George Osborne announced a massive pension reform in his Budget.
In this video, Ed Bowsher looks at what the 'pension big bang' is all about, and who it affects.
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Transcript
Hi. In this video I'm going to look at George Osborne's massive changes to the pension system. Now, here at MoneyWeek we think they're really good news. We think they give people a lot more freedom and control over their pensions, and that's very positive. We're actually calling all these changes the pension big bang'. So in this video I'm going to take a look and see what the big bang actually is and, just as important, I'm going to look at who is affected by these pension changes.
So let's start by looking at who is affected.Basically, it's anyone who's still working who has a defined contribution pension. These are sometimes known as DC pensions' or money purchase pensions'. The idea behind that is that through your working life or some of your working life you're making contributions into a pension scheme, and every time you make a contribution the tax man gives you some tax relief, which just boosts it up some more. With some decent investment growth, hopefully by the time you retire you've got a decent sized pension pot that can then provide an income when you're no longer working.
For many people it's not just the employee who contributes to the pension pot. The employer will contribute too. So I might have a pension scheme where, say, I'm paying in 5% of my salary each month and my employer matches that and pays in 5% too, and then the tax man pays in a bit more on top of that. Some employers will pay more than 5%, and some less than 5%. Just depends on what the employer decides to do.
The good news is that more and more people are now getting employer contributions thanks to some previous government changes called auto-enrolment'. So if you've got a DC pension scheme where the employer is willing to make contributions, make sure you sign up and hopefully by the time your retire you'll have built a decent sized pension pot.
Now if you don't have a defined contribution pension, you may have a defined benefit pension; also known as a DB pension or a final salary pension'. Here, the basic idea is that when you retire you might get, say, 30% of your final salary as a pension and then that pension will rise in line with inflation until you die. Now, if you've got one of these final salary pensions, it's really good news for you. Well done, you're lucky. You won't be affected by the pension big bang. You really don't need to worry about this anymore. You can switch off, go away, and do something else more interesting.
But, if you've got the DC pension scheme, please do keep watching. As I said a minute ago, hopefully if you've made these contributions into a DC scheme and the employer has contributed too, you should have a decent sized pot when you come to retire. The big question then is, what do you do with that pot?
Until recently you had very little control. You basically had to use most of the money to buy an annuity from an insurance company. So if you have £100,000, you pay the insurance company, it then pays you a guaranteed income for life which might be say £5,000 a year. The big plus point here is you have an income for life, guaranteed until you die. The big minus points are you don't have much flexibility and also annuity rates in recent years have been very disappointing. People have been really fed up when they discovered how low their annuity actually is.
Well, with the new changes you've now got lots more freedom and lots of alternative options you can choose from. So under the new rules you'll almost certainly be able to take all of your money out of your pot from April 2015. Huge flexibility if you can do that, and actually some people can even take all the money out now, right now, under the new rules.
You just take out that full £100,000 if that was your pot. That's great in many ways. You've now got control and you can decide how to invest your money and get a good income in your retirement. Or indeed you could take all the money out right now, go on a round-the-world cruise or spend it on a Lamborghini. Or, of course, you could mix and match and use some of the money to spend right now and invest some of the money for the long term, or you could even spend some of the money now, invest some of the money now and then use the remainder in ten years' time to buy an annuity when you're heading towards the end of your life.
Now the thing is, when you make this decision about what to do with pension pot there's lots of different issues you need to consider. Ideally you want to get the maximum return possible from your pension pot. You want to get as much money out and actually spend that money as you can. You want to keep your tax bill as low as possible, but you also need to remember that your retirement could last for a long time and you still want to have some income if you're still alive when you're 95 or 100.
If you want to keep the tax bill as low as possible, one thing you can do is take out what's called the 25% tax-free lump sum. So take that money out when you retire. You don't have to pay any tax. That's fantastic. But, if you take out the remaining 75% in one go, you may end up paying more tax than is necessary. So if you want to keep the tax bill down, you may want to spread out the period over which you pull out money from your pot.
If you want to get the maximum return, you may want to leave some of your pot invested in the stock market so you get more growth. Your pot grows to a larger size and you get a bigger return. On the other hand, if you're thinking about living, having a retirement that lasts for 30 or 35 years, you may need to consider putting at least some of your pot into an annuity. It's complicated stuff. Lots of things to consider. I can't go through it all in one video, but don't worry.
Here at MoneyWeek we've put together a free email series that will take you through all the different options that you could choose with your pension pots and we also take you through all the different issues that you should think about. So if you want to sign up for this email series, we have a pension big bang sign-up page on the MoneyWeek site. If you just look below this video right now, you'll see a link to that pension big bang landing page. Click on the link, go through on that page, you can give us your email address and then we'll then send you our free email series on the pension big bang.
It's primarily aimed at people who have just retired or are about to retire in the next year or two. Hopefully it'll really make things less complex. You'll now be less confused. In fact, you won't be confused at all and you won't be scared at all either and you can then make the right decision. So please do sign up for the series if you fancy it. It's completely free. There's no obligation. I think you'll find it really interesting and worthwhile. I'll be back with another video soon, so until then good luck with your investing.
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