Pension changes – here’s all you need to know

736-covers-storyFrom 6 April, pension changes mean that you can do whatever you like with your pension money. But with that freedom comes responsibility, says John Stepek.

“Pensions” and the word “exciting” do not sit well together. Yet 6 April (Pension Freedom Day, as it’s being called) threatens to make pensions, if not exciting, then a lot more interesting than they perhaps once were. From that date, pensions become a lot more flexible (we’re talking about defined-contribution, or money-purchase schemes here – if you have a defined-benefit scheme, see below).

Once upon a time, your biggest choice when you came to retire was which provider to buy an annuity from – in other words, you swapped your pot for a guaranteed lifetime income. If you weren’t keen on the idea of an annuity (and with today’s low interest rates, it’s easy to see why you might not be), you’d have to jump through various hoops to access drawdown options on your pot instead.

That’s not going to be the case any more. As soon as you turn 55, in effect you can do what you want with your pension pot. You can take the whole lot out (with 25% tax-free). You can draw a regular income, or take money out as and when you need it.

You could still trade the whole thing in for an annuity if you want the guaranteed income. Or you could leave your entire pension untouched (which assumes you have other sources of income, of course) and pass it on to your heirs.

As Pensions Minister Steve Webb famously said, people could end up spending the lot on a Lamborghini if they really wanted to – the point is, the changes give us all much more control over what we can do with our retirement pots and when.

Hold the Lambo

Clearly, with these new freedoms come new responsibilities. You might be happy about the idea of not being (effectively) forced to buy an annuity – but if you can’t guarantee an income for life that way, then it does mean that you have to be willing to do some serious thinking about the alternatives.

Firstly, let’s look specifically at why blowing your pension on a Lamborghini (or the sports car of your choice) is not a good idea. Let’s say your sports car is going to set you back around £100,000. By coincidence, you’ve got £100,000 in your pension, and you decide you just want to spend the lot, live on the state pension, and damn the consequences. Let’s assume you’ve already got £10,000 in gross income from elsewhere that year.

You get 25% of your £100,000 tax free, so that’s £25,000. But the remaining £75,000 is taxed at your marginal income-tax rate. So you end up paying more than £23,000 in tax. That’s completely unnecessary – withdrawing money patiently over a number of years, to a level below the 40% tax rate, would leave you with a far lower tax bill.

On top of that, if you take out your pension and spend it all, don’t expect any sympathy from the state. The Department for Work and Pensions (DWP) has said that anyone applying for means-tested benefits will have their pension treated as though it still exists – “even though the money may have long been spent”, notes the Daily Mail.

The means-tested benefits in question include housing benefit, jobseeker’s allowance and pension credit. In short, says the DWP, “if it is decided that you have deliberately deprived yourself, you will still be treated as having that money and it will be taken into account as income or capital when your benefit entitlement is worked out”. So don’t be tempted to blow your savings.

So what should you do?

Rather than taking the lot out at once, then other than buying an annuity there are three main routes most of us are likely to go down (assuming you have a decent-sized pot). There’s the “flexi-drawdown” route. This enables you to take the 25% lump-sum tax free, then leave the rest of the pot to keep growing. When you start taking the rest of the pot as an income, this will be subject to income tax (you’ve already had your tax-free lump).

An alternative is to take the Uncrystallised Funds Pension Lump Sum (UFPLS) route. Again, the pension fund stays invested. But instead of taking your 25% lump sum all at once, whenever you withdraw money, 25% of that sum is tax free and 75% is taxed.

Why might you want to do this? The big difference is that you spread taking your 25% tax-free cash over a longer period of time with UFPLS. This means that, as Tom McPhail at Hargreaves Lansdown puts it, over the long run “using UFPLS could deliver a higher tax-free cash payment as the pension fund remains invested and grows”.

The problem is that once you start withdrawing money from your pension under UFPLS, your annual allowance is reduced to £10,000 a year (from £40,000 – see below).

With drawdown, then as long as you’ve only taken the 25% tax-free lump sum, you can keep contributing up to £40,000 a year. Also, says McPhail, using UFPLS is more of an administrative hassle – so if you plan to withdraw a regular income rather than a series of lump sums, drawdown may be more sensible.

There’s also “phased drawdown”, which offers some of the benefits of both. You can transfer part of your pot to a drawdown plan, and then take 25% of that portion tax free. You can do this without jeopardising your £40,000 annual contributions allowance, but it also means that you haven’t taken the entire tax-free lump sum all at once.

You can, of course, still buy an annuity. And you don’t have to use your whole pension to do so – you could annuitise a portion of it and drawdown the rest, for example. So if you are looking for a guaranteed income then it may well be worth considering. However, we’d suggest that you don’t act too hastily – the nice thing about the rule changes is that there’s no point at which you have to buy an annuity. Make sure you tell providers of any health problems that you have (as you’ll get a better deal). And make sure you shop around.

The key points for your plan

The core point behind all this is that you have more freedom to plan for how to provide for your own retirement. For all their disadvantages, you know that annuities are not going to run out before you die. The risk with using drawdown and the other pensions freedoms is that your cash could conceivably run dry and leave you dependent on the state pension and any alternative sources of income.

So in deciding on the best course of action, you have to do a fair bit of planning. On the question of how long you need the money to last for, then err on the side of optimism – life expectancy is increasing all the time, with the average 65-year-old now expected to live into their mid-to-late 80s.

That’s good news, but it does mean that your pension is quite likely to have to last you for 20 to 30 years – and that will have a big impact on the amount you can sustainably withdraw each year.

So have a think: how much money do you need each year? What income do you have coming in already, and from where? Do you have individual savings accounts? The state pension? A part-time job? Is there scope to downsize your property? Should you supply at least part of your “vital” income – the minimum you need to pay the bills each month – with an annuity?

But equally, don’t get too panicked. Your cost of living will probably fall as you get older – you hopefully won’t have a mortgage to pay off, you won’t be commuting, and your children will have jobs and places of their own (again, hopefully!), which means bills should be lower than you’ve been used to during your working life.

Of course, you might be hoping that you’ll be able to leave something behind. Prior to Pension Freedom Day, if you died having withdrawn any money from your pension, or when you were over the age of 75, then the remainder of your pension would be taxed at a penal “death tax” rate of 55% before your beneficiaries inherited it. That’s no longer the case. If you die before the age of 75, your pension can be paid to your beneficiaries tax free.

If you die at the age of 75 or over, the pension will be taxed at their marginal income-tax rate, or at 45% if taken as a lump sum. Clearly, this makes pensions very attractive from an inheritance-tax planning perspective (which is one reason why many financial advisers think these changes are very unlikely to survive a change of government next month, as we’ll discuss in a moment).

The flies in the ointment

This all sounds great, doesn’t it? However, there are a few flies in the ointment that mean you shouldn’t make pensions your sole savings vehicle. The first is the lifetime allowance. There’s nothing wrong with capping the amount of tax relief that someone can receive from a pension – funding all that tax relief is expensive, after all. And the annual limit on contributions has already fallen from more than a quarter of a million to the current £40,000. That’s easy enough to understand from a saver’s point of view.

However, there’s also this matter of the lifetime allowance. This is a cap on the amount you can have in your pension when you come to take it.

If you breach this lifetime allowance, the excess will be taxed at a penal rate – 55% in the case of any lump sum you take out. That’s the sort of penalty you want to avoid. But it’s also tricky to plan for, because it very much depends on how your pension performs over the years. That might not matter if the lifetime allowance was unachievably high – but that’s certainly not the case any more.

As Ian Cowie points out in The Sunday Times, the lifetime allowance stood at £1.8m when Chancellor George Osborne entered Downing Street. Currently, it’s down to £1.25m. And at his Budget last month, he reduced it to £1m as of April 2016. “Shrewdly, the chancellor calculated that most innumerate comment would focus on the capital value of the new £1m lifetime allowance, an apparently massive sum, rather than the relatively modest retirement income it will produce.”

As Cowie adds, that £1m would currently buy you an index-linked annuity (with spouse’s benefits – so your partner isn’t left without an income when you die – of around £27,000. “That’s not much reward for a lifetime of serious saving.” It’s also rather unfair, given that someone on a defined-benefit pension scheme can be earning more like £50,000 a year (disregarding the 25% tax-free lump sum) before they are considered to have breached the lifetime allowance.

And while Osborne has now promised that the lifetime allowance will rise with inflation from 2018, there’s absolutely no guarantee of that happening. So the ceiling on pension pots could conceivably fall further – certainly in “real” (after-inflation) terms, if not in nominal terms.

Quite apart from the fairness issue, having a constantly moving target to avoid hitting doesn’t seem like the way to encourage people to save for their retirement. We started a petition at the government’s e-petitions website that drew in roughly a thousand signatures in the brief time it was up before the site was temporarily taken down during the general election campaign, and we’ll be returning to the topic after the election.

The political risk

One useful rule of thumb to remember is that, the further away you are from retirement, the greater the political risk involved in using a pension as your main savings vehicle. Governments can’t resist tinkering with pensions. It’s a fact of life. This isn’t the first pensions revolution (remember A-Day in 2006?) and it won’t be the last.

The most obvious immediate hurdle is next month’s general election. The pension reforms are popular and it seems unlikely that the broad gist of them would be reversed immediately if the current coalition loses power. But there are certainly elements – such as the generous inheritance tax (IHT) treatment – that might fall by the wayside.

And in the longer run governments may well decide again that people can’t be trusted to provide for their own retirement, and go back to forcing the purchase of annuities. That’s why we still believein using an individual savings account (Isa) as well as a pension – just in case.

Watch out for scam merchants

You’ve probably read the blood-curdling warnings about scammers out to take advantage of the new pension freedoms by conning people into taking out their hard-earned savings and investing them in all sorts of tempting-sounding schemes. Jane Vass at Age UK tells The Sunday Times that savers should be on the lookout for people trying to sell them unsuitable renewable energy schemes, for example.

Then there are the “pensions liberators” – who try to persuade the under-55s to “unlock” their pensions – which could result in anyone who does it having to pay tax amounting to as much as 70%. Then there are your usual scammers who offer investments that promise double-digit returns from various forms of exotica – unusual property schemes, supermaterials, rare commodities, and the like.

You might think that you’re too smart to fall for something like this, but the fact is that lots of people do, so don’t get complacent. There will always be new scams around, but there are some basic rules to keep in mind that will help you to avoid them.

Treat cold callers with suspicion. Watch out for companies that have names that sound vaguely like existing well-known companies but aren’t in fact connected to them. Be very wary of unusual investments, particularly those that involve some sort of “green” or ethical spin. And above all, just remember the golden rule – if it sounds too good to be true, it almost certainly is.

What if I’ve already got an annuity?

If you’ve already got an annuity, and you’re gazing enviously at the new pension freedoms, then you might have been heartened by the news in last month’s Budget that the chancellor had decided to look at setting up a second-hand annuity market, where you would be able to trade in your annuity for cash, which would be put back in a pension. Don’t hold your breath: as we noted a few issues ago, there are problems.

One big one is that it’s very hard to value an annuity – and not just for the potential sellers. As the Institute for Fiscal Studies (IFS) puts it, an annuity’s value to a potential purchaser is going to be based on how long they expect the seller to live – that’s what ultimately dictates the longevity of the income stream after all.

The IFS (very roughly) calculates that the median cash value of the annuities in issue to the over-55s currently is just under £26,000. One in four is worth less than £11,000, while another one in four is worth more than £61,000. Even if you’re looking at the higher end of the scale, it’s not a king’s ransom.

But there’s a further problem here. The difficulty for potential annuity buyers is “adverse selection”. In other words, the people who want to swap their annuities for a cash lump sum are more likely to be those with impaired life expectancies.

“If those buying the annuity cannot fully reflect this in the price”, because they don’t have sufficient information on family history or lifestyle choices, perhaps, or because they aren’t allowed to discriminate by gender (women tend to live longer than men so all else being equal, their annuity cash-in price should be higher), then “prices on offer will assume that those looking to sell will be likely to die soon. These prices will be unattractive to many potential sellers.” As a result, the secondary market in annuities may be almost impossible to establish.

Pensions and Isas: the basics

A pension is a wrapper that protects your investments – shares, bonds, etc – from tax. You get income-tax relief on pensions contributions. So if you’re a basic-rate taxpayer, for every 80p you put in, the government tops it up to £1. If you’re a higher-rate taxpayer you get £1 for every 60p you put in, or at the highest rate, £1 for every 55p you put in (though you have to claim the higher-rate element of that in your annual tax return).

Once in the pension, your investments grow free of capital gains and income tax, but the money stays locked up until you are 55. When you come to take the money out, you can take a 25% lump-sum tax free. Income over and above this is taxed. You can save up to £40,000 a year into a pension, as long as you earn at least that much.

An individual savings account (Isa) is also a tax-efficient wrapper. The main differences are: that you can access an Isa whenever you like; the annual allowance is less generous, though still substantial – you can save £15,240 in the year from 6 April; and, while there is no income-tax relief on the way in, income generated by an Isa is tax free.

In terms of tax relief, the 25% lump sum certainly gives pensions the edge over Isas. It’s also much easier with the new rules to manage the amount of income you take each year, so that contributions that benefited from higher-rate tax relief on the way in only end up being subject to basic rate tax on the way out.

Pensions also carry inheritance-tax benefits that Isas don’t. On the other hand, Isas are still more flexible than pensions and they arguably carry less political risk.

What if I’ve got a defined-benefit pension?

A defined-benefit (DB, or “final-salary”) pension means you know exactly what income you’ll get when you retire (usually based on some sort of formula). Put simply, your employer takes all the investment risk on your behalf, and you can look forward to a relatively stress-free retirement, without any concern that you’ll run out of money before you run out of road, as it were.

That sounds like a good deal, and it is – which is why you rarely get these pensions any more outside the public sector. If you’re lucky enough to have a private-sector DB scheme, it’s almost certainly worth hanging on to it. There are really very few reasons why you might want to transfer out to a defined-contribution (DC) scheme instead, to take advantage of the new pensions freedoms.

If you are in poor health and don’t expect to live long, it might be worth considering a transfer to enable rapid access to your pot. And if you want to leave your pension pot to your children it might be something to think about (DB pensions die with you, or sometimes your spouse) – although you’d really need to be sure that your pot would actually outlast your retirement, which suggests you’d have to have significant alternative sources of income. It’s also worth remembering that the new pensions freedoms can be changed or reversed at will by this government or a future one.

So you might swap the security of a DB pension for the flexibility and inheritability of a DC pension – and end up finding that both those advantages get wiped out by a future regime. In short, the vast majority of those with DB pensions should just thank their lucky stars. And if you do decide to transfer for whatever reason, then make sure you get good advice before doing so.