This article would examine the April reforms to UK pensions that will let savers withdraw their money early. Are these reforms likely to help or hinder savers and investors?
by Dr. Ros Altmann
(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)
A revolution is taking place for UK pensions. From April 2015, the old inflexible system will give way to a brand new era of freedom and choice. All aspects of pensions are affected – whether you are saving in a personal pension scheme or an occupational pension scheme, the pensions landscape is changing dramatically.
Under the old rules, pensions were very inflexible for most people. Any money that you had saved in a pension was locked in until later life and then, when you needed to take some money out, you were forced to buy an annuity. An annuity is an insurance policy in which an insurer takes your pension fund and then promises to pay you a specified amount of regular income until you die. One quarter of the fund could be taken tax free, but the income received on the remainder was taxed.
The majority of pension savers had no choice but to buy these annuities, which have become much worse value in recent years, as the amount of pension they paid out in exchange for your fund is tied to long-term interest rates and the lower rates fall, the less pension income you receive when buying an annuity. Most people do not understand annuities and received no help with their purchase. They were usually offered a standard annuity product, that made no provision for their partner, no allowance for poor health and no inflation protection. Unfortunately, many bought the wrong type of annuity but, uniquely in financial products, once an annuity is bought it can never be changed. This irreversibility has left many people stuck in products that do not suit their needs and put many people off pensions.
Those with the largest pension were, however, able to avoid buying annuities. Some could use an income drawdown fund, which allowed them to take out money each year but the amounts that could be withdrawn were strictly limited by Government rules and they had high charges. A tiny minority of people with the very largest pensions actually had the freedom to take as much money as they liked, or could even move their fund offshore to avoid tax, but most people had to convert their pension savings into a carefully controlled income stream, paying tax at their marginal rate on the withdrawals.
In future, the rules that forced people into annuities are gone, and everyone over age 55 will be able to choose what is best for their needs. You can withdraw all the money, you can buy an annuity if you want to, you can just take some tax free cash and leave the rest invested, it is up to you.
The fact that you no longer need to buy an annuity means that the investments in your pension fund need to be reconsidered too. Under the old rules, most pension funds – in anticipation of annuity purchase – would automatically switch your investments from riskier assets into bonds and cash in the five or ten years before the retirement date you had selected when you started the pension. This is now outdated for two reasons, firstly because you don’t need to buy an annuity and secondly because you may be working longer and will not stop working at the date you expected many years ago.
There is further exciting news too. Under the old system, any money left in your fund when you died was taxed at 55%. That meant you wanted to minimise the money in your fund as you reached older ages. But that draconian death tax has been abolished and in future the money in your pension fund can pass on tax-free – no income tax, no inheritance tax – as a pension for your loved ones. So you can think of passing pensions down the generations. Keeping money in your pension for longer makes sense and it could help you fund long-term care too if the need arises, which was not possible with annuities.
In theory, these new rules give you more choice and control over what to do with your pension, opening up exciting new opportunities for you. But there are also new risks. Now you have to make choices – and take far more responsibility for your decisions rather than being dictated to by Government rules. Unfortunately, however, in practice many pension firms seem to be intending to den y you the new freedoms and force you to move to another firm if you want to benefit from them – indeed you may even have to pay a penalty to move as well.
In order to help, the Government has set up a free, impartial financial guidance service called ‘Pension Wise’ which aims to ensure you have information and some help to understand what options are available and guide you to finding out what might be best for you to do.
Pension Wise is really important because you need to beware of many of the risks in the new system.
There are several key risks you should bear in mind. The first and probably most important is to understand the tax implications of any decisions you make. If you cash in all your fund you may regret it later. And dont’ think that having, say, £50,000 in your fund means you have £50,000 to spend. You lose quite a bit in tax. It may sound really attractive but in practice many pension companies may not offer the new freedoms.
Money Purcahse Annual Allowance may mean you want to stay in capped drawdown
I would expect pensions to be far more attractive and they are certainly very efficient from a tax perspective.
However, it will be vital to ensure you understand the system – ideally most people would benefit from paying for independent expert financial advice, on top of the free guidance.
Don’t be in a rush to take money out of your pension fund. Just because you are allowed to, does not mean you should. There are powerful reasons why you might want to simply do nothing when you reach age 55. If you don’t actually need the money, it can stay invested and hopefully grow further over time. If you are still working or have other pensions, you may just want to leave the fund alone. Many people have not saved enough to see them through several decades of retirement and the longer you work and keep saving, the more you should have to live on in later life.
Public sector workers will not be able to participate in these freedoms as they do not have a fund. Council workers will have the freedoms if they want them, because local authority schemes are all funded, but NHS, teachers, civil servants, police and armed forces are unfunded schemes.
Overall, these reforms are a fantastic opportunity for people to put more money into their pensions, with reassurance that the money will be able to work better for them and with even greater tax incentives to keep the money for their advanced old age. Then, if you die before you have spend it all, your fund can pass on tax free to the next generations. Keeping pensions all in the family is a powerful attraction indeed.