’ve ignored costs in this, but you get the picture. He’s in danger of having to pay some pretty nasty taxes on what he probably thinks of as far too small a pot to interest the government. And the better he invests, the more risk he is running.
There’s more. In the example so far I have only used inflation-adjusted numbers. But doing so makes the implicit assumption that the lifetime limit is raised along with inflation. That’s a hopelessly optimistic assumption.
Pensions savings are easy targets for broke governments. A very easy way to both save on tax relief upfront and to claw it back later is simply to use ‘fiscal drag’ to cut the amount people can save on an annual basis and have on vesting over time. Even assuming the limit stays where it is in nominal terms is pretty ‘glass half-full’: the Liberal Democrats are already lobbying to cut it to £1m.
Still, let’s assume that the £1.25m limit stays exactly where it is. Let’s then assume that inflation runs at 3% a year until our would-be pensioner retires. He now has a sum of just over £2.5m on retirement. Double the permitted amount. His tax bill on his “tax-free” pension is going to be £687,500. Or maybe more: BlackRock puts the annual total return (not inflation adjusted) on UK equities over the last 42 years at 11.3%. If our man makes that, he’ll have £4.5m to his name. So he could end up effectively paying a total of 55% on £3.25m of it.
And that assumes that he doesn’t save any more into his fund until he retires. If he makes the mistake of tucking a little more away every month (as we tell everyone to do) the bill will be even higher. As it stands, the LTA is a classic tax on mathematical ignorance and inflation.
You will say that none of this is a given. You’re right. It isn’t. Investment returns over the next 27 years may be lower than usual, making the risk of hitting the limit slightly lower than I suggest – although valuations don’t really suggest that is the case.
The LTA may well also rise over time. But even if rises with inflation, our man is still in trouble. And I can’t see it rising with inflation. There’s a major political move afoot to reduce the tax relief that goes to pensions. Doing it via cuts in the real LTA has the twin benefit (from a politician’s point of view) of being simple to implement and hard to understand.
So what do you do about all this? The first thing might be to accept that this is the way of it. We live in a deeply indebted state that must finance itself. The more you have, the more you are going to end up paying one way or another – so you might as well just keep saving and hoping for the best.
The next is to look into applying for either ‘Fixed Protection 2014’ or ‘Individual Protection 2014’ both of which – if you apply fast – can fix your LTA above £1.25m (we looked at these last week, see here for more detail).
But if you aren’t already over funded – and I think a lot of you will find that you are – the best thing to do is to hedge your bets. My own guess is that the LTA will fall to around £400-500,000 in real terms – the amount that yields enough of an income to stop you being a burden on the state in your old age. So, use your ISAs first and then save no more than enough for the miracle of compounding to get you to that level by retirement. Then put your spare cash somewhere else.
• This article was first published in the Financial Times