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This is the first in a series of articles from Standard Life Wealth exploring the new world of pension 'freedom and choice'.
Ever since the chancellor announced his radical reforms to pension legislation back in March 2014, the industry has been in the spotlight. Never before have pensions been such a hot topic. An inordinate number of column-inches have since been devoted to the 'freedom and choice' that pensioners will soon be afforded. What appears to be causing the most stir is the uncertainty around what exactly individuals will do with this new freedom when they approach retirement. Will they spend irresponsibly, exhaust their retirement funds, and become a burden on the state as some doomsayers are predicting? Or having saved carefully throughout their working lives, will they continue to take a sensible approach in their retirement?
The Treasury's pension's freedom message certainly struck a chord with the public and press alike. However, amid these sensationalist headlines, it is easy to miss the detail and lose sight of what the imminent pension reforms actually are. Worryingly, research undertaken by Standard Life found that as many as a quarter of those approaching retirement are unaware that anything is changing at all, let alone the finer detail of what lies ahead. Having only a vague understanding of something so critical and not taking appropriate action could leave pensioners facing a financially challenging retirement.
The reasons behind the reforms
There are several reasons why the government has decided to intervene and completely overhaul the retirement market. Inefficiencies and rigidity in the current system are two of the main drivers. What may have worked for past generations of retirees may not suit current and future generations. Retirement is changing, lifestyles and spending patterns are very different, people have diverse financial requirements, and they want control over their retirement savings. The imminent government reforms tackle these issues by opening up choices that simply weren't available before. Under the new legislation, giving individuals complete freedom with their pension pots means they can make decisions to suit their own unique circumstances.
Demographic time-bombs also prompted the need for further change. People are living longer, and retirements of 30 years+ are entirely feasible. Declining birth rates, meanwhile, mean that there will be fewer and fewer active workers to support retirees, thus threatening the sustainability of current state and private pension schemes. These pressures are only set to intensify over time.
Against this backdrop, what the chancellor announced in the 2014 budget was a complete game changer. Under new legislation, from 6 April 2015, UK pensioners will have the kind of freedom and choice with their hard-earned pension pot that their fellow Australian and New Zealand retirees have long enjoyed. And about time too many would argue.
'What the chancellor announced in the 2014 budget was a complete game changer.'
So with the most significant pension reforms for almost a century only a few months away, here's what we all need to know about them.
Understanding the key changes
Under current pension legislation, retirees' options are limited and dependent on the size of their pension pots. From 6 April, the following key changes will create greater choice and flexibility in pensions.
- Individuals will have complete autonomy over how they choose to take income from their pension savings. They can opt for a guaranteed income for life through products such as an annuity. Alternatively, they may wish to choose a flexible income, where they can start, stop and change what they withdraw, also known as drawdown. They can also choose a combination of both.
- Tax rules will be simplified to give people unrestricted access to their pension. Most people will be able to take 25% of their pension pot tax free.
- Drawdown of pension income will still be taxed at marginal income tax rates. ¬Individuals can take money from their pension from the age of 55 and do not need to stop working and retire in order to access their retirement savings. They can even keep working and paying into a pension.
- Those approaching retirement will have access to free and impartial advice through the guidance guarantee scheme 'Pension Wise', to help them make informed choices. The guidance is not intended to replace professional advice but should act as a gateway to advice for those who need it.
- The 55% 'death tax' on pensions is to be abolished. Pension savings can be passed on to loved ones tax free, if a person dies before age 75. On death after 75, death benefits will be taxed as the recipient's income when they drawdown the funds. For 2015/2016 only, non-drawndown lump sums will be taxed at a flat rate of 45%, but marginal income tax rate will apply thereafter.
- The old tax distinction between 'crystalised' (funds in use) and 'uncrystalised' (funds that have yet to be drawn) pots is removed, meaning that the age at death is the sole determinant of tax treatment.
Comparing the before and after
Under the old system, only those at either end of the savings spectrum could access their pensions flexibly i.e. those with pots of less than £18,000 and those with more than £300,000. For the rest, an annuity may have been the only other alternative. However, under the new system, everyone with defined contribution pensions will be entitled to full flexibility, regardless of their pension wealth.
And as for annuities, will we witness the death of this market? Not entirely. The pension changes simply mean that retirees will have a wider range of investment options than previously, and annuities may continue to be the right option for some people. However, we expect to see more appetite for pension drawdown as a viable alternative. For any new annuities, the government has announced that it will remove some restrictions on these products to enable providers to develop more flexible options. What we expect to see as a result of the reforms is a more diverse pension mix, where annuities can potentially sit alongside lump sum withdrawals and flexible income options.
In terms of death benefits and inheritance, the reforms transform the wealth planning landscape. After an individual dies, any remaining retirement savings will be able to cascade down to children and grandchildren, and pensions could also increasingly be viewed as a vehicle to transfer wealth across generations.
These reforms will also likely open up a more innovative and competitive retirement income marketplace that is focused on the interest of those saving for retirement, which can only be a good thing.
'Everyone with defined contribution pensions will be entitled to full flexibility, regardless of their pension wealth.'
The weight of choice
The 2015 reforms reflect the government's vision for a more flexible regime giving people more choice, control and, ultimately, responsibility over how they use their pension savings. But with greater choice there are inevitably more decisions to be made and more things to consider. It is a big sea-change and some investors are adopting a 'wait and see' approach as 6 April draws closer.
Undoubtedly the biggest challenge that individuals face when planning their retirement is making sure their savings last. Having a sustainable income for the rest of their lives is a major concern for people reaching retirement age. This challenge could see investors stick with the tried and tested annuity solution. However, people are living longer and even a healthy annuity could be eroded by inflation over time. Also, once signed up to an annuity, clients are locked in, so the very control and flexibility that the new reforms are offering are ultimately relinquished if pensioners choose this route.
Another option for retirees is to withdraw the entire pension pot as cash. This is the so-called Lamborghini option after pensions minister Steve Webb said that people should be free to blow all their funds on a sports car if they felt like it. As tempting as that may sound, it also sets off alarm bells. While the first 25% taken out is usually tax-free, everything else will be subject to income tax. So retirees could end up handing over a substantial proportion of their hard-earned pension pot to HMRC if they choose to withdraw it all at once.
Many people approaching retirement may instead be looking to leave the money invested and take it out through drawdown. But since most people have no idea how long they will live, making their money last is crucial. In this drawdown phase, factors such as volatility and the severity and timing of short-term losses in their investments can be as important as the investment return itself. These are technical investment details that pensioners may not have considered.
The value of good advice
With so much change up ahead, seeking the best advice will be invaluable when selecting the most suitable investment solutions to meet financial goals in retirement. The government's 'Pension Wise' service is a good starting point for those with less sophisticated financial planning needs, but it is not a substitute for professional financial planning advice. Only an experienced adviser will be able to help retirees assess their needs and make informed investment decisions based on their individual circumstances.
The choices that people now have in their hands may be irreversible in many cases and critical in determining whether they face a financially challenging retirement or one that is long and comfortable.
Over the coming weeks, we will continue to provide guidance around the new world order of retirement and wealth planning, and explore some of the most salient issues. We hope you find these communications helpful and informative.
'Retirement savings will be able to cascade down to children and grandchildren after death.'