In the first instalment of this 3-part series, Money Marketing’s Head of News, Thomas Selby explains all you need to know about the 2015 pension reform.
Chancellor George Osborne stunned the pensions industry when, delivering his penultimate Budget speech in March 2014, he announced the most radical overhaul of retirement rules in almost a century. The idea is simple – the Coalition believes people aged 55 or over should be trusted to spend their retirement nest egg as they see fit. But the ramifications of the changes are potentially enormous for individual investors, the UK as a whole and future generations.
Previously, anyone who did not have guaranteed pension income worth at least £20,000 a year had two basic options on how to spend their savings – enter ‘capped drawdown’ or buy an annuity.
Under capped drawdown savers could keep their money invested in the stock market but the amount they were able to withdraw each year was restricted by the Government. An annuity, by far the most popular option prior to the reforms, locks savers into a retirement income for life.
While annuities remain a “safe” route for consumers who don’t want to take any investment risk, the industry has systematically failed to ensure people get the best deal when they convert their savings into a guaranteed stream of income. Furthermore, the Bank of England’s quantitative easing programme – essentially printing money to boost asset prices – has pushed down interest rates on gilts and corporate bonds. As insurers tend to buy these assets to match annuity liabilities, annuity rates have also plummeted.
In addition, before 6 April anyone who wanted to take their entire pot as cash would be punished with a 55 per cent tax penalty from HMRC.
The new rules, introduced by the Government on 6 April, dramatically liberalise the rules governing how people can spend their pension pot.
“We will legislate to remove all remaining tax restrictions on how pensioners have access to their pension pots,” Osborne told the House of Commons just over a year ago.
“Pensioners will have complete freedom to draw down as much or as little of their pension pot as they want, anytime they want. “No caps. No drawdown limits.
“Let me be clear. No one will have to buy an annuity.” The “tax restriction” referred to by Osborne is the 55 per cent penalty previously imposed when a saver tried to withdraw their entire pension pot in one go. Instead, anyone aged 55 or over in a defined contribution scheme can now take their entire fund as cash and will only be subject to tax at their marginal rate. A quarter of their pension can be taken as cash tax-free, as was the case previously, but any extra withdrawals will be added to earned income when HMRC calculates an individuals’ tax liability. This means anyone who makes large withdrawals from their pot risks pushing themselves into a higher income tax bracket.
Research commissioned Just Retirement, an annuity specialist, found that almost one-in-ten (8 per cent) of people thought they could take their entire pot tax-free.
Just Retirement group external affairs and customer insight director Stephen Lowe says:
Sarah Pennells, founder of consumer finance website SavvyWoman.co.uk, adds:
It’s great that people are excited about pensions and seeing the possibilities the new rules create, but they have to open their eyes to the pitfalls too. There’s a tax trap waiting to catch the unwary – take care not to get snared.”
"Simply spreading withdrawals over a number of tax years could save thousands while keeping the remainder growing in a tax-free environment but still accessible if you to need it.
“There is a danger that some actions that seem like financial good sense such as taking pension money to pay off a mortgage or give lump sums to children could end up handing a large slice to the taxman unnecessarily.”
There are five clear options for savers in this brave new world of pension freedoms: take the lot as cash, by an annuity, enter “flexi access” drawdown, take a series of ad-hoc lump sums (called “Uncrystallised Funds Pension Lump Sums” or UFPLS), or a blend of the above.
Flexi access drawdown is the same as capped drawdown, but without the restrictions. So savers can invest their fund how they see fit, and take withdrawals however they choose.
UFPLS has been described by some in the media as the hallowed “pensions bank account”. However, it is not as simple as this – some providers simply won’t offer the option for a start, while most administration systems will take at least two weeks before paying out cash. Savers will also need to consider the tax consequences of making regular withdrawals in this manner, as only 25 per cent of each withdrawal will be tax-free.
Early indications suggest a significant minority of consumers will withdraw all of their money from their pension. On the first day of the freedoms brokerage firm Hargreaves Lansdown received 150,000 enquiries about the new rules.
Of these, just shy of 8 per cent were asking about taking their entire pot as cash, while over 6 per cent asked questions about their tax-free cash. Hargreaves Lansdown head of pensions research Tom McPhail says:
“It will take some time for a clear pattern to emerge in terms of how investors are looking to use the new freedoms. However a couple of things are already immediately apparent.
“Investors saving with a pension company which doesn’t offer a full range of choices are going to find themselves at a disadvantage and may have to move their money to get what they want.
“Initial demand has been focused on an investment income rather than buying an annuity, though we do expect this balance to swing back to some extent in the weeks to come.
“Relatively few people are asking to take all their money out; we’ll be tracking the sums involved however in the main we expect it to be at the smaller end of pension pot sizes.”
Despite the hyperbole surrounding the reforms, Osborne’s pensions revolution is not a free-for-all. Firstly, anyone with a public sector pension – such as doctors, dentists and civil servants - will not be allowed to take advantage of the freedoms.
Secondly, private sector workers with valuable defined benefit pensions – which pay out a guaranteed retirement income based on the number of years a person has been a member of the scheme – will be required to take paid-for, regulated advice if their pension is worth more than £30,000. This is also the case for savers with old-style insurance policies that contain guarantees.
These safeguards have been introduced by the Government because, in most cases, it will not be in savers’ best interests to swap their guaranteed pensions for a riskier (but more flexible) defined contribution alternative.
Thirdly, millions of savers have older plans which have an exit fee attached if they draw their benefits before a certain age. For these people, the cost of transferring to a new provider to get their hands on their cash could be prohibitive.
Fourthly, while most pension schemes will offer people the option to access their funds through UFPLS or flexi access drawdown, some will not. In these cases, savers will need to transfer their money to an alternative provider but, again, fees could prove a barrier.
Finally, the reforms do nothing for people who have already bought an annuity. However, in Osborne’s final Budget before the general election he set out plans to allow people who have already turned their pension pot into a retirement income to sell it on the open market. Osborne set a deadline of April 2016 to introduce the new flexibility.
But while the Conservatives and the Liberal Democrats have committed to the plans, it remains unclear whether a Labour government would press ahead with the proposals. There are also concerns within the industry that allowing people to sell their pension back to insurers could see savers offered poor deals. Broadstone technical director David Brookes says:
“While in the name of fairness this seems reasonable, the reality of it does seem to be a can of misselling worms where the value for the individual is hard to see and points to an idea that still seems headed for the scrap heap of pension ideas.”The Government has also been warned the risk of fraud could yet undermine the positive publicity created by the pension freedoms. The primary concern is that scammers will attempt to convince savers to use their flexibilities to invest in dodgy schemes with high charges.
“The pension freedoms are hugely popular but they are not risk free. Over time we believe investors will adapt to these new rules and use them to their advantage. “However, the first waves of investors taking advantage of the new rules in April this year are particularly vulnerable to unwanted or unexpected problems with their pensions, so it is vital that everything possible is done to make sure they are well looked after.”To mitigate these concerns, the Government has launched Pension Wise – a free-to-use guidance service that explains the options available to investors and the potential tax implications of taking too much money at once.
It is hard to predict with confidence exactly how much of a boost the mortgage market will receive from the freedoms. However, with roughly 400,000 people reaching age 55 each year, even a small proportion of savers cashing out their funds could provide a fillip – particularly in an environment of rising house prices across the UK.
Alternatively, people who already have housing debt – either through a residential mortgage or through buy-to-let – could use their pension to pay this off.
Respected think-tank the Strategic Society Centre estimates 5 per cent of pre-retirees aged 55 to 64 have a buy-to-let property, while 6 per cent have a second home. “These individuals may be incentivised to use their pension to pay off any mortgage debt associated with such property,” it says. Furthermore, 31 per cent of defined-contribution pension savers aged 55 to 64 have outstanding mortgage debt.
“These individuals may be incentivised to cash in their DC pension savings to pay off their mortgages, even before retirement,” the Strategic Society Centre says.
“Indeed, subsequent cohorts may be incentivised to take on larger mortgage debt in the knowledge they will be able to pay-off this debt with their DC pension savings.
But while the returns offered by bricks and mortar may well be a sound investment for some, experts warn the tax consequences of taking more than the 25 per cent tax-free cash must be carefully considered.
Axa Wealth head of retirement planning Andy Zanelli explains:
“Those looking to take money out of their pension for a buy-to-let property that generates income should think very seriously about the tax implications. A client cashing in a £250,000 pension fund would end up paying 40 per cent income tax on the bulk of this money, 45 per cent on some of it, as well as losing their personal allowance.
“They could end up with somewhere around £165,000 for a buy-to-let property after income tax, stamp duty and various fees. Then there are potential letting agents fees, the potential loss of another 40 per cent if the property is liable to inheritance tax and maybe 28 per cent capital gains tax on the profit if it is sold in the future.
“Bricks and mortar have always had an appeal but the saying ‘Don’t put all your eggs in one basket’ should be heeded here.”
The new pension freedoms offer savers far greater freedom over how they spend their hard-earned pension pots. Some will inevitably be reckless and splurge their new-found wealth on sports cars and expensive holidays, while others will explore a range of investments, including property.
But pensions remain hugely complex and most people with a reasonable sized pot would benefit from discussing their options with a regulated financial adviser.
For those with smaller pots or who don’t want to pay for expert help, the Government’s guidance service (www.pensionwise.gov.uk) is a good place to start.