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How to avoid pension freedom dangers

Making use of pension freedoms incurs a number of risks, but there are ways to avoid or mitigate them
April 28, 2017

Pension freedoms introduced in April 2015 were supposed to benefit investors by increasing the flexibility of their retirement fund, for example, allowing those over 55 to cash in their entire defined contribution pot. Other options include the ability to take up to 25 per cent of your pension as a tax-free lump sum, known as an uncrystallised funds pension lump sum (UFPLS), although anything you take over this amount is taxed as income. But you can move the rest of the money into investment funds, which will pay out a regular taxable income.

When the freedoms were initially announced, the government estimated that the tax take would be £0.3bn over the 2015-16 tax year, but this actually totalled £1.5bn. The Treasury now says its tax take for 2016-17 is likely to be around £1.1bn, up from the initial estimate of £0.6bn. This suggests that individual investors are paying more tax than expected.

HM Revenue & Customs (HMRC) statistics show that investors have withdrawn £10.8bn from pensions during the two years after freedoms were introduced.

Financial Conduct Authority (FCA) figures, meanwhile, show that the majority of people accessing their pension pots for the first time between April and September 2016 withdrew the full amount as a cash lump sum. Of the 302,107 pension pots accessed during that period, 168,765 or 56 per cent were fully cashed out.

The next most popular choice was flexi-drawdown, which accounted for 27 per cent of pots accessed for the first time during this period, followed by annuities, which represented 14 per cent of pots. The least common choice was taking a partial UFPLS, which accounted for around 3 per cent of pots.

"People have been taking far larger average withdrawals than originally expected, which has meant much more has been paid in income tax," says Stephen Lowe, group communications director at specialist financial services company Just. "It was expected that people taking lump sums out of pensions would spread them over four years, but instead they have taken bigger amounts more quickly, leading to higher tax rates and larger tax collection. The problem is that we really don't know if this is starting to turn into a major problem or not - there are no systems in place to look across people's pensions in aggregate, so we have little idea who is taking the money and what they are doing with it."

But it is possible to benefit from pension freedoms without triggering an unexpected tax bill or running into trouble further down the line - if you steer clear of three main risks.

 

Risk 1: running out of money

If you buy an annuity that offers a guaranteed income for life, running out of money in retirement is not a concern. But if you make use of pension freedoms to draw down income and/or take lump sums from your pot there is a serious risk that you could run out of money - especially as increasing life expectancy means your retirement could last for 30 years or more.

And the fact that most people who accessed their pension pot for the first time between April and September 2016 took the full amount is a concern. "People may be accessing more money than they should and so risk running out of money in later life," says Stan Russell, retirement income expert at Prudential.

With flexi-drawdown, meanwhile, if you draw large amounts of income from your retirement fund you risk running out of money. "Investment performance seldom provides a constant return and even a couple of poor performing years, particularly at the start of withdrawals, can have a dramatic effect on how long a person's pension fund will last when taking a regular income," explains Mr Russell.

But Danny Cox, chartered financial planner at Hargreaves Lansdown, argues that it would be surprising if people who have saved sensibly towards their retirement for many years made poor decisions.

"[Of our clients] who take drawdown, about 85 per cent don't draw more than 4 per cent a year, which if you don't want to overspend is generally the maximum amount of income you want to take," he says. "And what we've found with our clients who cash pots in is that [it generally involves] smaller pots of less than £15,000."

In many cases, cashing in smaller pots can make sense as these could not be used to provide a decent annuity, but you need to be aware of the income tax implications of doing this.

Mr Cox says most investors would benefit from taking a mix-and-match approach to retirement income. For example, taking out an annuity that meets the costs of your essential expenditure, and topping up your income through other sources such as state pension, workplace pension or income drawdown.

Risk 2: a higher tax bill

Taking anything over the tax-free amount from one or more of your pension pots may push you into paying a higher rate of tax. This is because pension income is treated as earned income for tax purposes, so your withdrawals over the tax-free 25 per cent will be added to the rest of your income for the tax year.

Everyone can earn up to £11,500 in the 2017-18 tax year before paying any tax. After that, you pay basic-rate tax of 20 per cent on the next £33,500 of income, higher-rate tax of 40 per cent on taxable income between £45,001 and £150,000, and additional rate tax of 45 per cent on taxable income over £150,000.

In the worst-case scenario, you could become a top-rate taxpayer if you make a pension pot withdrawal that, combined with your other income, takes you over £150,000.

Your personal allowance, meanwhile, is whittled away by £1 for every £2 that your adjusted net income is above £100,000, meaning that if your income is £123,000 or above, your personal allowance is zero.

"Someone earning £85,000 might choose to cash in a pot of £40,000 without realising that they would lose all of their personal allowance," explains Richard Parkin, head of pensions policy at Fidelity International. "People have got to be very mindful of that."

At the other end of the scale, retirees who pay no tax because their annual income is less than the personal allowance of £11,500, may make a withdrawal that pushes their income over this threshold.

Also make sure you don't overpay tax when you first take a taxable lump sum from your pension, as this will often be taxed at the emergency rate. This is because HMRC rules mean your provider assumes you will make the same withdrawal on a monthly basis, rather than treating it as a one-off payment. You can contact HMRC to reclaim this excess bill, as explained in our recent article (Have you paid too much for pension freedom?, in the 13 April issue).

If you want to take a cash lump sum from your pension pot you could stagger it over a number of years to reduce the amount of tax you have to pay. "A £30,000 earner cashing in a £30,000 pot would end up paying higher-rate tax on £7,500 of that money, giving a total tax bill of £6,000," says Mr Parkin. "But if they'd taken half the pot this year and half next, they would only pay tax at the basic rate and save themselves £1,500."

 

Risk 3: reduced future pension contributions

Most people are able to make tax-free contributions to a pension scheme of up to £40,000 a year. However, once you take advantage of the freedoms to access a pension via flexi-drawdown or a taxable lump sum, the amount you can subsequently contribute to a pension is limited to £10,000. If you exceed this money-purchase annual allowance (MPAA), the excess amount you contribute to your pension will be subject to tax at your marginal rate.

And the government has been planning to cut the MPAA allowance from £10,000 to £4,000 in an effort to prevent people from recycling this cash into defined-contribution pensions and getting a double helping of tax relief, although this move has been put on hold.

"People will have already started planning for this change and a sensible approach would be to continue to do so as [when it comes in] it may be backdated and still be applicable from 6 April this year," says Jon Greer, pensions expert at Old Mutual Wealth. "Many will prefer to phase into retirement, reducing their working hours and topping up income with pensions. But under the MPAA, those that choose to top up income with a retirement fund and then later make contributions during a period of work could be punished by this regressive curb on the standard annual allowance."

You can avoid triggering the MPAA by maximising your contributions before you start to take lump sums or income. Or you could avoid drawing an income from your pension at all. This is possible by using income drawdown to draw the tax-free lump sum only, without taking regular payments. But this is not possible if you take an UFPLS.

Another option is splitting your pension into parts and converting each part to income drawdown at different times, as and when you need the income.