A little knowledge can go a long way
Pensions Freedom presents retirees with more opportunities and complex considerations than ever before.
Very few of the frequent changes that take place in the world of personal finance – many of them imposed by governments and regulators – make much of an impact outside the industry itself. But the changes in the pension rules, described under the heading ‘Pensions Freedom’ and implemented at the start of the current tax year, are an exception. For those aged 50 or over, the new rules have quite rightly been described as the most important changes to the pension regime for decades: they will, however, be equally significant for those in their 20s, 30s and 40s, too.
The reason is simple: the changes are potentially too important to ignore and, unusually for legislative changes, the implications could be positive for a significant number of people.
The changes affect what you can now do with the pension savings you’ve accumulated over the years. There are, of course, caveats. The new rules apply only to one type of pension, known as ‘defined contribution’ schemes, and not the final salary schemes common in the public sector and some companies. While it may be possible to covert a final salary scheme into one which qualifies for the Pensions Freedom benefits, these schemes can carry significant other benefits and it is essential to seek advice before taking such a major step.
It’s also important to understand that, while the freedoms may generally be favourable, there are some potential tax drawbacks, along with some other restrictions, that must be taken into account before making any decisions. First, the good news: as far as the essence of Pensions Freedom is concerned, the clue is in the name. The key milestone is your 55th birthday – because from then onwards there will be complete freedom to take as much or as little of the money in your pension fund as you like, although your choice could have tax repercussions.
This means, crucially, that getting access to pension savings need not wait until retirement, although of course it will still be an option to leave savings to grow until a retirement date is reached. Indeed, for many people, that will actually be the most sensible option as pension savings are, by their very nature, intended to provide financial support through a long retirement.
But now there are plenty of other options, too. First, some may find it useful to draw upon pension savings long before they are ready to retire. These days, people in the later stages of their working lives can find things getting a bit bumpy, with gaps in their pattern of employment as they opt to reduce their hours or change careers, which can leave gaps in their income. The result can be cash flow problems that make it hard to cope with the costs of family living – school and university fees, even mortgages. Now, if necessary, it will be possible to take some money from a pension pot to cover such contingencies – and then, subject to certain limits, pay it back in when a new job is started.
Now for the bad news: complete Pensions Freedom could come with a tax cost. Under the new regime, you will no longer be restricted to taking only 25% up front as a tax-free lump sum. Instead, you can choose to take lump sums when you need them – with the first 25% of any such payment paid tax-free and the remainder taxed at your highest marginal rate.
While the reforms make the whole business of pension planning much more flexible, they should not detract from the fact that pensions are a long-term savings vehicle. Most people dramatically underestimate their life expectancy: a 65-year-old man could expect to live for a further 18.6 years, according to calculations from the Office for National Statistics; while a woman’s life expectancy at that age is even higher, at 21.1 years. A pension fund may, therefore, need to last a considerable amount of time: the more you take out of it in a lump sum, the less that will remain to generate an income in retirement.
The tax benefits attached to pension fund contributions have been steadily eroded: the maximum annual contributions is now £40,000 and the Chancellor announced a further restriction in the Budget in March, cutting the maximum amount that can be accumulated, tax-free, in a pension pot to £1 million, from April next year. But they are still generous enough to mean that pensions should be one of the core savings vehicles for most individuals. The tax concessions, combined with complete freedom to access your money after 55, means that, for many people, it would make sense to think of their pension as their main long-term savings vehicle – or, at the very least, as one of the biggest components of their long-term financial planning.
From now on, pension saving can be about far more than just retirement – it can allow almost complete flexibility in managing your financial affairs later in life. Indeed, these days, a growing number of people don’t really accept the whole idea of ‘retirement’ anyway.
Many have every intention of continuing to work and to earn money – perhaps on a part-time basis or in a consultancy role – indefinitely. For them, and especially for those who have accumulated large pension pots, the most valuable opportunities now available may be to do with drawing their pension benefits more slowly. They’re now free to keep some or all of their money invested in their pension fund so that it has more time to grow in value and not look to take an income from it until their earnings are lower and the tax implications are less horrendous. Pensions Freedom is good news for them, too.
It’s important to be clear that the new freedoms should only be considered as part of a complete long-term financial plan. For many, the most valuable freedom will continue to be, quite simply, the freedom to enjoy a reasonable standard of living in retirement, and to be able to live their lives without the fear of running out of money. Over the years, by far the most popular way to eliminate this fear has been to convert pension savings into an annuity, a financial product that can pay a guaranteed income for life.
Some commentators have suggested that Pensions Freedom marks the ‘death of the annuity’, but this is likely to be proved wrong – at a time of ever-increasing life expectancy, the basic need for financial security in later life isn’t going to go away. But in the new Pensions Freedom world, for those who can afford it, an annuity may be home for part of their pension savings, rather than for the whole amount.
In summary, while Pensions Freedom is undoubtedly welcome, opening more opportunities than ever before, it also adds extra layers of decision-making to the process of retirement, and makes the decision on how, and when, to take benefits even more complex.
Whatever your existing pension arrangements, plans for future contributions or plans to take advantage of the new pension freedoms, it is essential that you consider your options and their implications carefully before taking any decisions. Before rushing out to use your pension to buy a Lamborghini, as pensions minister Steve Webb alluded to, you should seek professional advice. Whether you’re already well past the age of 55, just coming up to that magic age, or still planning for it from a long way in advance, it’s a financial issue that’s too important to ignore – and, for once, in a good way.
The level and bases of taxation and reliefs from taxation can change at any time. The value of any tax relief depends on individual circumstances.