UK pension reform

With all the news about UK pension rules changes and even the possibility of spending all your savings, what are the choices at retirement?

Much more flexibility than before

Many people in the UK retiring from April 2015 now have much more flexibility as to what they can do with their retirement savings. Finding out information about choices can be complicated, and although many online sources do well on the generalities, they also seem so incomplete or elusive to the facts that trying to work out exactly what’s going on can be frustrating.

One of the better explanations appears in this video, by Killik’s Tim Bennett:

What are the choices now with our pension pot?

First, a lot depends on the type of pension you have. If it’s a final salary scheme (direct benefit, or DB) then the usual advice is to leave it where it is. You know these are generous because companies are closing them down at vast rates. But you can move money to a DC scheme (see below) if you want, and in certain circumstances, it’s the right choice. If yours is a scheme funded by the state, there is no option to move the money elsewhere (because there isn’t any – it’s paid by taxpayers not a fund). If the scheme is a money purchase scheme (defined contribution, or DC) then there are a number of options available, which loosely distil down to these five:

• Do nothing, perhaps making further contributions but not withdrawals

• Make one or more withdrawals from the “uncrystallised” fund. 25% of the value of each withdrawal is tax free, the remainder is treated as income. Further contributions are restricted to avoid the fund being used to recycle tax benefits.

• “Crystallise” the fund, taking a lump sum of up to 25% tax free, and go into “drawdown” with the remainder. The total value of subsequent withdrawals are taxed as income and no more contributions are allowed.

• Buy an annuity with the fund, paying a specified amount each month for the rest of your life. Annuity payments are taxed as income.

• Remove all money from the fund. The first 25% is tax free and the remainder is treated as income in the same tax year. Invest it or spend it on what you like. Really.

Not all these options are mutually exclusive, either. You could buy an annuity with part of the fund whilst keeping the rest in “drawdown” – useful as a risk management exercise, if you want to have some level of guaranteed income. Or you could make a number of uncrystallised withdrawals before buying an annuity at a later date. Also, and perhaps annoyingly, just because the law allows all these things, any particular pension provider may not, or may charge.

The words “uncrystallised” and “crystallised” will appear a lot. Basically, a fund is “crystallised” as soon as it goes into drawdown, which in turn is triggered if you take all or part of the 25% tax free lump sum. The first 25% of any withdrawal from an uncrystallised fund is tax free (this is known as a UPFLS and there is a lifetime tax-free maximum which applies), but with the crystallised fund, all withdrawals are taxed, mostly because you have (hopefully) already taken your 25% tax free amount. Which choice to make depends on a number of things, including your nervous disposition and your tax situation.

Annuities

Let’s deal first with annuities. Contrary to urban myth, these are not dead. But with the new rules in place, we can expect some more imaginative designs coming to the market. Traditionally an annuity will pay you a certain amount each month or year depending on your life circumstances and whether you want that amount to increase with inflation. Women get lower annuity payments than men but because they statistically live longer, the total amount paid by the provider will be about the same in both cases. And if you want your annuity payment to increase each year then the starting value with be somewhat lower than if the annuity payment is to remain constant. Again, statistically the deal is worth about the same.

Under the new rules, annuities can be designed differently, and payments can be allowed to decrease with time, for example. Look out also for hybrid products which combine annuities with drawdown, for example.
The case for annuities hasn’t changed, though. Although the annuity rates today are rubbish compared with historic averages, and that’s the fault of our low interest rates, even an expensive annuity will buy peace of mind. Anyone who doesn’t care to worry about investment returns in a drawdown account would sleep far better with an annuity than with anything else available in this space. It’s the price of certainty.

Something to keep in mind, though, is the 25% tax free lump sum. Annuity payments are taxed as income, although this isn’t an issue if payments are below the basic allowance (there being no other source of income). In order to reduce the amount of tax paid on the pension, it is likely to be worth taking the 25% lump sum and using it to pay off debts, to pay for things which you will need in the near future or investing it in an ISA.

Drawdown

In many ways, a pension fund in drawdown is much like a pension fund before drawdown. It can hold a wide range of qualifying investments, and it might be managed by a pension provider (usually a life insurance company) or it might be self-invested. The difference is mostly in the tax treatment, although there used to also be a maximum amount per year a fund in drawdown was allowed to pay out which has now gone.

Anyone who has knowledge of investments, or has a requirement for an irregular cash flow might find drawdown a useful alternative to an annuity. On the plus side, usually unlike an annuity, any money remaining after death can be passed to a beneficiary. On the minus side, anyone enjoying a long life might find they run out of money.

To crystallise or not to crystallise?

It’s an important decision. Once the fund is crystallised, it can’t be uncrystallised. The individual’s tax situation is likely to be a major determinant here, as well as the individual’s need to use the fund to provide the main source of income. This is best shown using two examples.

Example 1 – a higher rate tax payer

Although Mr Toad already has a good payment from his final salary scheme, he also has a DC scheme his financial advisor recommended many years ago and which he can now, being 55 years old, draw upon. Being a 40% tax payer, he likes the idea of taking a 25% tax free lump sum but he knows he doesn’t actually need this money yet. But he would like to cash in 7% of his DC pension pot to buy a new car.

Mr Badger did some calculations for Mr Toad and suggested he keep his pension pot uncrystallised. Yes, he would have to pay higher rate tax on 75% of his withdrawal, which means he has to liquidate 10% of the pension pot to buy the car rather than 7%, but any withdrawals in the future will also attract tax relief on the first 25%. If he crystallised the fund, then amounts withdrawn under drawdown will each be taxed at the higher rate, meaning he eventually pays more tax.

In fact the only case where the crystallised fund would be as tax efficient for Mr Toad as the uncrystallised fund is when the full 25% tax free lump sum is withdrawn.

Example 2 – a non-tax payer

Mr Mole was never in a final salary scheme, but he did save in his employer’s DC scheme, into which his employer also contributed. Now, at retirement, he looks at the annuity rates and yawns. He then reads about his other options, and calls his friend Mr Badger.

Mr Badger explains that because Mr Mole has no other sources of income, he would be well advised to make use of his personal tax allowance of £10,600 each year. He explains that Mr Mole should take the 25% tax free lump sum, perhaps to buy the land he’s currently renting for his burrow or to open an ISA, then choose an annuity or drawdown with the remainder. Mr Mole has got quite interested in investments since working at Toad Hall, and would like to manage his own pension fund, so he chooses the drawdown option. He can then pay himself a modest amount of money each year, perhaps even avoiding paying tax altogether. If he did not crystallise his fund, he would have to pay tax on 75% of his lump sum.

Unlike Mr Toad, Mr Mole can make use of his personal allowance and an income from a fund in drawdown or from an annuity and maybe even pay no tax at all.

Take all money from the pension pot

This is the most drastic alternative available under the new rules, and crystallisation doesn’t come into it, because there will be nothing left. Whilst the pension pot has thus far been invested to buy income at retirement, there is no law stopping anyone from withdrawing the whole amount. As with any UPFLS, the first 25% is tax free and the remaining 75% is taxed as income, which means that even a basic rate tax payer might find themselves paying 40% tax on at least part of the value. The only thing to remember is that you can’t have your cake and eat it. Once the money has been withdrawn, it can’t be put back and there will be no subsequent income of any description (apart from the state pension). As Tim Bennett says in his video, there might be a temptation to buy a property and let it out for income, but is this really what you want to do in retirement? As always, though, this may be the option that is right for some people some of the time, and I won’t attempt to advise anyone one way or the other.

Real world pension choices

The two examples are deliberately simplified extreme cases, and the case for withdrawing all the money from a fund can only be made by an individual in the context of wider financial provisions. Many people will be somewhere between the these various options whilst others will have particular life circumstances which might overwhelmingly dictate one course of action over another. Having more than one DC pension fund to call on might also add another degree of complexity, as you may or may not wish to merge the funds into one product.

But I hope the illustrations help to explain how to set a course through the bewildering number of alternatives available.

Death and taxes

These are famously the two certainties in life. But now death has acquired a certain multidimensionality to it, at least as far as a pension fund goes. The April 2015 changes also ushered in more flexibility about how pensions can be transferred after the person’s death, such as to whom and subject to what tax. This article doesn’t deal with death, but if the fate of a fund or annuity is a concern, then I recommend looking up information elsewhere.

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