The new pension freedoms - what are you planning?
The new pension freedoms starting April 2015 open up valuable opportunities to use pensions much more flexibly to enjoy a comfortable retirement. The ability to draw on your pension more or less how you wish – if it is in a personal pension or some other defined contribution scheme – is a great new freedom that could allow you to spend your money as you wish.
But there are potential pitfalls. The potential tax costs of this new freedom could turn out to be penal. The investment risks could mean that many people will run out of money. What’s more, many will fail to make the most of these valuable new opportunities.
Our aim here is to explain very briefly some of the new options and how they may affect you. After you have read this you may decide to come and have a discussion with us about the advice and other help you may need.
The new freedoms
Until now, most people have been severely constrained by the rules on how they could take their retirement benefits. But the new rules from April 2015 mean that when someone reaches the age of 55 they can have the freedom to take as much of their pension fund they want, when they want.
So your main options when you reach 55 or later will be:
- Take the whole of your fund in cash — A quarter of the fund is normally paid free of tax. The remainder will be taxed as income.
- Use the pension fund to provide an income for life — You could buy an annuity to provide a guaranteed income or you can draw down money directly from the fund to provide a flexible income.
- Leave as much as possible of the value of your pension pot to your family — The pension can now be used as a really tax-efficient vehicle for inheritance tax planning.
It is important for your decisions to be centred around your own personal goals and circumstances. The new rules, especially in relation to tax, can make the decisions complicated and there are some major pitfalls for the unwary. Here are some points to think about if you are considering any of these options.
Option 1: “I want the money and I want it now”
The new pensions freedoms may lead you to the conclusion that you would like to draw out all the money in your pension pot as soon as you can. Some people want to blow all their money on a big holiday or an expensive car. Others aim to reinvest it.
If that’s your first idea, you should think hard about the possible impact on your finances - especially the resulting income tax bill. Remember, three-quarters of anything you draw from your pension pot will suffer income tax. The taxable amount will be added to your income and will taxed at anything up to 45%. At the very least, it will probably make sense to spread the encashments over several tax years.
What’s more, taking all the cash now will probably mean you won’t have enough to live on in retirement.
But one reason some people may want to cash in all their pension now could be the desire to make another type of investment, such as a buy-to-let property. Leaving aside whether this is a sensible investment in itself, there are two things to consider before making such a move. As we have seen, the tax costs of switching out of your pension pot and into some other investment are potentially huge, giving you much less to invest than you would have if you left it in the pension. In any case, there are very wide investment opportunities in pensions. A pension is just a tax efficient pot for holding money.
You could of course just take up to a quarter of the fund as tax free cash without such adverse income tax consequences. The rest of the fund could then be drawn more slowly as you need it.
Option 2: “I want to use the pension fund to provide an income for life”
Most people want their pension to provide them with a retirement income that will last the rest of their lives – and also the lifetimes of their partners or spouses.
The first key issue is to determine how much income you will need in retirement. Then it’s necessary to relate that to how long it will be required and what return can be expected from the investments in your pension pot. That can be quite a complicated exercise and your investment will need to be reviewed and adapted to your changing circumstances as time goes by.
There are several ways to provide an income in retirement. The conventional method is to buy an annuity – a regular income paid and guaranteed by an insurance company. But in recent years, pension drawdown – taking the income directly from the fund - has gained in popularity. And the rules about pension drawdown have been liberalised and many more people are therefore choosing this route.
There are also some new products that insurance companies and other providers are launching. They aim to provide a halfway house between the safety of an annuity and the flexibility of drawdown. So they can look superficially attractive but they vary considerably in design, quality and cost.
One of the advantages of drawdown under the new rules is that you can draw the tax free cash from the pension gradually to provide your income in the first few years of retirement. The rest of the fund can then be left to draw on later when your income tax rate might possibly be less.
Option 3: “I want to leave as much as possible of the value of your pension pot to my family”
One of the unexpected outcomes of the new pension freedoms has been the opportunity to leave your pension fund free of inheritance tax to the next generation – and it will be possible for them to leave it to their successors as well. Pensions can be a new way for wealth to cascade down the generations of a family.
The income tax position of the pension pot you leave for the next generation will depend on your age at death. If you are under 75, it will be tax free; if you are 75 or over, it will be subject to income tax. If that’s your aim, it is important to secure your retirement income from other sources and to make sure your pension trust arrangements are properly set up.
The new freedoms have led to new risks and greater complexity. We believe that many people will want to combine several of these solutions. It may be best to use drawdown in the earlier years of retirement, and then later buy an annuity with at least some of the pension fund. You may need to use some of your pension funds to generate an income, but you could find that there are funds left over to pass down to your family. The new rules even allow the possibility of making further pension contributions after starting to draw funds from a pension pot.
The choices can be complicated, bringing together tax, investment and financial planning skills and knowledge. The Government has recognised the difficulties that many people will now face as they approach retirement and has introduced a free guidance scheme called ‘Pension Wise’. The aim is to try and stop people making some of the more obvious bad choices and to point people towards professional advisers where they need this kind of help.
We believe that many people will require professional advice on a one-off or ongoing basis to consider the various possibilities opened up by these pension freedom. You may feel that you owe it to yourself and to your family to make the best use of the new pension and financial planning opportunities and to avoid the numerous pitfalls.
For more information on your specific situation, please contact us at 020 7614 1000 or by email at email@example.com.