For some time there have been calls for an overhaul of pensions due to their lack of flexibility.
In the space of six months two radical changes have been proposed.
The way we receive income in retirement has fundamentally shifted. For all but a few, retirement income is based on the fund we have built up.
At retirement we face two choices – either to draw an income from the fund, or purchase an annuity. With longer life expectancy, annuity rates have gradually come down making annuities less attractive for many. However, the ability to have a fixed income for life still appeals because drawdown income still retains investment risk.
The announcement made earlier this year changed all of this. It is proposed that from April 2015 individuals can take as much income as they like at retirement (subject to income tax).
Additionally individuals can ‘cash in’ the whole fund pension and use the money as they so wish (also subject to income tax). The announcement caused the price of shares in specialist annuity companies to crash because it was assumed that this would be the end for annuities.
As the dust settled many have accepted that although some individuals may take the whole fund as cash, there are disadvantages of doing this:
- The fund will be treated as income and therefore any individual taking the fund will be taxed at the highest marginal rate
- Funds will be moving out of a tax efficient environment, and therefore not only will individuals be taxed as they take the money out but potentially they could be taxed if they re-invest the money to provide an income
- Funds will move out of an IHT favourable environment and therefore could form part of an individual’s estate
- Funds could reduce any benefits or potentially be used for nursing home fees (although there is some argument under the new rules that the pension will be a target because there is no restriction on income)
In conclusion, although the headline is exciting, the reality is that the proposed changes provide more flexibility on the level of income an individual takes, (which is good news) but care will need to be taken on the management of the income and fund.
Currently a 55% tax charge is payable where the pension fund is paid as a lump sum when the fund is in drawdown or where the individual is over 75. A dependent can receive an income which would be taxed at a marginal rate.
The Chancellor has announced changes which appear to be coming in from April 2015 – although there remains some uncertainty around the timing as the wording is ambiguous.
As it stands the rules are radical and make drawdown very attractive if carefully managed.
Death benefits pre 75
- Whether an individual is in drawdown or not the whole fund can be passed to the chosen beneficiaries free of tax, i.e. without the 55% tax charge on the fund
- Beneficiaries can draw income, tax free, if taken via the new flexible income route
If the rules come in as they are stated then this is significant, and in theory individuals could withdraw the whole pension fund tax free.
- Where an individual chooses to take the whole fund tax free they are likely to move it from a tax efficient environment to a taxable environment (if they are looking to invest it or use it to provide an income)
- If an individual is in receipt of means-tested benefits then this could impact on those benefits
- Any large lump sums would form part of an individual’s estate
However, beneficiaries could use the fund to pay down mortgages, purchase property, pay off debt etc and therefore would not fall into a taxable environment.
Effectively the pension becomes like an ISA for the beneficiaries, with the flexibility to do what they want with the money.
A cautionary note, the written press and even the HMRC appear to imply this favourable tax treatment is a fantastic giveaway. The question is whether when the final proposal comes out will there be a sting in the tail……?
Death benefits post 75
The big difference now is twofold – firstly benefits on death can go to any named beneficiary (spouse, children, grandchildren etc) and those beneficiaries can choose whether to take the benefits either as a cash lump sum or income.
Unlike an individual who dies pre-75, the income and lump sum will be taxable.
It appears the income will be subject to the new flexible income rules so there is no restriction on the level of income but it will be taxed at the beneficiary’s rate of tax. If they want to take the full amount as a lump it will be taxed at 45% (which is the highest rate of income tax currently).
There are two things that strike me with these changes: firstly, life expectancy being longer these days means that the majority of people are likely to live past 75 so the giveaway on tax may be calculated in that the actual loss to the revenue will be minimal. Secondly although it may be appealing to take the fund as a lump sum, the ability to take as income (or not) may be more attractive because it is in a tax efficient environment and individuals can take any amount at any point in time.
There is a considerable amount of excitement about the changes and what these will mean.
Two things are certain; firstly there will be greater flexibility with the level of income that individuals can take, and secondly death benefit treatment will make pensions an attractive option for those wanting to leave benefits tax-free to children or grandchildren.
We argued that we thought annuities still had a place; this latest change challenges this. Although an annuity gives certainty of income there is currently little flexibility with death benefits. Therefore a lot of care will be needed in retirement planning and shifts the emphasis away from ‘direct offer’ providers (i.e. no advice given) to financial planners.
The date for the diary is the 3rd December when we should know more……
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.