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How do I avoid breaching the pensions lifetime allowance?

This investor's pensions are close to the lifetime allowance limit
How do I avoid breaching the pensions lifetime allowance?
  • Alan could consider stopping contributions of £375 a month into his Sipp
  • It is a good idea to reduce risk and volatility, at least for a proportion of investments, when drawing an income
Reader Portfolio
Alan 56
Description

Defined benefit pension, Sipp and Isa invested in funds and shares, cash, residential property.

Objectives

Retirement income of £4,000 per month, pay off mortgage, avoid breaching pensions lifetime allowance.

Portfolio type
Managing pension drawdown

Alan is age 56 and has recently left employment with a voluntary severance package which should fund his living expenses until next April, and some home improvements. His partner is age 56 and earns £50,000 a year.

Their home is worth about £450,000, and has a mortgage of £138,000. Alan may pay this off when he turns 60 using an occupational pension lump sum. But if he thinks he can make a better return by investing the money he will instead refinance the mortgage.

“I would like an income of £4,000 per month when I retire,” says Alan. “I'm not sure whether to return to work as a teacher in the immediate future on a full or part-time basis. If I work part time I could draw my former workplace pension at an actuarial deduction of 12.2 per cent and/or my self-invested personal pension (Sipp.) The former workplace pension, a final salary scheme, would otherwise pay £30,000 per year from age 60 and this amount will increase in line with consumer price index (CPI) inflation.

"If I do resume work, should I join the pension scheme, which would be a career average one, and get the benefit of three times salary life insurance?  

"If I don’t go back to work, in each of the next two tax years I will withdraw £58,000 from the Sipp. From age 60, I will draw £18,000 per year from the Sipp, paying income tax on 75 per cent of that. Together with £30,000 per year from my former workplace pension I should get £43,500. I will start to receive the state pension from age 67, so will reduce the Sipp withdrawals to  £6,700 per year to keep within the for higher-rate tax threshold for Scotland.

"I aim to reduce the value of the Sipp to avoid breaching the pensions lifetime allowance and keep my income below the higher rate-tax threshold. I also don’t want to draw from my former workplace pension early, if possible, because of the actuarial deduction.   

"I am very close to the pensions lifetime allowance limit. The value of my former workplace pension is £687,000 and it continues to grow in line with CPI. My Sipp, into which I make gross payments of £375 per month, is worth about £323,000.

"My partner plans to work until age 60. She also has a final salary pension worth about £448,000. She expects to receive £67,500 as a lump sum at age 60 and a pension of £22,500 per year. She also invests £50 per month into an individual savings account (Isa) invested in a FTSE 100 tracker fund, though tends to avoid investing and holds cash.

"I regularly make small adjustments to my Sipp and Isa to rebalance them, although I keep the same core holdings and hang onto ones which have rewarded me. I need to manage the Sipp’s volatility to avoid exceeding the pensions lifetime allowance, but also large market falls as I gradually run it down.

"I plan to draw on the Isa for large expenses during retirement so think it should be growth orientated and the Sipp more defensive. That said, I have started to add direct shareholdings to the Sipp because its size justifies this level of risk.    

"I take a growth and momentum investment approach, hence the large holdings in Scottish Mortgage Investment Trust (SMT) and Baillie Gifford US Growth Trust (USA). But I dislike investing in the UK."

 

Alan's self managed investments
HoldingValue (£)% of the portfolio 
Scottish Mortgage Investment Trust (SMT)73,89715.67
Cash61,00012.93
Baillie Gifford US Growth Trust (USA)50,66010.74
MI TwentyFour Dynamic Bond (GB00B5VRV677)18,7733.98
RIT Capital Partners (RCP)18,5653.94
Jupiter Strategic Bond (GB00B4T6SD53)18,0233.82
Miton UK MicroCap Trust (MINI)17,9643.81
Liontrust Special Situations (GB00B57H4F11)17,8183.78
Baillie Gifford China Growth Trust (BGCG)16,9833.6
Fidelity Emerging Markets (GB00B9SMK778)16,4493.49
Baillie Gifford European Growth Trust (BGEU)15,1303.21
Baillie Gifford Shin Nippon (BGS)14,5863.09
Stewart Investors Asia Pacific Leaders Sustainability (GB0033874768)14,2283.02
BlackRock World Mining Trust (BRWM)13,6672.9
Sylvania Platinum (SLP)11,4892.44
Allianz Technology Trust (ATT)10,7682.28
Murray Income Trust (MUT)10,1052.14
Henderson Smaller Companies Investment Trust (HSL)9,8582.09
BlackRock Throgmorton Trust (THRG)9,7552.07
AVI Global Trust (AGT)9,6432.04
Personal Assets Trust (PNL)9,3801.99
Caledonia Mining (CMCL)8,0961.72
Antofagasta (ANTO)8,0281.7
HgCapital Trust (HGT)6,4641.37
Standard Life Private Equity Trust (SLPE)6,3541.35
iShares Core MSCI Japan IMI UCITS ETF (SJPA)2,1320.45
Fidelity Index World (GB00BP8RYB62)1,8630.39
TR Property Investment Trust (TRY)270.01
Total471,703 

 

Partner's self managed investments
HoldingValue (£)% of the portfolio 
Cash100,00076.92
Isa invested in FTSE 100 tracker30,00023.08
Total130,000 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

 

Chris Dillow, Investors' Chronicle's economist, says:

Starting withdrawals from your Sipp seems like a reasonable way to try to avoid hitting the pensions lifetime allowance. It is also reasonable to try to reduce volatility in your Sipp by shifting it to more defensive assets, perhaps moving more volatile ones into your Isa. Your Sipp is heavily weighted to high risk/high return assets such as emerging markets funds, miners, and Scottish Mortgage which is now a momentum asset.

You could de-risk the Sipp by holding more bonds or defensive equities, such as those favoured by many popular investment trusts. That said, as a rule I’m not happy when the tax tail wags the investment dog. Holding risky equities is more viable for you than for many investors because your large final salary pension means that you have, in effect, a massive bond holding – a safe asset which pays a big income. This means that you are better placed than many to take on the cyclical risk that miners and emerging markets incur. Given the complication of the lifetime allowance, however, it’s better that you hold these outside the Sipp.

There’s also a warning in this for younger investors who don't just face investment risk but also regulatory risk. The current favourable regulatory regime could become less friendly. If the pensions lifetime pension allowance changes again it may not be an increase. One way to mitigate this risk is to spread your investments across different accounts, such as Isas and general investment accounts, as well as Sipps.

On whether to resume working, consider what exactly it is that you like about your job and see if you can recreate those elements in retirement. Former Labour MP Tony Benn once said that he was leaving parliament to spend more time in politics, so think about how you can follow his example. And I’m hoping to retire soon, but won't stop reading and thinking about economics.

Having an aversion to UK investments is not a problem – most investors make the opposite mistake and hold too many UK assets. And although UK equities seem relatively cheap right now, we could have said that any time in the past decade only to see them become even cheaper.

Also, if you are a long-term investor who can tie up money for a long time, consider adding to your holdings in private equity funds. A lot of future growth might come from stocks that are not yet listed. But private equity funds are prone to manager risk as one or two good or bad investments can make a big difference to their returns. So there’s a case for diversifying your private equity exposure across different funds.  

I applaud you for being a momentum investor. But remember that momentum works in both directions – especially with assets that are sensitive to investor sentiment such as emerging markets and miners. These two in particular are so closely correlated that you should regard them as the same asset. This means that you need an exit strategy. The strategy of selling assets when their prices fall below their 200-day moving average is as good as any, if you have the discipline to stick with it.

 

Shelley McCarthy, managing director at Informed Choice, says:

Whether or not you re-enter employment is entirely down to preference, as you have demonstrated that your required retirement income is already achievable. I would not let the tax implications of the pensions lifetime allowance charge to deter you from returning to work if it you want to do that. It can take some time to prepare for retirement, and decide how to spend your time and money. So if you are not ready for it, work may be a good option. People can struggle with purpose and structure in their lives when retiring.

You continue to pay £375 gross per month into your Sipp. If you have no earned income in this tax year you will exceed the maximum possible contribution of £3,600 gross per year. And given your lifetime allowance issues, it might be a good idea to stop these contributions. If you go back to work, consider redirecting these payments to your Isa so that you have a larger pot from which to top up your income in retirement, tax efficiently. Or you could make additional mortgage repayments of this value, though given your risk appetite you may not find this as appealing.

If you return to work it could be a good idea to join the pension scheme but not for the life assurance benefit. As you approach the point at which you can afford to retire, you are effectively self-insuring and typically may not require life assurance.

If you went back to work part time and earned, say, £50,000 a year, you would accumulate further pension of £666.66 a year. If you allowed for a 25 per cent lifetime allowance tax charge and basic-rate tax, you would still have £400 a year at a cost of £320. You would also have a further £900 as a lump sum – even allowing for a 55 per cent tax charge. This seems like a pretty good return.

Given that income is your priority you need to be careful of the order in which you take pension benefits. Fully crystallising your money purchase pension benefits by taking the available tax free cash, prior to taking your defined benefit pension from age 60 when it is available without a reduction, may mean that you have insufficient lifetime allowance left. This means that you would have a reduced income from the guaranteed portion of your pension plan. 

If you don’t return to work, your strategy for generating a tax-efficient income from your pensions seems sensible as it would help to minimise both income tax and the lifetime allowance tax charge. But remember that there could be another tax charge at age 75 on the growth of the pension fund. 

Risk and volatility should be reduced, at least for a proportion of the investments, when drawing an income. The investments overall appear very high risk and I’m not sure that the size of the portfolio justifies direct share holdings.