How am I affected?
“Let me be clear. No one will have to buy an annuity. Pensioners will have complete freedom to draw down as much or as little of their pension pot as they want, any time they want.”
These were the words spoken by George Osborne in March 2014 as he proposed changes that were described as the most radical to the retirement savings landscape for nearly a century.
Pension Freedoms were formally launched in April 2015 and the legislation has completely changed Defined Contribution Pensions (more commonly known as Personal Pensions).
Historically, these investment vehicles were seen as inflexible and complicated, having been battered by more and more legislative changes. By 2014, they were simply perceived as poor value. The Government was concerned that not enough people were saving adequately for retirement and those who were, considered the humble pension not to be fit for purpose.
The point was fair. The traditional Personal Pension had strict limits as to how much could be withdrawn either as income or as a lump sum. Further to that, when income requirements were considered, more problems arose. Either the guaranteed income, in the form of an annuity, was becoming poor value as interest rates reduced, or those who took income from a Drawdown plan found the limits restrictive and inflexible. Finally, it was upon death that penalties hit hardest, with tax rates on death being as high as 55% of any remaining fund.
But even allowing for pensions’ previous complexity, the changes announced in 2014 and launched in April 2015 were remarkable and changed the face of pension planning.
It was upon death that penalties hit hardest, with tax rates on death being as high as 55% of any remaining fund
Pension Freedoms, PS Aspire, December 2018
…this is now
That was over three years ago. Now that the Pension Freedom rules have settled down, what has really changed? The purpose of this Guide is to explain what you can now do with your Personal Pension that you couldn’t do before, and what else is planned to change as we go forward. Before we discuss this in more detail, it’s important to note two things.
These changes ONLY affect Defined Contribution schemes. Defined Benefit schemes (often called Final Salary Schemes) don’t benefit from Pension Freedom.
Whilst the legislation has changed, many older Personal Pensions haven’t amended their rules, so it’s wise to check with your provider to see if you can benefit from ‘Pension Freedoms’, especially if you haven’t changed your Pension recently and certainly if you started your plan before these changes were announced in 2014.
So, what are Pension Freedoms?
Pension Freedoms mainly relate to what you can do with your money at retirement, when you’re looking to provide yourself with somelevel of income. Changes to the Death benefits are also very important. It’s these that we’ll discuss here, and we’ll assume that you’ve funded your Personal Pension to a certain level and now wish to draw benefits from it.
There are a few different ways you can take your money out; how it’s withdrawn can have tax implications. Typically, there are also plenty of caveats that must be considered.
Firstly, you had a pension that was broadly funded as part of your employment with a large limited company or through the public sector, (final salary schemes). Secondly, you had private or personal pensions, which were normally funded either by the individual or as part of your employment.
The benefits from a final salary scheme were built up by continued service and increases in salary. It was perceived as being risk free and, for most, was deemed as being ‘gold plated’ due to the guarantees offered and the protection against inflation both as it grew and especially in retirement.
On the other side, personal pensions carried the full risks of the Investment market and, in some cases, the annuity that was used to purchase the income in retirement was perceived as poor value with a low starting level and little or no inflation protection.
So, based on that information, why would anybody consider transferring out of a final salary scheme into a personal pension?
Well, the new ‘pension freedom” is one reason why.
Potentially, the biggest change in pension legislation happened on April 6th 2015. The ability to access all of your personal pension money from age 55, and to be able to pass your pension on to whoever you wish upon death meant that many people were seeing their pension in a new light.
However, these options were only made available to personal pensions and those in final salary schemes would have to transfer from the scheme to access such flexibility. And there lies the dilemma.
Do you transfer from a pension that provides a guaranteed income, with excellent protection against inflation, but very little flexibility, to a pension that offers full access to your money and full flexibility, but the potential to lose you money, either due to poor investment performance or inflation eroding the income?
Generally, you are not allowed to take your benefits until age 55.
This was increased from age 50 in 2010. It has also been suggested by the Government that this minimum age should be linked to the State Pension Age, with confirmation that this will happen in 2028, when the State Pension Age increases to age 67, increasing the minimum pension commencement age to 57. From that point onwards, the minimum age to draw benefits from your pension will then be set at an age ten years less than the State Pension Age.
However, just to complicate matters, the State Pension Age is expected to rise to age 66 in 2020 and there has been no mention of the minimum age for Personal Pension changing to 56. Watch this space.
How much can you take out?
Assuming you’ve reached age 55, how much can you have?
Well, the good news is the Pension Freedom changes mean that you can withdraw ALL the money in your pension at any time from age 55. It’s crucial to remember that in all instances, 25% of the fund can be taken tax free and the remaining 75% will be taxed as income.
This money can be withdrawn all at once or, as is more likely, used to provide a regular income in retirement. In many instances, people will mix the two options up and take both a regular income and some lump sums as and when they need them.
Flexi Access Drawdown (FAD)
The concept of a Drawdown contract to provide an income in retirement has been with us since 1995 when the likes of Equitable Life and National Mutual became the first to launch in this market.
However, until Pension Freedoms arrived, the level of income was nearly always restricted. Once FAD was launched in 2015, it meant that people could withdraw as much as they wish from their pension plan. It must be remembered that 25% of the fund is tax free with the rest taxed as income.
This taxable income is added to your other income in the relevant tax year, so care has to be taken when withdrawing large sums of money, to ensure that you don’t pay more Income Tax than expected.
For example, should you have £80,000 in your Pension and choose to take it all out, £20,000 (or 25%) is paid tax free but the other £60,000 is paid to you as income.
This will certainly mean that some of it is taxed at 40% and possibly more if you are a high earner. By taking advice, it may be suggested that this income be paid to you in smaller amounts over a period of years to ensure that all the payments are made when you are a Basic Rate Tax Payer. It is this sort of advice that can make all the difference to the final sum you receive from your pension.
Should you have £80,000 in your Pension and choose to take it all out, £20,000 (or 25%) is paid tax free but the other £60,000 is paid to you as income
There are also two further, but less utilised options to withdraw money and they are called ‘Uncrystallised Fund Pension Lump Sum’ (or UFPLS) and ‘Small Pots’.
This tends to be used for smaller sums of money or when the pension contract that is being used doesn’t have a Drawdown option. UFPLS is the ability to take a specific sum of money from a Pension plan. In all instances here, 25% of it must be taken Tax Free and the rest must be taxed as if income.
‘Small Pots’ is slightly different in that, as the name suggests, it’s used with very small sums of money in a Personal Pension plan. The maximum amount that can be taken out is £10,000 and the whole amount must be withdrawn from the plan. You can also only use ‘Small Pots’ three times in total, when withdrawing money. This can be very important if you may be affected by Money Purchase Annual Allowance or MPAA. (We’ll cover this in more detail later in the Guide.)
As you can see, you can broadly take what you want, when you want it from age 55 onwards. In most instances, this money will be used to drive an income throughout your retirement. But what happens if you still have funds left in your Personal Pension or Drawdown plan when you die?
The new Pension Freedom Legislation allows you to withdraw your money using different options, so let’s start with the most popular.
The rules upon death changed radically in 2015 when Pension Simplification was launched. Before this, there were specific and very different rules for those in a Personal Pension vs. those in a Drawdown plan.
Now, the rules are the same whether you are accumulating (in a Personal Pension or SIPP) or decumulating (in a Drawdown plan).
Put simply, if you die before age 75, the fund value can be paid to anybody, free of all income tax. This includes a dependent such as your spouse, or it can be paid to your children, grandchildren, nieces, nephews, other family members or even that nice lady who lives next door.
After age 75, the fund can still be paid to anybody, but the amount of money received by the beneficiary is deemed as income and will be taxed at their marginal rate. To try and mitigate what could be a large income tax payment, this money can be paid into a Nominee Drawdown plan, so that funds can be drawn more efficiently. (There are further rules involved which we won’t cover here but which your adviser can of course explain to you).
What is key is that your Personal Pension or Drawdown plan can be paid to anybody upon your death.
What is also important to note is that a Personal Pension and Drawdown is written under a Trust and so is free from Inheritance Tax (IHT). This makes it a very efficient investment vehicle. If IHT is an issue, it may be more sensible to draw income from assets that are liable to IHT and to leave the Personal Pension to grow, free of IHT. Clearly, in these circumstances, advice must be taken.
As Pensions are written under Trust, it is crucial that the Trustees are offered some level of guidance when it comes to paying these death benefits.
This is provided using a ‘Death Benefit Nomination Form’. In most instances, the options are quite simple. In our experience, most people will request that the benefits of the Pension or Drawdown plan be paid to the spouse or partner. They may also consider paying benefits to children or even grandchildren.
But what about when there is no spouse, or the spouse has predeceased? Now the Policy holder has to consider what the position is with the funds. As mentioned before, it can be paid to absolutely anyone and that includes a charity as well.
Another instance when this can become complicated is with second marriages. It may be that the policy holder wishes to pay the benefits to their new partner, who may need the fund to support them in retirement. However, the original policy holder may also wish to ensure that any children from the first marriage are also provided for.
This now becomes difficult as, on death, the funds are paid to the new partner and it is THEIR decision as to where funds are paid upon their own death. Trusts can be put in place to manage this but then Trust taxation can become an issue.
A final consideration is that the Nomination Form is simply just that. A nomination.
The ultimate decision as to where the funds are paid is held by the Trustees. In most instances, they will adhere to the nomination provided by the policy holder, but what if it isn’t that easy. What if two children are nominated and on death, a third child, perhaps estranged, comes forward?? Historically, children had no right to any money in Drawdown plans unless they were a dependent child (possibly due to a disability), but now, things have changed.
So much of this is unintended consequences. It clearly seems fair that the beneficiaries of an Estate should have access to all assets in that estate and that should include the Pension. However, as it is written under Trust and free of IHT, it becomes a little more complicated, especially when ‘jigsaw’ families are involved.
It’s therefore absolutely vital that advice is sought, especially when assets are being paid to somebody other than a spouse.
The legislation that commenced in April 2015 was formally known as Pension Freedoms but whilst it offers many opportunities, it’s still too complicated, especially when managing the tax implications.
Whilst it shouldn’t be difficult to simply allow people to withdraw all their money from their pension from any time after age 55, sadly, it does tend to be. We don’t have space in this Guide to discuss the taxation implications in too much detail.
However, here’s a brief idea of how ‘simple’ it is.
Firstly, there’s a limit to how much can be put into a Pension each tax year, which is called the Annual Allowance. As at Tax Year 18/19, that amounts to £40,000.
However, if you are a high earner who pays tax at an additional rate, this £40,000 maximum contribution level can be tapered down to a cap of only £10,000.
It should also be noted that anybody who generates what is known as a ‘trigger event’ (for example, a withdrawal of any form of taxable income from a Personal Pension or Flexible Drawdown is classed as a trigger event) will also be affected by the Money Purchase Annual Allowance, retracing their future contribution level to only £4000.
As mentioned before, there are exceptions to these ‘trigger events’ and taking benefits on a ‘Small pots’ basis is one of them.
There are then limits to the overall amount that can be taken from a Pension. This is currently set at a total withdrawal level of £1.03m. That level is linked to RPI at present and increases annually. Any benefits that are withdrawn in excess of this amount at any time during the lifetime of the plan will be charged at 55% should they be taken as a lump sum or 25% if withdrawn as income payments. This also includes death benefit payments.
In terms of personal taxation, ALL benefits drawn from the Pension or Drawdown in excess of the 25% Tax Free Cash allowance are subject to marginal income tax at the time the money is withdrawn. Finally, as mentioned before, all benefits in a Personal Pension or Drawdown plan are free from IHT.
So, what are the implications
of the Pension Freedoms?
The changes that were put in place in April 2015 were described as the biggest change in pension legislation in a century and there’s no doubt that the flexibility now offered by Personal Pensions is remarkable. However, with added flexibility comes added responsibility.
Historically, income levels within a Drawdown plan were restricted to either a specific factor that was reset every three or five years or the income was simply guaranteed by the purchase of an annuity.
Now, any level of income can be taken from the fund. This runs a very obvious risk that if you take too high an income, you could run out of money. Interestingly enough, a recent survey highlighted that people don’t spend enough in retirement and often die with large sums still available in their Drawdown or Pension. It’s difficult to get the balance right, especially when the date of death is naturally a variable – and an unknown one at that.
The other interesting factor involves Inheritance Tax (IHT). As has been mentioned, investments held in a Pension wrapper are free from IHT and for those with IHT issues, a better option may be to use assets that fall into the estate, such as an ISA, to fund income.
We therefore have a rather strange situation where the roles of a Pension and ISA have been reversed, with the ISA now used for income and the Pension for rainy day money, rather than the other more traditional way around.
Finally, and most importantly, this legislation only affects Defined Contribution plans such as Personal Pensions. Many people still have Defined Benefit (or Final Salary) Pensions and the only way they can benefit from Pension Freedoms is to transfer away from the very beneficial guaranteed income offered by a Defined Benefit scheme.
There are very serious implications concerning this...
...and if you are affected, we would, in ALL instances encourage you to read our Guide to Defined Benefit transfers before you consider anything else.
Click to read 'Thinking about Transferring a Defined Benefit Pension?