UK pension reforms: The benefits and pitfalls
Ian Harper assesses the pros and cons of greater flexibility in UK pensions.
In 1995, Australia's then prime minister Paul Keating introduced laws allowing people to access their pension pots without having to buy an annuity.
Now, 20 years on, Australia is contemplating reversing that decision because of the financial mess in which people who have exercised this freedom find themselves.
A report carried out as part of the Murray Review – a wide-ranging inquiry into the Australian financial system – detailed the scale of this mess:
- About half of retiring Australians take their pension fund as a lump sum.
- Of these, 44 per cent use it to pay off housing and other debts, to purchase a home, or to make home improvements.
- A further 28 per cent use the money to repay a vehicle or holiday loan or to buy a holiday or new car.
- The upshot is that a quarter of those with retirement funds at age 55 had run out of cash at age 70.
The changes in the UK, which came into force on 6 April, closely mirror their Australian counterparts. They include removing the need to buy an annuity to provide income for life, giving access to drawdown schemes previously restricted to wealthier savers, and axing the 55 per cent "death tax" on pension pots left invested.
Also, savers are no longer limited to a single tax-free lump sum worth 25 per cent of their pension pots, with the rest taxed as income. They can now make numerous withdrawals, each eligible to a 25 per cent tax-free lump sum with the balance taxed as income.
The changes apply to individual and company-sponsored defined contribution (DC) schemes where fund growth is linked to the stock-market performance of the invested contributions. They don't apply to employee defined benefit (DB) pensions, although they could encourage employees to transfer DB arrangements into DC schemes to gain access to funds.
A good thing – with good advice
Advisers tend to hold that the positives outweigh the negatives, with the caveat that the new options require quality advice to avoid potentially enormous problems.
The big advantage is the flexibility pension scheme members have to tailor benefits to suit their circumstances. The big risk is that a generation may fritter away their pensions and have nothing for later in life. The big challenge is to get people to appreciate the value of paying for good advice.
Alan Steel, managing director at Alan Steel Asset Management, warns: "For those with DIY tendencies who rely on sensationalist headlines from inexperienced financial journalists, you can be assured a massive mis-buying crisis looms large a few years down the line."
Regarding employers, Derek Robertson, managing director of Central Investment, says: "They are beginning to realise that their pension scheme members need advice or guidance to avoid making wrong decisions. As time passes, I expect a greater number of employers will become more proactive in communicating with their scheme members and will try to direct them to valuable and accurate sources of information."
State of emergency
Another big issue awaiting the unwary is tax. Aside from the risk of being pushed into a higher rate tax bracket on pension withdrawals, there is the matter of "emergency tax".
People taking a lump sum from their scheme will be taxed as if they were starting the first of a series of monthly withdrawals which will continue for the rest of the year. Consequently, they will be given an emergency tax rate that pushes them up the tax bands – potentially to 45 per cent – and removes their tax-free personal allowance.
Billy Burrows of Retirement Intelligence gives an example: if you withdraw £24,000 then the new rules mean 25 per cent or £6,000 of this can be taken tax free, leaving £18,000 to be taxed. A 20 per cent taxpayer would expect to pay £3,600 in tax on this withdrawal, leaving £20,400 including their tax-free cash. But, because the withdrawal is subject to emergency tax, HMRC will take £6,570, leaving just £17,430. The 20 per cent taxpayer will have overpaid by around £3,000. To get the overpayment refunded requires completing an HMRC repayment form and repayments can take six weeks. Alternatively, HMRC will correct overpayments automatically at the end of the tax year.
According to Sarah Smart CA, a member of the ICAS Pensions Committee and chair of the trustee board at The Pensions Trust (a provider of pension schemes, DB ones in particular): "The evidence is that a significant number of people do not understand the consequences and assume, for example, that 100 per cent of a lump sum is tax free and that they may, unwittingly, end up paying a higher rate of tax than they expected."
Colin MacPherson at Alan Steel Asset Management says: "It is clear… that people are unaware of the tax consequences of unfettered access to their pension funds. It is quite a clever way for the government to get the tax take upfront, and actually once the effective tax charge is explained to individuals they backtrack."
Billy says: "By far the most tax-efficient way to take a pension is through phased retirement where a slice of pension is taken every year and income is made up of a combination of tax-free cash and taxable pension."
Evidence to date supports the view that it is pension scheme members who are taking the initiative, and that most of these are people with smaller pension pots. Smart says: "The main impact that we have evidenced from April 2015 is a significant increase in the number of pensioners enquiring about and taking trivial commutations."
According to Michael Spink, head of DC services at Spence & Partners: "The average DC pot at retirement is somewhere between £25,000 and £30,000 and we might expect a reasonable number of members in this range to cash out over one or two years, perhaps paying off some debt, taking that retirement holiday, helping kids with house deposit, etc."
Long line of changes
The UK pension industry is used to change, and this is just the latest in a long line. According to Steel, there have been some 565 since 1987, which includes 176 since the introduction of so-called "pension simplification" in 2006, but excludes the 16 pieces of legislation rushed through to allow the new pension freedoms. What impact might the latest changes have on the industry?
Adam Tavener, chairman with Clifton Asset Management in Bristol, says: "The biggest impact has and will be felt by the annuity providers, which, whilst sometimes the same, are not always the pension providers. Anything that makes pensions more relevant and popular is likely to lead to an increase in pension savings, not a decrease, so overall it will probably benefit both the customer (more awareness and transparency) and the industry. There will be some outflows as customers hit 55, but this will be balanced by greater inflows."
As for financial advisers, Jonathan McDowall, financial planning consultant with Henderson Loggie Financial Services, says: "Advisers are adapting to the changes in the advice options and this includes the structure of income and creating plans especially around the succession planning aspect of pensions. Because of the new freedoms, clients can plan much more tax effectively and we hope to hear of new propositions from providers to offer greater access to products that will suit the new climate."
How are employers responding?
From the employer perspective, Michael Spink says: "A key implication will be more employers looking to master trusts (MTs) as their preferred DC vehicle. These trusts will invest heavily in governance so that, when combined with economies of scale, they will look increasingly attractive. This in turn will trigger consolidation… upwards of 80 per cent of new MT business is being won by no more than five MT providers."
Employers and accountants advising them need to be aware as to what they can and cannot say to employees about their pensions options under auto-enrolment.
Griselda Williams, head of business development with TRUST|Pensions, explains: "An employer, accountant or adviser providing general information to employees about the nature of the scheme, the investment options and retirement options is not regulated advice. But any provision of actual or implied recommendation based on an employee's personal circumstances needs to come from a regulated financial adviser. Increasingly, trust-based schemes are proving a range of 'non-advised' options for employees to choose from."
She adds: "The new pensions freedoms create a lot more choices. But workplace schemes, not employers, have a responsibility to educate members about their options.
The freedom to mis-sell?
Have the conditions been created for a new mis-selling scandal? Adam Tavener thinks this is not the case, and argues: "The phrase traditionally refers to the point at which the pension is sold to the customer, nowadays a highly controlled process. The risk of customers pulling out all their cash to invest in lunatic scams offering improbable returns is there, of course, but the scammers have been pretty active in this area prior to the new rules. I think that the basic tenets of caveat emptor and 'a fool and his money' apply equally both before and after the changes."
However, Colin MacPherson believes the changes do create a greater risk of mis-selling: "The attraction of 'money now' rather than later is a very strong one for people who are in short-term need and I believe advantage could be taken of these people. It will be very important that individuals go through a process of using the government services, as well as any further adviser input, before making any decisions on their pension pots."
Michael Spink says: "The workplace scheme environment is experiencing a significant increase in governance levels, including the ways in which trustees and pension providers communicate with scheme members. As such, we can expect to see a fairly wide gulf emerging, in terms of pensions understanding, between those individuals in workplace schemes and those who buy their pension privately."
The lifetime pension saving allowance
The recent changes also limit the "lifetime allowance" – the maximum value of a pension fund that attracts favourable tax treatment. McDowall warns: "With more options around pensions it is likely that more people will save into pension arrangements, and save in greater amounts. This could lead to many more individuals reaching the lifetime allowance limit, especially when it reduces to £1m in 2016/17. "
Colin says: "This government legislation is basically an unfair attack on legitimate contracted pension accrual (defined benefit) and on investment growth within pension funds, especially when you consider the tighter controls now on the annual allowance."
Derek Robertson agrees: "To many £1m sounds like a large pension fund. However an increasing number of individuals will find this is achievable, particularly for those gaining access to an employer pension scheme from an early age."
Whether the new freedoms survive long term will hinge on how people respond over the next few years. Based on the Australian experience, they may be relatively short-lived.
In the UK, a big concern must be that easily accessed pension funds will further fuel consumer spending; good for economic growth but bad for the future welfare bill. In the short term, expect a reduction of pensions tax relief as the new government aims to cut some £12bn of spending.
This article first appeared in the June 2015 edition of The CA magazine.