The Chancellor’s 2014 Budget heralded a revolution in providing for retirement. Here is a summary of what pension savers need to know.
Reasons for the 2014 Budget changes
The objective of the Budget changes is to remove the need for pension savers to apply their pension pots to purchasing annuities and to enable them instead to draw cash from their funds. The release of funds into consumers’ hands is likely to have the incidental advantage of stimulating economic activity.
The changes affect all personal pension and other defined contribution (‘dc’) pension schemes, which now account for more than 90% of the pensions market.
The 2014 Budget changes
The changes will come into effect in two stages. For 2014/15, the current restrictions on withdrawing cash from pension savings have been relaxed. Then the intention is that in 2014/15 they should be removed altogether, so as to enable anyone over the age of 55 to remove funds from their personal or ‘dc’ pension scheme whenever and for whatever purpose they wish, subject to income tax.
The interim restrictions on withdrawing cash from pensions
‘Drawdown Pension’ is the arrangement which enables pension savers to withdraw cash from their pension pots to provide a retirement income, and thereby avoid the need to purchase pension annuities. These currently offer relatively poor value, particularly for younger annuitants, as a result of the prevailing low levels of interest rates.
There are currently two variants of Drawdown Pension – capped and flexible. Under capped drawdown, the annual amount which can be withdrawn is restricted to 120% of the equivalent annuity rate (that is to say, the level of income which might be obtained from an annuity). This has now been increased to 150%.
Flexible drawdown is only available to people with a guaranteed pension income of at least £12,000 p.a., provided for example by State pension, annuity or occupational scheme. Subject to satisfying this requirement, there is no restriction on the amounts which can be withdrawn, though all withdrawals will be subject to income tax at the investor’s marginal rate.
Those whose total pension savings are no more than £30,000 are now permitted to draw the whole value in cash, 25% of which will be tax-free and the remainder subject to income tax. Also, people with total pension savings in excess of this amount, but whose savings include small pots of not more than £10,000 each, are entitled to encash up to 3 of such pots, again subject to tax.
The big change in April 2015
The proposed abolition of the ‘minimum income requirement’ for flexible drawdown in April 2015 provides a clear incentive to delay entering into this form of drawdown until April 2015 (by which time annuity rates might in any event have improved).
An alternative to pensions
To provide yet further flexibility for savers, the Government has substantially improved the rules relating to ISAs (now re-named ‘New ISAs’ or ‘NISAs’). The maximum which can be contributed annually by a UK adult has been increased to £15,000 with effect from 1 July 2014, and this can be invested wholly in either cash or stocks and shares or a mixture of the two, with free movement between the two asset classes. All existing ISAs will be brought into the new regime.
How do pensions and NISAs compare?
Pensions and NISAs provide access to a similar range of tax-advantaged investments, but in other respects the two savings media differ.
What happens if the investor dies?
If a pension investor dies before the age of 75, the value of their pension pot will pass to their beneficiaries free of tax. After age 75, a 55% tax change will be levied on the fund, though the Government is considering reducing this charge to perhaps 40%.
NISA investments would form part of the investor’s estate for the purposes of inheritance tax.
Possible future changes
Governments are forever tinkering with pension scheme tax and it has been suggested that contributions should qualify for only basic rate tax relief of (currently) 20%, rather than the higher rate permitted at present. It is possible that this might happen under a future Labour Government.
It has also been suggested that the right to withdraw 25% of the value of pension savings in the form of tax-free cash might be abolished, and the logic for this is stronger now that there is no longer an obligation to invest the remaining 75% in annuities.
It has also been suggested that a maximum limit might be imposed on NISA savings
Which to choose – pension or NISA?
Given that pensions and NISAs both offer tax advantages over other forms of savings, most people would be advised to invest through both media if they can afford to do so, However, it is clear that the advantage of tax relief on contributions gives pensions a flying start, because each contribution is boosted by tax relief of up to 45%. Consequently the growth potential of pensions is considerably greater, particularly over longer periods of time, though tax is charged on all but 25% of the benefits.
VCT and EIS
Investors who have utilised to the full their entitlements of invest in pensions and ISAs, or whose main concern is to reduce the impact of inheritance tax on their estates, might consider might investing in Venture Capital trusts or Enterprise Investment Schemes. These encourage investment in higher risk smaller companies by offering 30% tax relief on sums invested, tax-free dividends and capital gains (subject in thr case of EIS to a three year qualifying period). Investments which qualify for Business Property Relief also provide exemption from inheritance tax after being held for two years.
The fact that the obligation to apply pension funds to purchase annuities has been removed does not mean that annuities should be avoided. The main criticism of annuities is that they involve irrevocably exchanging capital for income at times when annuity rates might prove to have been unattractive. However, annuities do serve the important purpose of providing an income which is guaranteed and is not subject to the fluctuations of stock market investment.
Also, not all annuities provide a fixed income. For an extra cost, inflation-linking can be built in, and payments can be guaranteed for a fixed period of time regardless of how long the annuitant lives. Joint life annuities are available for couples, and enhanced annuities for people with medical conditions which indicate a reduced life expectancy.
The older the annuitant, and the poorer their health, the greater proportion of each annuity payment consists of capital rather than the income earned by the annuity provider; and the capital element of the annuity is tax-free.
Striking a balance
The previous restrictions on Drawdown Pension were designed to ensure that pension savers did not squander their pension pots and oblige them to rely on State support for their retirement income.
Now that the restrictions are being removed there will doubtless be occasions when this occurs, and for many people annuities will remain a sensible part of their retirement planning. Previously the balance has been weighted in favour of annuities, but in future it will be weighted in favour of drawdown. The challenge will be to achieve a suitable balance between the two options.
Although they have been simplified, the pension rules are still complicated, and the Government has indicated that it would like all pension savers to have the benefit of impartial advice. So make sure that the advice you receive is from an independent financial adviser whose impartiality will not be affected by their relationship with any provider of financial products.