Pension changes: How will they affect you?
There have been widespread complaints that the pensions system wasn't fit for purpose for years. An ageing population has meant the number of pensioners is increasing every year and many are struggling financially. In order to tackle the crisis – and win support ahead of next year's election – George Osborne unveiled big changes to pensions in his 2014 Budget. But how has the Chancellor's announcement changed your income options in retirement?
First, changes that have already come in:
- Increased access to small pensions – If your total pension is no more than £30,000, you are now able to withdraw the whole lot when you retire. The cut-off used to be £18,000.
- You can take up to three pensions worth £10,000 each as cash – Anyone with large total pensions savings spread across different pots can now take them as cash in these amounts. It used to be limited to two worth £2,000.
- Increased income – Pensioners who opt for 'income drawdown' will be able to draw down a higher income. Previously, this was 120% of the equivalent annuity income but it is now 150%.
- Easier access to flexible drawdown – Previously, you had to prove you had pension income of at least £20,000 to qualify for flexible drawdown plans that allow you to withdraw as much or as little as you choose. That has now been cut to £12,000.
All of the above changes were introduced on 27 March 2014 but further tweaks are due to take place next year as the government also announced it is consulting on how it can allow savers to have unrestricted access to their pensions when they retire.
These changes – to be introduced in April 2015 – mean anyone approaching retirement will have far more choice over how they fund their later years. You could still opt for an annuity, withdraw your cash and invest it as you see fit, keep it invested and take an income from it, or a combination of all three.
"The key considerations for those nearing retirement remain largely unchanged," says Andy Zanelli, head of retirement planning at AXA Wealth. "Each person approaching retirement must think about how they want to spend their later years and, more importantly, how they fund it."
So what should you do? First and foremost, seek expert advice. Managing your retirement income is the biggest financial consideration most of us will face. For the past 40-odd years most of us will have received a monthly income without having to give any thought to investment performance or risk profiles. All of a sudden, you will need to make some big decisions regarding financial instruments you may never have come across before, so it is definitely worth getting advice from an independent financial adviser.
But you should also familiarise yourself with the income options available to you, so you can make an educated decision.
"With some of the changes announced in the Budget subject to a consultation process and not coming into force until next year, people should take their time and think carefully about their options," says Zanelli. "It could mean the difference between achieving the retirement they want or finding themselves financially stretched in later years."
The attractions of annuities
Rumours of the death of annuities have been greatly exaggerated. When the Budget was first announced, the future for annuities looked uncertain and the share price of major providers tanked but in reality many people will still opt for this much maligned income option.
With an annuity, you hand over a set amount and in return you get a guaranteed annual income for the rest of your life. So you get peace of mind knowing that you aren't going to run out of money.
"While flexibility is great, many people will still want at least some level of guaranteed income for the remainder of their life, or in other words an annuity," says Andrew Tully, pensions technical director at MGM Advantage. "This will be especially important as people get older, an insurance policy against 'living too long'."
While returns on annuities are fairly pathetic right now – a 65-year-old man with a £100,000 pension pot could expect to receive a maximum annual income of just £6,000 at the moment – they come into their own when it comes to longevity. Yes, the man in the above example would have to live to be almost 82 before the annuity provider begins paying him anything more than his own pension pot but with people living longer that security of knowing you aren't going to run out of cash in your later years is pretty valuable in itself.
The main advantage for those approaching retirement is that they don't need to lock up all their pension pot in an annuity. Now you can use part of your pension to give you that peace of mind of a guaranteed income but keep the rest of your pot to manage yourself.
We could also see new types of annuities emerge as a result of the pension reforms. Tully believes we will see providers create more flexible annuities where people have more control. "Investment-linked annuities may also grow in popularity – the ability to take a flexible income while still controlling the investment approach but with the benefits of an underlying guarantee and mortality subsidy reducing risk," he says.
If we won't all be buying annuities in the future, what will we do with our pension savings? The new rules mean most of us will be able to opt for 'income drawdown' to fund our retirement.
This is where you keep your pension pot invested and withdraw an income from it. The benefit here is that you get to keep hold of your pension savings and retain control over what happens to them.
As well as living off the interest from your savings you can also withdraw some of the capital each year. Under the old rules, you could only withdraw the equivalent of 120% of the annual income you would have got if you had bought an annuity but that has now been raised to 150%. So our 65-year-old man would be able to withdraw around £9,000 from his pension pot each year plus any interest income he earned.
The obvious drawback to income drawdown is that you risk running out of cash, which is why many people may choose to combine income drawdown with a smaller annuity.
Take your money and run
The final choice you have is to withdraw the whole lot and do whatever you like with it. If you take this option, the first 25% can be withdrawn tax-free but you'll pay income tax on the rest, taxed at your marginal rate of tax (whatever income tax rate you pay).
While you could use that cash to tour the world, most of us will have more sensible plans. Experts predict people will use the money to invest in buy- to-let property in order to set themselves up with a monthly income plus potential capital growth. Or people may use the money to clear debts so they have lower outgoings in retirement.
This cash-in option will be especially useful for couples where one person has a much smaller pension pot than the other. They can cash in the small pension pot to clear mortgage or other debt or invest as they wish, while using the larger pension to set themselves up with a small joint annuity and income drawdown, so they have a regular income for the rest of their days.
If you do plan to cash in your pension pot, think twice before withdrawing it all at once. With 75% liable for income tax, you would be better off spreading those withdrawals over different tax years in order to utilise your personal allowance – how much you can earn before income tax kicks in – to minimise your tax bills. Also, money held within a pension isn't liable for inheritance tax, so it may well be better to leave it where it is and only withdraw what you need.
A change for the better
All in all, these pension changes are long overdue and could help a lot of people take control of their retirement income and have more flexibility to use their hard-earned savings to fund the retirement they desire. Moreover, the government is also insisting that consumers are given free financial advice before they make any decisions.
While there are those who say that letting people avoid annuities and manage their own pensions could lead to people blowing their cash, this is a far-fetched argument when you look at the current reality. According to the Financial Conduct Authority, the average pension pot is just £17,700. That buys an annuity income of just £1,062 a year using our earlier 65-year-old healthy man example. So making that person buy an annuity doesn't put them in a position of wealth.
The key to making these pension reforms work is a concerted effort by the government and the pensions industry to educate people so that they make the best possible investment decisions for their retirement.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.