Welcome to the first in a series of blogs on pensions. We’re diving straight into the juicy topic of pension freedom. And if that tempting intro hasn’t got your attention, this just might…
Few areas of personal finance have undergone such dramatic change in recent years as our pensions. These changes directly affect what money you’ll have and what sort of lifestyle you’ll be able to afford when you retire. That’s reason enough to make sure you’re clued up.
Pensions have a reputation for being a tad boring with the potential to disappoint; they can be a source of frustration, panic too in uncertain times. But avoiding pension panic is easily done with a bit of knowledge-building to clear the air and discover the simple reality that a good pension is a wonderful thing: a tool you can optimise and use to your advantage.
In the words of Money Saving Expert Martin Lewis
“a pension is just a tax wrapper – a bit like the cling film you can put around a sandwich to protect it… in this case from the taxman.”
The key benefit is the opportunity for long-term saving with the help of generous tax reliefs. And the challenge is to take advantage of new opportunities and get savvy about our pensions.
Why? Because this is the age of pension freedom.
Change you need to know about: how are pensions different now?
The new pension freedom regime, introduced in April last year, has transformed the pensions landscape, giving millions of people greater control over how they use their long-term savings to fund their retirement. The big difference is that people now have access to their entire pension from the age of 55.
Before and after pension freedom
Previously pensions worked something like this. Once you hit 55, you would have the option of taking 25% of your personal pension tax free.
The rest you’d need to use to buy an annuity: an insurance product that pays you an income each year until you die. Sounds fair enough, but you didn’t have a lot of choice, which wasn’t ideal especially when annuities spectacularly underperformed…
Why annuities have a bad rep
The problem with annuities is that the payout rates have crashed over the last 15 years. That’s unless your pension pot has a guaranteed annuity rate.
Why the crash? Firstly, life expectancy has grown; and secondly, gilt yields have taken a plunge. Annuity rates are closely tied to long-term gilt yields – as yields rise, annuity rates for new retirees go up. And vice versa. According to Tom McPhail of financial advisers Hargreaves Lansdown, over the past year there’s been a steady decrease in gilt yields and annuity rates.
And now there’s Brexit to contend with. Just Retirement and Retirement Advantage have both announced cuts to their annuity rates, and experts say more are likely to follow. But that’s another blog entirely.
If you look at payouts since 2008 you feel the true extent of the plunge. Payouts are down 37%. Eight years ago, a 65 year old with a £100,000 pot could have bought an income of £7,855. Today they’d be looking at £5000.
New pension rules and the freedom to choose
Enter the then-Chancellor George Osborne, wielding the flag for pension freedom and the promise to unchain people from the old pension regime. In the 2014 Budget, Osborne announced his pension freedom plans, which would start in the 2015/16 tax year.
You’d still be able to buy an annuity, but you now had far more choice. And with that choice comes important decisions to make and pitfalls to avoid.
Key things to understand
With the new pension freedom regime, once you hit 55 you can take out everything as a lump sum; the first 25% is still tax free but the remaining 75% is taxed as if it were a salary at your income tax rate.
One pitfall to avoid here is bumping yourself up a tax bracket and gaining a hefty tax bill.
If you’re still working, your tax contribution would work like this:
You can earn up to £43,000 a year (2016/17) before you pay the higher 40% rate of tax. So if you earned £30,000 then took a taxable £10,000 out of your pension it’d still be at the 20% basic-rate. If you took £15,000 out, £13,000 would be at the 20% rate, the rest at the 40%.
So when they’re ready to retire most people will look to avoid withdrawing too much in a year to avoid tax eating into money they could otherwise spend or invest.
One way of doing this is by steadily tapping into your pension pot. Under the new rules you can make multiple lump sum withdrawals and get the first 25% of each tax-free. So you have the opportunity to keep your pension invested and simply take chunks of it out as your retirement income, which you can spend or reinvest.
A saver with an £80,000 pension pot would previously have been able to take £20,000 as a tax-free lump sum and would typically use the rest to buy an annuity. Now they could take £5,000 every two years, for example, and get £1,250 of each chunk tax free.
How people are using their pensions under the new rules
Data from the Financial Conduct Authority shows 40% of 55 to 59 year olds have left their money invested and taken an income as above. Even more, 44%, have taken lump sums. Whilst data from insurers shows around one in five savers used money obtained via the new pension freedoms to pay off debts, rising numbers are choosing to reinvest their money. The most widely bought funds were generally UK income funds, according to Hargreaves Lansdown.
Commentators also report widespread interest in using pension pot money to invest in property. Again tax is a big pitfall here. Calculations by Hargreaves Lansdown show if you were to take your entire pension and invest it in property, the upfront tax for accessing all your retirement savings would be a significant drag on future returns.
But using pension pot money to take advantage of the benefits of property investment isn’t off limits. Online investment has made it possible for DIY investors to invest smaller chunks of their pension in property. Platforms like LendInvest provide access to the solid returns of bricks and mortar in the form of short-term investments in property without big upfront costs.
The death of the 55% death tax
Another major change is the removal of the death tax when passing on pensions. Previously, if someone died aged 75 or over, without having spent all their pension funds, the money was taxed at 55% (unless a spouse or civil partner or dependent child under 23 took an income from it).
Now, if a person dies before the age of 75, whether or not their pension has been touched, it can pass to their beneficiaries completely free of tax. The money can be both transferred to and withdrawn by the beneficiary tax free.
If, however, the saver dies at the age of 75 or more, there is some tax to pay. The old 55% tax has been replaced by an income tax charge on money withdrawn from the pension. This charge is at the new owner’s top (or “marginal”) rate. So anyone who pays the basic rate of income tax will pay that rate (20%) on money withdrawn from the pension. If the pension withdrawal boosts their income in that tax year to above the 40% threshold, they would pay 40% or even 45% on the amount above that level.
A way out of inheritance tax?
Does this mean you can put money into a pension and avoid inheritance tax when it passes tax-free to your family? Technically wealthier pensioners who do not need their pensions to live on can ring-fence their savings for their family in a pension. But many experts advise against it. There is a concern that HMRC will not look kindly on those it believes are gaming the system. Tax relief on pensions for higher-rate taxpayers could also be curtailed according to industry experts.
Retirement expert Alan Higham said that while leaving your pension to loved ones is tempting, it ‘is not without risk from an IHT point of view’. He said that under the ‘disposition of assets’ rule, HMRC can levy IHT if it believes individuals are using pensions to shelter money.
Do the new rules apply to all pensions?
Pension Freedom mainly applies to private pensions where you and/or your employer saved up a pot of cash for retirement. These are known as ‘defined contribution’ or ‘money purchase’ pensions.
It doesn’t apply to the state pension.
People with ’defined benefit’ or ’final salary’ pensions, which provide you with a guaranteed income for life based on set criteria, won’t benefit from much of the new promised freedoms – including an ability to pass pension assets on to children.
Those with final salary pensions can, however, take up to 25% of what their pot is judged to be worth as a tax-free lump sum, although they will then get a lower retirement income to reflect this.
People who have already retired can’t cash in their annuity at the moment. But the Government has said that people will be able to do so from April 2017, so we’ll update this guide when more details are available.
Another major pitfall to avoid is fraud. Fraud remains a real problem as criminals seek to exploit the new freedom regime bombarding people with texts and cold-calls that promise people the opportunity to withdraw their money.
You can only take your cash out once you’re 55. If someone is promising to do it for you early, beware they could be a pension liberation scammer. Other cons include calls offering to cash in final salary pensions and a variety of other creative but dangerous promises.
All in favour of pension freedom?
For those who know what they’re doing pension freedom is great, but it also means it’s easier to make a mistake.
These are just a few of the concerns voiced by financial commentaries to date:
On the one hand there’s a concern that many will be nervous about releasing the cash in case they’re left with none in old age and will therefore sit on it, never spending it, depriving themselves of the benefit and living a worse life than necessary.
On the other hand there’s the worry that people will take advantage of the new freedom without the knowledge to use it to their advantage. Mistakes include withdrawing too much too quickly and being hit by a big tax contribution. Others fear some may be tempted to withdraw everything and spend it leaving them with no money to support them in later life.
Get guidance and financial advice
The government has set up a free guidance service called Pension wise. There is a good step-by-step guidance on ‘What you can do with your pension pot’, which includes a follow-up on each option with a tax calculator.
If you’ve a sizeable pension pot it’s worth spending the £300 to £1,000 it’ll cost to get an independent financial adviser who can tell you what to do (get quotes from a few first). You can find a local one through VouchedFor or Unbiased – read more info on that in our guide on Financial Advice.
Disclaimer: The purpose of our content is to support you in your financial goals with helpful information. We don’t offer advice, so please seek independent financial advice if you need it. You should always be aware that, as with any investment, on the LendInvest platform your capital is at risk.