Apples and pension freedoms carry similarities
2015 saw radical changes to the way pension benefits could be paid in retirement; suddenly it seemed everything was much simpler. I still remember the headlines the next day about using the pension fund to buy that yacht or sports car you had always dreamed about.
It is worth adding that not everyone could benefit from these changes; if you have a defined benefit scheme (i.e. a scheme that gives you a guaranteed pension, like a nurse’s pension) then potentially these changes do not apply.
In this blog, I want to explore three aspects of pension freedoms – firstly how income can be taken, secondly how it changes inheritance tax planning and thirdly how it might be used for those with defined benefits.
What are the options?
Essentially there are now six options open to people when they come to retirement:
- Leave the money where it is (we will cover why this might be an option when we look at inheritance tax planning)
- Use the fund to buy a guaranteed income for life (an annuity)
- Take an income from the pension fund, called drawdown
- Take money in chunks known as uncrystallised funds pension lump sum
- Cash in the whole pot
- Take a combination of these
These options are available from age 55, or 57 from 2028.
I discovered that there are 7,500 different types of apples grown in the world; luckily when we get to the supermarket this has been distilled down to perhaps fewer than ten to choose from. Of course, we probably know the ones we like and therefore the final decision is easy. But if we didn’t have someone to do this for us how would we decide what was right for us?
Apples and pension freedoms carry similarities. There are many permutations of what can be done at retirement and each one opens up different questions.
Annuities appear to have become less and less attractive over the years.
Giving up a pot of money for a guaranteed income when the level of income is so low no longer appeals; £100,000 used to give a guaranteed income of about £10,000 a year, now it is about £3,000 to £4,000 a year. On paper, it now seems a poor investment. But when £10,000 p.a. was offered life expectancy was 7 years, and it is now 20 to 30 years in retirement. So, although the income value is lower it is being paid for a much longer period, so judging what is good or poor value is not as simple as it first seems.
Taking the whole pot as cash seems an attractive option but there are considerations; there will likely be income tax levied and this could push people into higher rate tax. If the fund after tax free cash was £100,000 then tax might be £40,000 so the actual amount payable would be £60,000. If you assumed, you could buy that £100,000 holiday home in Spain suddenly you only have £60,000…it makes a big difference.
Drawing an income seems an easy option but this comes directly from the pension pot and careful planning must be done to ensure that the pot doesn’t run out. This might seem simple but consider that life expectancy is now 2 or 3 decades, and the effect of income withdrawal on investment strategies does not always do well.
In summary, what looks fairly straightforward needs a great deal of careful planning and management.
Inheritance tax planning
This has become a crucial aspect of pension planning. Pension funds can now be passed down generations, and the great thing is that it is shielded from inheritance tax. This is new and changes a lot of things when it comes to planning.
So, what are the rules:
- Any beneficiary can be nominated and on death of the member pre-age 75 the beneficiary can elect to receive the benefits as a lump sum or a regular or flexible income. Importantly all withdrawals will be free of tax
- Post-75 the same applies but benefits will be taxed
Take an example of someone with say £500,000 in investments and £500,000 in pensions. It may be more tax efficient to take the income from the investments, which could be paid tax free by using ISA and capital gains tax allowances. This reduces the capital outside the pension and reduces potential inheritance tax liability. To offset the reduction in investments the pension fund is left to grow and provide an inheritance tax free investment for the children or grandchildren.
In summary, this is a means of legitimate inheritance tax planning which can reduce tax bills on death. It is worth adding that not all pension providers offer this, it is important to check that they offer beneficiary drawdown because if they don’t then on death the money cannot be moved to another provider who does offer it and therefore the flexibility this offers is lost.
Defined benefit schemes
Pension freedoms only work for defined contribution schemes; which is basically a pot of money built up in a pension scheme with no guarantees to the amount it pays in retirement (for example, a self-invested personal pension).
For some people, they will be members of a defined benefit scheme (where there is a guaranteed pension at retirement) or have been in the past. Recently there has been a surge of transfers out of defined benefit schemes; the reason for this is that schemes are offering what appear to be attractive cash values in return for giving up the guaranteed pension. That money can then be moved to a defined contribution scheme (for example a self-invested personal pension scheme).
Unsurprisingly the FCA are concerned about this because they are worried people are being forced into giving up valuable benefits.
Take an example, a member of a guaranteed scheme has a pension of £7,000 a year payable from age 62. He is currently 48 and the scheme have offered him a transfer value of £270,000. Say the pension income grows to £12,000 by the time he retires then that is a very attractive benefit, but if he dies then the scheme pays half of that pension to his wife. The question is why would anyone consider giving up that pension. This the position the FCA is coming from.
However, there are many reasons why it might be considered. If the pension fund grew by 4% a year after charges, then the fund would be about £460,000 at age 62. Assuming an income of 4% a year that would be £18,400 which is potentially more than under the existing scheme. On the flip side the pension under the defined benefit scheme will increase automatically in retirement, whereas any increases from the pension fund must be self-funded.
Equally where the income is guaranteed for life under the existing scheme it is not under the new arrangement. So, what looks attractive might not be because the responsibility lies with the person not the pension scheme. Another area to consider is death benefits; under the existing scheme the pension dies with the member and his spouse. If he moves the money away he has created a fund which can pass down through the generations. This becomes an attractive death benefit for children, grandchildren or other beneficiaries which previously was not available.
In summary, the FCA is right in that defined benefits shouldn’t be transferred because members lose valuable guarantees, but there can be reasons for considering a transfer particularly the death benefits aspect. It is worth adding that the Government prohibited transfers out from unfunded state schemes (for example Teachers Pension scheme), so this option is not available to them.
To conclude
Pension freedoms is innovative as it changes how we plan our retirement and use our investments in the most tax efficient way. But far from being something easy, it unravels a raft of different questions which also applies to defined benefit schemes, where the debate can be down to guaranteed income vs death benefits.
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. 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.