In Budget 2014, Chancellor George Osborne announced radical new pension freedoms that looked set to crush the annuity industry and change the basis for retirement planning. In essence, all pension investors - not just the very wealthy ones - are to have total income flexibility in retirement.
The rule changes will come into effect in April 2015 and mark a complete departure from the Treasury's previous stance in which it said it had a moral obligation to prevent investors from exhausting their pension savings. In April 2015, if you want to and are at least 55 years old you will be able to take your entire pension out in one go, subject to income tax, and spend it exactly how you wish.
Until now, pensions policy has been to restrict income in retirement either by pushing people into annuities that provide guaranteed income for life or allowing them to draw income directly, but within strict limits that won't exhaust their pensions too quickly. This worked well for people who only had pensions as a source of income for retirement. However, it was extremely frustrating for those who had built up alternative sources of income, via, for example, individual savings accounts or buy-to-let property.
The surprise announcement on pension freedoms felt like a stab in the back for many who took out guaranteed annuities for life just before the Budget - there is no way to reverse an annuity purchase in order to take advantage of the new rules. Many say Mr Osborne's Budget 2014 speech signals that pensions policy is a tool that governments will continue to tweak at will, and without consultation. In fact, the lack of consultation with investors and pension providers was one of the most shocking elements of this pension policy U-turn. Until Budget 2014, all major pension policy changes had been subject to months or even years of consultation with industry and consumers.
In the immediate aftermath of the Budget, life assurers that provide annuities saw steep falls in their share prices. In the months following the announcement, annuity providers attempted to hold rates as high as possible. However, a slowdown in demand coupled with plummeting gilt yields took their toll and the third quarter of 2014 saw annuity rates plummet by 3 per cent to the lowest level since November 2013.
As a result, many experts are advising people to seriously consider whether they can afford to wait until April before taking their pension income because there will be a flurry of new flexible products. Nevertheless, if you would have been inclined to opt for income drawdown anyway, you're still going to face the same issues over drawing an income directly from your pension, albeit with a bit more flexibility.
The traditional guaranteed income for life that stays flat through retirement doesn't really fit most people's needs. Most commonly, there is a U shape to retirement income needs, made up of three stages. In the United States they call these the 'go go years', the 'slow years' and the 'no go years'.
In the 'go go' years, typically ages 55-75 (although this will vary a lot) you might travel the world and spend lots of money on having a good social life. In the slow years, typically 75 to 85, your income needs drop. In later life, many people need a higher income to pay for healthcare, or residential care.
Everyone's U shape will be different. And the new pension freedoms will make a U-shaped income easier to produce.
How it could go wrong
There will be plenty of consumer risks surrounding the new pension freedoms.
■ Companies will be lining up to persuade pension investors to part with their money, whether this is for the holiday of a lifetime, a new car, or another early retirement treat. Plus investment schemes that are at best unregulated and at worst bogus will be out to get a slice of your freshly released pension money.
■ Those who would previously have bought annuities can still do so. However, they may be tempted to stay invested, meaning they will face new worries about how to invest the money and whether they will run out of money before they die. Investors who suffer capital losses early in retirement often struggle to make these back.
■ People who don't understand the rules properly could end up paying too much tax. Or pay tax that they weren't expecting to pay.
Should you transfer out of a final-salary scheme?
Members of so-called 'gold-plated' defined-benefit (DB) schemes, also known as final-salary schemes, will not have access to the new freedoms unless they transfer their benefits to a defined-contribution (DC) scheme such as a self-invested personal pension (Sipp).
Nearly all final-salary schemes allow you to transfer what is known as the Cash Equivalent Transfer Value (CETV), which represents the value in cash terms of your existing benefits. These transfer values are more generous now than they have ever been because they are calculated with reference to gilt yields - which are very low.
However, if you want to transfer out there will be a statutory requirement to first take advice from an independent financial adviser. Transferring out won't be suitable for everyone. Many will find that the guaranteed, inflation-protected income that comes from a final-salary pension is an unrivalled source of comfort in retirement. Defined-benefit pensions also often come with substantial benefits for dependants, should the retiree die before them. These benefits can be difficult and expensive to replicate via personal pensions.
EIGHT REASONS TO LEAVE A FINAL-SALARY SCHEME
1. You have other assets to fall back on. If you can secure a better income from doing so or already have an alternative income to meet your needs. This could apply to someone with high levels of savings in an individual savings account (Isa) or a buy-to-let landlord.
2. You are in bad health and aren't likely to see an average length pension. If you are in ill health or have a shortened life expectancy you may want to enjoy a higher level of income through a defined-contribution pension. The guaranteed, generous but inflexible income of a final-salary pension is not as crucial for someone in ill health as it is for people who want their index-linked pension to still be paying out 30 years later.
3. You are single or your partner has independent means but your DB scheme provides for a spouse's pension.
4. You have a very small DB pension pot with funds less than £30,000. You may prefer to have this as a lump sum to spend.
5. You don't trust your former employer to keep funding the scheme. Or you think your former employer is in trouble. A DB pension is only as good as the company behind it. Alan Higham, retirement director for Fidelity Worldwide Investment, says that the chancellor's recent abolition of the death tax on products such as drawdown and annuities raises the likelihood of those in DB schemes transferring out if they are in ill health. This could, in turn, create funding concerns for DB schemes as they seek to pay out benefits to their remaining members.
6. You want to pass more to your family. In many final-salary schemes, the income generally ceases on the death of the member and their spouse. The option of transferring valuable benefits into a Sipp in order to pass on a share of a pension fund to children may prove attractive, although will not be for everyone.
7. Your pension will not be fully covered by the Pension Protection Fund if your former employer becomes insolvent (the cap at age 65 for 2014 is £36,401 annual income)
8. You are happy not to ever buy an annuity and want more flexible benefits.
KEY POINTS ABOUT PENSION FREEDOMS ■ From April 2015 individuals will be given the freedom to withdraw their entire pension pot as cash after age 55. ■ Those paying into a personal pension or a self-invested personal pension or a workplace pension which is classed as a DC pension will be affected by the changes. DC schemes are those where an employee and maybe their employer make contributions, and that money along with any returns is paid out on retirement. ■ As the rules stand, those in government-backed publicly funded DB schemes will not be able to transfer their money out. This means teachers, NHS employees, civil servants, police, fire service and armed forces will all be denied the chance to access their pension as a lump sum. |
Caution on buy-to-let dreams
Ipsos Mori research conducted for Hargreaves Lansdown suggests that 12 per cent of pension investors plan to take their entire pension as cash. Many of these people will hope to use their pension money to invest in buy-to-let property. And new stamp duty rules could push more people to try to follow their dream of becoming a landlord.
Patrick Connolly, a certified financial planner with Chase de Vere, says: "The advantages of property investments are that people can see that they own a real tangible asset, rather than a number on a statement from a pension provider. They can benefit from the capital appreciation of the property and, through rental payments, could benefit from a consistent and regular income."
However, anyone looking to withdraw their pension pot and invest it in property should think carefully about the tax situation. Firstly, only 25 per cent of the initial withdrawal will be tax-free, with the rest taxed as income. That will significantly deplete the funds available to buy property. Adrian Walker, a retirement planning expert at Old Mutual Wealth, says: "An individual withdrawing £200,000 would face a minimum tax bill of £53,627. After property fees, we calculate they would have just £144,373 left to spend. That is not enough for a one-bedroom flat in many parts of London and the south-east."
A 7 per cent yield on a £144,373 buy-to-let property would generate £10,106 income. However, if you had left the £200,000 in a pension you would only need a 5.05 per cent yield to achieve the equivalent income.
Buy-to-let assets will probably be more heavily taxed on death than pension assets, meaning you have less to leave behind for your loved ones. Plans to scrap the 55 per cent 'death tax' on pensions mean investments left in a pension will in future be transferable to beneficiaries with zero tax for those that die before 75, or at the beneficiaries' marginal rate thereafter. By contrast, a buy-to-let property would typically be included within the individual's estate, making it liable for inheritance tax at 40 per cent.
You also need to think about the risks of buy-to-let. Mr Walker says: "Many retirees may feel able to manage a buy-to-let investment now, but should consider their ability to do so later on in retirement and remember that they may need to sell the properties if they need long-term care in the future."
Investing in buy-to-let means you take out a large exposure to fluctuations in the rental and house price market. You could already be overexposed to residential property through your home. Investing in a balanced portfolio of liquid investments helps spread risk. Mr Connolly says: "Most people can only afford to buy a small number of properties so they may be unable to spread risks, and property is quite illiquid, meaning that investors might not sell quickly at the price they want.”
Interest rates could start to rise shortly after the new rules come in and mortgage payments will then become more expensive, impacting the yield on the property and its price.
