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Pension freedoms – beyond the hype

Much has been said about the government’s planned changes to the way people can access their pensions, due to be in place from April 2015. So much so in fact, that’s it’s been difficult to see beyond the hysteria of some commentators.

So, let’s first look at the facts. What are the key rule changes planned for pensions that may concern pension savers themselves?

• Access to all of their funds in a money purchase pension arrangement (from 55), avoiding the high ‘unauthorised payment’ tax charges that currently exist

• Income drawdown, where an income is taken directly from the pension fund, will be made more flexible by the removal of the ‘cap’ on the amount that can be withdrawn

• A reduced ‘annual allowance’ for pension contributions of £10,000 per year will be introduced for individuals who have already flexibly accessed their pension savings – for those who have not yet done so, the figure remains at £40,000

• A reduction of certain tax charges that apply to death benefits

• ‘Free’ guidance at the point of retirement

• Raising minimum pension age from 55 to ten years below State Pension Age (i.e. 57 by 2028 and 58 by some time in the mid 2030s).

On the face of it then, these changes look to be welcomed, especially with the gradual reduction in annuity rates over the past two decades reducing the faith in pension products by some people. Of course, reducing annuity rates are a direct result of falling interest rates and increasing longevity – issues that do not go away by allowing people to take all of their pension as a cash sum.

But, before we get carried away with the prospect of total pension freedom, let’s look at some hard facts about the changes.

Pensions – better the devil you know?

Let’s not forget that a pension is merely a ‘wrapper’ in which investments are held, benefitting from tax relief on the way in, almost tax free investment while in the pension, and 25% of the resulting fund being available as a tax free sum at the point of withdrawal, not forgetting beneficial treatment for inheritance tax (more on this later).

Some recent research suggests that a large number of people will take money out of their pension and invest it elsewhere, but this is usually unnecessary (unless ‘elsewhere’ is in residential property… again more on this later). But simply put, money held within a pension is tax efficient; money outside of a pension is generally tax inefficient, unless in an ISA, which has its own limitations, offers no wider investment choices than a pension and has no inheritance tax benefits.

This plan then, to take money from pensions and invest elsewhere, could be due to a lack of understanding about what the word ‘pension’ really means, and of the investment flexibility and tax advantages already available within the pension wrapper. That’s not to even mention the potential extra tax consequences of taking money out of pensions, where this pushes someone into a higher tax band.

Free guidance (not advice, Mr. Chancellor)

One of the most commonly discussed areas of the planned changes has been the guidance to members at retirement. The intention (currently) is for this guidance to be provided independently of the pension arrangement, with the Pensions Advisory Service and the Citizen’s Advice Bureau being lined up to deliver it.

Face-to-face guidance is something that a huge number of people could benefit from at retirement, although there’s a risk that the people who would benefit the most don’t take up the offer of guidance available, through either lack of understanding or interest in examining their options at retirement in detail.

Following the Chancellor George Osborne’s reference to “free advice” in the 2014 budget, there has been much debate around what the public expectation of this service would be. But to be clear, guidance is not advice. Many people don’t recognise the distinction, but it is important.

Guidance can help people understand what is possible in certain situations, whereas advice will, at a cost, take the further steps of examining an individual’s personal circumstances, other sources of income and capital, dependants, health and family history and possible need for future flexibility, before recommending what an individual should do at retirement.

Guidance though, is a fantastic starting point, especially to highlight to those individuals who would benefit from taking advice how they can go about this.

Defined Benefit schemes – have their cake and eat it

These changes affect only money purchase schemes. However, members of private sector defined benefits, often called ‘final salary’ or ‘career average’ schemes, can also take advantage of them. The government has confirmed it will still be possible to transfer from a private sector defined benefit scheme to a money purchase arrangement.

For most people, leaving their defined benefit pension alone is going to be more appropriate than transferring it to a money purchase arrangement – defined benefit schemes provide guaranteed pension amounts along with pension increases and survivor pensions.

However, not everyone is in the same boat – there will be certain members of such schemes who, for whatever reason, will be better off transferring and taking advantage of the new flexibilities. It is vital that anyone considering such a transfer takes professional financial advice.

Bricks and mortar

Another expectation is that individuals will take a large chunk (or all) of their pension to purchase property with the intention of renting it out. This, undoubtedly, will happen, as our love of property in this country is well known, with many people considering it a ‘safe’ investment.

There will be situations where this may be a wise investment choice, especially if it provides diversification for people with a large amount of savings and investments. However, before people make the leap as a buy-to-let property mogul, there are some key points to bear in mind:

• Property is expensive. If taking everything out of a pension in one lump sum to fund it, 75% of the fund will be added to the rest of their income and taxed at marginal rate (which could easily be 40%, 45% or even the 60% applying when total income is between £100,000 and £121,000).

• Costs of buying and managing property are significant. As well as the purchase price (or deposit if a mortgage is being used), there is Stamp Duty, solicitors fees, mortgage interest and fees, redecoration, repairs, tax (on rental income, on any capital gain if you sell in the future and potentially inheritance tax if you still own the property on your death), estate agency fees for rental services (how many people want to be dealing with tenants into their 90s?) and estate agency fees when it comes to sell.

• People buying property with the idea of cashing in on lucrative future rises in value need to take special care. Although over the last 20 years or so they would have done very nicely (even taking into account a slight wobble in 2007), it’s unlikely that we’ll continue to see double digit increases each year – we are currently seeing no real increases in salaries, combined with historical highs of house prices to multiples of salary. House prices simply cannot continue to rise at the rate they have been over the past couple of years, so purchasing property with the intention of sitting back and seeing your investment rise in value every year could be a dangerous (and nerve wracking) way to spend retirement.

Death and taxes – no longer a certainty

Money in pensions is outside of an individual’s estate for inheritance tax purposes. In the past however, punitive tax charges have applied on lump sums paid from a pension once an individual started to draw an income directly from their fund (via ‘drawdown’), or after age 75.

One of the government’s key changes is how money held in pensions will be taxed on death. Under the new rules, anyone below the age of 75 will be able to pass their pension on to anyone they like free of inheritance tax, whether or not it is already in payment.

After age 75, if a pension is passed on to beneficiaries as a lump sum it will be liable to a 45% tax charge (reduced from the current 55%). The government intends changing this further, possibly from April 2016, to make the lump sum payments subject to tax at whatever income tax rate the beneficiary pays.

If beneficiaries prefer to take the deceased’s pension as an ongoing income rather than a lump sum, this will continue to be taxed as the beneficiary’s income, as it is at the moment.

A brave new world

OK, so now we know the facts, what do the changes actually mean for people wanting to access their pensions from April 2015?

It means they will have the flexibility to decide what is right for them, without being forced (or even nudged) down a path that might be unsuitable.

It means they will need more help to make sure they are making these right decisions, especially as with added flexibility comes added complication, and therefore the need for guidance and advice.

Annuities will still have their place, whether in the lifetime or fixed term format, for those people with little other income or capital and who need secure, reliable income in retirement. And enhanced annuities will continue to deliver value via a higher guaranteed income for those with certain lifestyle and health factors.

So, while we welcome the additional flexibility, we believe it’s vital that those coming up to retirement understand what the options are as well as the implication of each, to ensure they have a sustainable income in retirement that lasts as long as they do.