UK Pensions - Your money, your choice
Last year’s announcement by Chancellor George Osborne regarding the pension reforms gave many soon-to-be pensioners cause for celebration. However, sceptics fear the absence of a requirement to turn at least part of the pension pot into a secure income could have gloomy consequences.
It’s legislation that has polarised opinion, and with the new rules set to take effect in a little over five weeks, it’s vital that those approaching 55 have a good understanding of it all.
Until now, savers have been able to withdraw 25% of their pension in a tax-free lump sum. But with the tax on the remaining funds set at an extortionate 55%, the rest has typically been ushered towards “buying” an annuity in order to avoid this charge.
Yet the combination of people living longer and the steadily declining return on annuities has prompted a rethink, and, from April 2015, certain restrictions will be significantly relaxed.
The first 25% of a full withdrawal from a defined contribution pension will remain tax free, but the remaining 75% will instead be taxed at the individual’s income tax rate. Unquestionably though, the game changer is the unprecedented choice for those over the age of 55 to draw down their pension pots with a series of smaller lump-sum payments.
Why is this such good news?
Those with relatively high pension pots will benefit most, and likely use the system to their advantage. Depending on how much the person decides to take out per year, he or she could even end up paying a lower Income Tax rate than they do currently.
Let’s take the example of someone who intends to withdraw their £200,000 pension pot in one go as their only source of income. Under the outgoing regulations, the first £50,000 to be taken out would be tax free. However, up to £77,000 of the remaining £150,000 could end up in the taxman’s pocket (factoring in the personal allowance).
Doing the same in just over a month’s time will see that figure diminish, but as much as £53,600 could still be swallowed up by tax. However, drawing down the pension with four lump-sum amounts of £50,000 over four years would whittle down the amount lost to tax considerably further.
In this instance, the first £12,500 of each withdrawal would again be tax free, while the remaining amount of £37,500 will see the person move into a lower Income Tax bracket (20%). Thus, in theory, just £5,500 might be paid in tax each year, and £22,000 in total.
The caveat to the above calculation is that it excludes the individual’s other earnings and state pension, which HMRC will factor in. However, deferring taking a state pension for the duration of the drawdown period helps to solve this problem, and concurrently increases the state pension itself by 10.4% for each year of deferral.
New-look pension portfolios
Pension pots will ultimately become as liquid and accessible as bank accounts, give or take some administrative time required to process transfers, thus liberating over 55s to do with their money as they please. Breaking the shackles of the traditionally poor returns of an annuity thus means that those looking to go on once-in-a-lifetime holidays, buy a fancy car or give their grandkids an early inheritance can do just that.
Of course, with these new freedoms come greater responsibilities, and the onus is now on pensioners to ensure that their pots will sustain them for the remainder of their life; bearing in mind that a typical 65-year old retiree can expect to live for another two decades.
How soon-to-be pensioners react to the changes remains to be seen, but investment will likely be an attractive option, with the decision to take on some risk a seemingly reasonable one if it can grow the pot.
Annuities will no longer be the automatic choice, but they won’t disappear either, as the guarantee of a lifelong income will continue to entice many people.
Then there is peer-to-peer lending (P2P), which could be seen as a “middle ground” between the two in terms of risk and reward. In the absence of financial institutions acting as an intermediary, lenders are able to earn significantly superior rates of return on their money compared with those offered by banks, without the volatility of stocks and shares, and the imminent inclusion of P2P lending within ISAs will further increase its appeal.
Indeed, the most desirable portfolio of all may well be a mix, with a portion of the pot going towards an annuity or drawdown scheme, and the remainder dedicated to a combination of high and low-risk investments.
Deciding on how to apportion the funds will thus be a very personal choice. But, for an estimated 320,000 people in the UK each year, it’s a choice nonetheless, and one that pensioners have been crying out for. The risks are inherent, but so too, for the savvy saver, are the rewards.