Pensions are being radically transformed under plans announced in the Budget last month.
From April 2015, savers will be given total freedom over how they withdraw pension money. In the meantime, temporary measures will be put in place to ease the strain on those seeking a retirement income.
Here we explain how the changes affect savers.
How do pensions work today?
Savers who put money into defined contribution (as opposed to workplace final salary schemes) currently have three options to access the money after age 55.
If they have less than £18,000 in total pension savings, the entire lump sum can be taken as cash (this is called “trivial commutation”). Of this, 25pc is tax-free; the remainder attracts income tax at the individual’s marginal rate.
Savers who have more than £18,000 in cash can take up to two pensions worth up to £2,000 as cash lump sums, again subject to income tax.
The second option, used by the vast majority of pensioners, is to buy an annuity. This is a form of insurance that provides a guaranteed monthly income that lasts until death. A 65-year-old with a £100,000 pension can obtain just £5,800 a year from an annuity today, unless he or she suffers from medical conditions which enhance the payout.
The final option is to leave the pension invested in the stock market and take a gradual income. This is called “income drawdown”. Unless a pensioner can show £20,000 of guaranteed pension income from other sources (for example, the state pension, final salary pensions or another annuity), their annual income is capped.
Currently the maximum a 65-year-old with a £100,000 pension can withdraw is £7,080. Anything withdrawn above this amount is classed as an “unauthorised payment” by HM Revenue & Customs and attracts a 55pc tax charge. As a result, no major pension provider offers this facility.
Individuals with £20,000 of income from other pension sources can make unlimited withdrawals, subject to income tax at the marginal rates. This is called “flexible drawdown”.
What is changing now?
From March 27 2014, the Government will introduce arrangements to give savers greater access to their pensions.
Savers whose total pension savings amount to £30,000 – rather than £18,000 – will be able to take the entirety as cash (“trivial commutation”). This will be taxed at marginal rates.
Savers with larger amounts in pension savings will be able to take up to three pensions worth £10,000 each as cash, rather than two worth £2,000.
Savers who use “income drawdown” will be allowed to take larger sums as income. This is likely to be several thousand pounds extra a year from each £100,000 in savings.
An individual will need just £12,000 of secured pension income from other sources to make unlimited withdrawals through “flexible drawdown”.
When can I make full withdrawal?
The temporary reforms introduced on 27th March 2014 will fade away in April 2015, when savers will be able to access the entirety of their pension at any time after age 55, subject to income tax at marginal rates on three-quarters of the money.
The ability to take the whole pension as one lump of income would mean someone with a £100,000 pension could take £25,000 tax-free and then withdraw the remaining £75,000 to spend or invest as they saw fit.
The £75,000 would be treated as income for that tax year, pushing the individual into the higher-rate tax band for the year.
Will I be able to withdraw more slowly to limit tax?
The alternative will be to take the money in annual lump sums. This might mean keeping the money invested in the stock market and going into “income drawdown”. From April 2015, there will be no cap on the amount of money that savers can withdraw from this arrangement, so income can be varied to stay within the basic rate tax or even nil-rate threshold for the year if desired.
Will I still be able to buy an annuity?
Yes. Those who want to guarantee an income for life will still be able to purchase an annuity. The difference is that they will now do so on their own terms, rather than effectively being pushed down this route due to the restrictions on accessing small pots and the high costs and caps on income drawdown.
Insurance companies have for many years made sizeable profits from selling annuities. Some of the biggest margins are on selling poor value contracts to those in poor health, who should qualify for a boost to account for a lower life expectancy.
With this revenue stream now under threat as annuity sales tail off, the danger of firms trying to sell these contracts inappropriately is as strong as ever. The City regulator is investigating and is acutely aware of the need to protect customers.
The plus point could be a rise in annuity rates as providers are forced to compete to attract a smaller pool of customers.
What’s the catch?
The price for savers will be that access to their pension pots will be pushed back, at the same pace as the State Retirement Age. Initially it will move to age 57 in 2028. This could affect those around age 40 and under.
What if I have already taken a pension income?
The millions of savers who have purchased an annuity already will be tied to that contract. They will be trapped in the old system.
Those who have gone into income drawdown will be able to increase their incomes by calling an emergency “review” with their pension provider or financial adviser. However, this can only take place on the anniversary of the last review.
What will happen to other assets?
From next April, there could sudden drop off in annuity purchases. Pensioners who withdraw the money instead will be able to spend it how they wish. This could be other investments, such as buy-to-let property, but equally it could involve paying down debt.
Those on interest-only mortgages will have the chance to square off debts left by poorly-performing endowment policies, for example. Others may want to spend a small amount of the money on a holiday or to give an early inheritance.
The average amount of money in defined contribution pension savings is £30,000. So it is unlikely that buy-to-let, for example, will get a giant uplift.
How do I decide which is the best route?
The new rules could trigger a wave of demand for independent financial advice. While the Government is giving £20m to insurers and other pension providers to give “impartial face-to-face guidance”, it remains to be seen how this will work in practice. Each individual’s circumstances will be different. Click here to request a call back: Link to contact page.
I’m just about to buy an annuity, should I wait?
Seek financial advice with a qualified expert through Link to contact page. If you have access to guaranteed annuity rates which are only available for a short period at your named retirement date, it may be worth purchasing.
For others, there is no requirement to take an income. Explore the temporary measures, but also consider waiting a year – if you can – for the full reform.
Some annuity providers, including LV and Partnership, will accept cancellation if you are in the cooling off period. LV has extended this window to 60 days.
Source: The Telegraph