Could you take advantage of the new pension rules?
With all the bad news for savers and investors about low interest rates, stock market shocks and poor returns on pensions, a very important improvement in individual choice has been largely overlooked.
We no longer need to relinquish control of our life savings when we retire. It is now possible to retain ownership of pension funds and seek to live off dividends and income produced from the underlying portfolio. In the past we had to irrevocably transfer most of our life savings to an insurance company in return for an annuity – a form of guaranteed income – we can now opt for what is known as income drawdown.
Similar to anyone else entering retirement, this option allows you to take up to 25% of the value of your pension savings as tax-free cash to use for whatever you please. Then, subject to limits set by the Government Actuary’s Department, you can draw income from the underlying assets – such as dividends on shares – which remain your property.
Successive governments have been moving in this direction for more than a decade but the final abolition of compulsory annuities, which used to bite at age 75, only took place in April 2012. This is a major extension of investors’ property rights and individual choice.
Income drawdown options
Our pension savings are most investors’ most valuable asset outside their home – and, among other attractions, the income drawdown option allows the remainder of these funds after tax can be left to investors’ heirs (IHT Planning Point). Income drawdown is also a flexible option for those who do not believe now is a good time to ‘cash up’ and convert a lifetime’s savings into the fixed returns annuities usually provide.
While nobody knows what the future holds, there is a risk that sellers of shares today might do so near the bottom of a bear market and buyers of bonds might hit the top of a bull market.
Disadvantages of income drawdown include the risk that your capital and income can fall without warning. You might get back less than you invest. Another disadvantage is that assets bequeathed from income drawdown are liable to tax at 55% – but even that eye-watering tax charge may still seem preferable to 100% loss of capital when an annuity is purchased from an insurance company.
Comparison with past schemes
The blue chip shares that constitute the FTSE 100 index of Britain’s shares are paying dividends that average more than 3.8% of these shares’ purchase price, income drawdown can be seen as a flexible alternative.
Most people regard the closure of traditional Defined Benefit (DB) schemes as a financial disaster which will condemn rising numbers of workers in the private sector to poverty in old age. However, Defined Contribution (DC) savings which include all personal pensions, such as self-invested personal pensions (SIPPs) and rising numbers of company schemes – are better for people who wish to retire early. Members of traditional DB schemes are punished for doing so by an adjustment known as an “actuarial reduction”. The logic being the younger person is at retirement, the longer they are likely to receive their pension. The effect is an early exit penalty which is pretty harsh if illness or redundancy force your decision to retire early.
What are the sums?
The reduction will usually be 4% for each year you go early and some schemes actuaries could deduct more. So there would be a 40% reduction in pension for a man who retires at 55 instead of 65 and there would be a similar reduction in the yield you could obtain from an annuity. Now income drawdown offers savers and alternative to that unsatisfactory state of affairs. The explanation is that the shares don’t care how old you are. The yield is the yield; whether you are 55 or 65.
So people who have saved sufficiently to cope with fluctuating valuations can leave their pensions invested in shares, bonds or stock market-based funds and live off the income they produce.
That option was not available to earlier generations. True, they enjoyed the certainty of receiving a sixtieth or eightieth of final salary for each year’s services; a degree of security many people would still rather have today. But the golden age of pensions with annuity rates greater than 8% are gone and it is doubtful they are coming back.
To take advantage of the new rules the first step is to save sufficiently to retire with a big enough fund to afford the new flexibility. For example, most experts reckon that you need to have saved at least £100,000 by the time your retire before considering foregoing the certainty annuities provide in favour of remaining invested and opting for income drawdown.
If that sounds like a lot, then remember that £100,000 delivers annual income of just £5,869 from the best annuity available today for a 65 year old man – and that it is fixed rate, before tax with the immediate loss of all your capital, because it is irrevocably transferred to the life company providing your guaranteed income for life.
By contrast, the maximum income drawdown allowed by the Government Actuary’s Department for a man of the same age investing £100,000 is £5,300 before tax. While there is no guarantee that capital and income may not fall in the future, there is also the possibility they may rise – and, as mentioned earlier, the certainly that you retain ownership and control of your capital.
The pensions quoted above demonstrate just how much capital needs to be saved to generate a decent income in retirement for those born too late to enjoy the golden age of pensions.
Our advice is to start a pension as early as possible, and save as much as you can afford out of the family budget and take independent advice on the choice of the Pension Plan.