The General Election delivered some big surprises and left some Pollsters looking for a new job, but it also served to hide the biggest change to pensions in the UK for decades. This was the introduction of ‘pension freedoms’ – a change which allows anyone reaching age 55 with savings in a ‘defined contribution’ pension (rather than a ‘defined benefit’ or ‘final salary’ pension) to withdraw some or all of that money at any time to spend or invest elsewhere as they wish, subject to some tax charges.
Many argued that this was simply a Tory vote-winning wheeze to attract people in their 40s or older who would love the sound of this new freedom, even if they didn’t end up using it. With the Tories now in with a majority Government, it is hard to argue with this suggestion.
Many in the pensions industry have cried foul, not least I suspect because of the enormous negative impact it has had on those pension companies that sold hundreds of millions of pounds worth of annuities each year to a legally captive audience. That captive market has now gone – permanently – as has the higher share values of the companies affected.
However, not all of those that have questioned this reform can be dismissed over vested interests. Many campaigners for those on lower incomes are worried that this change panders to wealthier people for whom this new freedom could be highly useful, at the expense of those that previously benefitted from the wider pooling offered by everyone being forced into an annuity and for whom the new freedoms are largely an unaffordable and potentially dangerous distraction.
Like so many things associated with pensions, time will tell.
So what might the new pension freedoms mean to you?
For a start, at age 55, it will present you with fundamental new choices. You will – for the very first time – get ongoing, full and open access to the money you have saved in any defined contribution pensions up to that point, including any Personal Pensions, SIPPs and others. That money will have been boosted over the years by some quite generous tax reliefs. When the money was invested, it would have earned back the income tax you had theoretically paid on it, at the highest rate you paid at the time. In addition, like an ISA, the money invested grows free of capital gains tax while in the pension.
When you take money out, you are entitled to 25% of it entirely free of tax, which is a great perk. Any amount you take out above that will be subject to income tax at the rate that applies to you at the time.
Many commentators had fun when this freedom was first announced, talking about people cashing in their pension to buy a Lamborghini, or some other such insanity. Already the reality is proving far less exciting, with most people thinking carefully before doing anything dramatic with their pension savings. Nobody can cash in without confronting the fact that the money they have saved in their pension was to provide them with an income in retirement, beyond the very modest amounts paid by a State Pension, for as long as they live. So the big risk that this freedom creates is people spending all their savings too soon, and running out of money to live on as they get older.
For many, this whole matter is a storm in somebody else’s teacup, as for them, if they only have modest savings, the best thing to do might still be to buy an annuity which will guarantee to pay an income for the rest of their days.
This will mean that when you die, any money theoretically ‘left over’ in your annuity will be gone – that is what pays for the guarantee that it will be paid for as long as you live, however long that may be.
The other thing that has made annuities unpopular is that the rates paid – the amount that determines how much you will get each month as income – have been very low for years now. And once you have bought your annuity, that rate – and that level of income – will apply permanently from that day on.
So what are the alternatives?
The choices can be bewildering, so take a deep breath! In fact, I will limit this to a brief summary here, and follow up with another blog expanding on each. So here is the summary:
Tax-free cash – you can withdraw up to 25% of your pension pot whenever you like after age 55 in one go or in a number of chunks, as and when you need them, and escape all forms of personal tax liability. The rest of your pot can be left invested, enjoying ongoing pension tax relief, until you want to access it in a number of different ways you can choose from (see below).
This is a great way to access a lump sum for anything from paying off any remaining mortgage, funding home improvements, or even investing the money elsewhere, where it can produce attractive regular sums to top up your income.
Drawdown – this is an arrangement where the money stays invested in one or more funds, similarly to how you were saving into the pension to grow the pot of money, but you start to withdraw an amount each year or each month as you like. The value of the money that you leave in the pension continues to go up or down as per the funds in which you are invested. This arrangement is widely offered by pension providers, and has existed for a long time as a way to draw money down from your pension pot before you reached age 75, when the old rules insisted you bought an annuity. Once you have withdrawn more than 25% of your fund, further withdrawals would be liable for income tax.
Use a Self-Invested Personal Pension (SIPP) – you may already be saving into a SIPP in which case you can simply withdraw money from that as and when you want it, leaving the rest invested or in cash as you prefer. If you haven’t got a SIPP, you could take one out and move the money you have invested in other pensions into that SIPP, investing it where you wish.
SIPPs are simply a pension ‘wrapper’ enabling you to hold any assets that are pensions-eligible including funds, shares, foreign shares, bonds, debentures, commodities, commercial property and cash. Subject to certain restrictions applying to some of these asset types, you can then withdraw the money at your discretion, whilst leaving the rest of your pot invested and enjoying pension tax relief. Once you have withdrawn more than 25% of your total pension savings, further withdrawals will be liable for income tax.
Look out for my next blog, in which I will explore each of these alternatives in more detail. I will also take a look at the wider range of options available outside of pensions that could be attractive income generators. This will include buy-to-let, ISAs and alternative finance products like peer-to-peer lending and some forms of crowdfunding.
The information contained in this article should not be used by consumers to make financial decisions. Consumers have a range of different financial needs and requirements and as such should always seek independent professional financial advice before making an investment decision.