It is now almost three years since the biggest overhaul in pensions in over a century – known as pension freedom.
The reforms, which were announced in the Budget 2014 and were implemented from April 2015, gave individuals much greater flexibility when accessing their pension savings. Amongst the most significant changes were to the tax rules. Here we review some of those changes, and how they have affected the UK’s retirement savings landscape ever since.
For schemes which support 'Flexi-Access Drawdown’, withdrawals can be made up to the full amount at any time, subject to an individual’s marginal tax-rate in that tax-year.
Flexi-Access Drawdown: when the time comes to take your pension you reinvest your pension pot into funds designed specifically to provide you with a regular retirement income.
Withdrawals from a defined contribution pension were previously capped at 120% of an equivalent annuity each year, with full withdrawals taxed at a whopping 55%. This hasn’t resulted in a drove of retirees splashing out on brand new Lamborghini’s, but it certainly has allowed income in retirement to be tailored specifically to an individual’s needs throughout each phase of their retirement. Whilst this may be an attractive option for those who can afford to do so, making larger withdrawals in the early years of retirement will leave less in the pot for later.
Annuity rates are determined by many factors including interest rates. With interest rates having been low for so long, it is no surprise that annuities continue to be less popular with clients. Since pension freedoms were implemented, it could be argued that annuities have proven to be even less popular with more and more people favouring flexible access and varying income to suit their needs. The overhaul to the annuities market promised by the government, in attempts to make them more attractive, hasn’t materialised and we are yet to see new annuity products hit the market.
There is also no longer a mandatory requirement to purchase an annuity at 75, as was the case before, further denting their appeal.
This is one of the most significant changes applied to the rules surrounding passing on pension assets to beneficiaries on death, including the taxation of these benefits.
Whilst previously these were restricted to passing on benefits to a surviving spouse and/or financial dependent under the age of 23, there are no longer any restrictions on who can inherit your pension benefits. Inherited pension benefits were also taxed at 55% previously, but now pension benefits can be inherited with no tax to pay should the member die before the age of 75. If after 75, any benefits withdrawn (rather than the whole pot) will be taxed at the individual’s marginal tax-rate, which is still significantly lower than 55% and the Inheritance Tax rate of 40% (for basic rate taxpayers).
This has brought defined contribution (DC) pension benefits to the fore when it comes to estate planning, with some people now able to leave their pension assets as a ‘legacy’ for future generations, which can be passed on indefinitely, in a tax-efficient manner.
Freedom of not having to take an income from a pension, could simultaneously allow one to reduce their IHT position, by spending from their taxable estate rather from their pension, whilst having peace of mind that their beneficiaries will be able to inherit their pension assets and access those benefits flexibly.
The fact that beneficiaries can also defer taking any benefits from the inherited pension, also provides them with much needed flexibility since they may have tax considerations of their own at the time of the inheritance.
Annual Allowance and Lifetime Allowance
Whilst pensions have become more attractive for many reasons, the amount that people can save into a pension has reduced. The standard allowance is £40,000/year with some high earners reduced to as little as £10,000/year.
The Lifetime Allowance now also stands at £1 million.
This has certainly made it harder for some individuals to build up significant pension assets over their lifetime, making it ever-more important to seek professional financial advice to ensure that savings can be made in the most tax-efficient manner over the long-term. It has also meant that those who have already built up significant pension assets are more at risk of incurring a Lifetime Allowance tax charge at some point during their retirement, with the final ‘Benefit Crystalisation Event Test’ taking place at age 75.
Defined benefit pension transfers
Unlike DC schemes where the benefit you receive is determined by your own contributions and investment returns, defined benefit (DB) schemes like final salary pensions promise a monthly benefit based on a pre-determined formula.
With many schemes offering record-high transfer values boosted by a persistent low-yield environment, as well as growing pension deficits, more people than ever are transferring their guaranteed pension benefits in favour of the flexibility offered in a DC scheme such as a self invested personal pension (SIPP).
Death benefits have also been a factor, with many DB schemes offering 50% of the benefit as a spouse’s pension, with generally no scope for other beneficiaries to inherit any benefits.
We work closely with our clients to build highly personalised Lifetime Financial Plans, which can highlight need areas and tax considerations many years in advance – such as a hefty Lifetime Allowance tax charge at age 75 because of transferring a final salary scheme for example. This helps our clients to understand what their best options are, but most importantly – why.