Keynotes June 2015 -An Excellent Return on Your Pension… for the Government that is!

If you were wondering why the Government has turned all nice and eager to please everyone with its new ‘pension-freedoms’ legislation, then look no further than the Chancellors coffers.

The Treasury expects to net more than £1.2bn in new tax revenues over the next 4 years, as a direct consequence of the new ‘pension-freedoms’ it introduced before the 2015 general election. This is the predicted result of people removing money from their tax-free pensions and placing it in taxable schemes and bank accounts or simply spending the money rather than holding it back to pay themselves an income for life in retirement. It would seem the principle that pensions should provide a sustainable income has been turned completely on its head with the Government being the main winner and individuals facing a bleak financial scenario in their later years, should they exercise their right to take the money and run without first taking adequate advice and carefully planning.

If the Australian experience is anything to go by then a very large number will indeed take the money and run. There, pensions rules allowing freedom and flexibility similar to the UK rules were introduced 14 years ago and the result has been that only 21% of retirees actually took a pension income with the money, the other 79% made improvements to their homes, bought new cars, went on holiday or invested the money elsewhere, crucially outside the tax free environment of a pension. Of course this is not necessarily wrong, but it is not what the pension had been intended for until the new rules were introduced and then the good intentions all went out of the window! Unsurprisingly only 4% went on to buy an annuity.

In claiming to be following the Australian example of pensions liberalisation, Mr Osborne should have exercised a little circumspection. In Australia, the state pension is more than it is here, with an average equivalent weekly value of around £200, providing a bigger safety net for when all the pension money has been spent on vintage didgeridoos, trips to the opera and the must have submarine for those days out at the Great Barrier Reef. Now the Australian Government is in the process of tightening the rules to make it less easy to raid one’s pension fund, acknowledging that the experiment has not been a complete success.

Given the wealth of research on human behaviour, which supports the hypothesis that most people have an enormous propensity to put today before tomorrow; spending now and worrying about things later to satisfy their immediate needs ahead of most future requirements, it is interesting that the UK Government failed to realise the likely effect of what they were planning. Add to that the resentment that many feel about saving for their long term future, borne out by the need to make pension savings compulsory for the masses through Auto-Enrolment, it seems fairly obvious that the result of pensions liberalisation would be significant withdrawals to meet short term requirements.

Evidence that the measures were not well planned or consulted upon, can be found in the fact that the regulatory authorities are now playing catch up with the new rules and many pension providers seem unable to adequately support the new pension freedoms. All this amounts to a pre-election rush job. The conclusion I draw from this is that short to medium tax revenue requirements have trumped what might loosely be described as the long-term public interest. The likely outcome may be a long-term rise in social security expenditure when the income from pensions is no longer available and more pensioners fall on hard times as they live longer with less pension funds to support that longevity.

The detail

If you are at all interested in the mechanics of what has happened then this is for you:

Used as they were intended, pensions provide a tax efficient way to save for the future. The marginal rate of tax on the eventual pension income, when tax-free cash is accounted for is usually far less than the equivalent earned income and when tax relief is factored in then the arrangement is very attractive. But under the new Freedoms rules all of that is turned on its head. Not only do individuals risk loosing significant amounts of their pensions funds to the Government in additional tax, they will also suffer initially higher tax bills than they should because pensions are taxed on a month one basis. This means that when drawing the whole pension in one go individuals get only one twelfth of their personal allowances and tax bands, as if they will receive the same payment every month of the year. This will inevitably take most individuals to the higher rate band of 40% and many will find themselves being taxed largely at the additional rate band of 45% tax. Only on completion of a self-assessment tax return can the tax situation be rectified and a claim for overpayment be made or the extra tax due be paid. This is further complicated by the fact that the personal income tax allowance could be reduced or completed lost as a result of the single pension payment. If one was contemplating something this stupid then having the pension paid on the 5^th April would mean the tax could reclaimed on the 6^th April once the whole tax year has run its course.

As well as tax, there is also the cost of advice, which is another significant factor that cannot be ignored. Assuming it takes 20 hours to provide well researched and detailed planning advice, that could cost in the region of £2500 or more.

Here are two examples, which assume that there is no other income and normal tax allowances apply:

In the first an individual has a pension fund of £400,000. They take the maximum tax-free cash of £100,000 and then draw the rest of the pension in the form of taxable income of £300,000. The total tax due is £168,262. The net pension (including the tax free cash) comes to £231,737. The possible cost of advice at £2500, which wasn’t very good advice considering the outcome, means that 43% of the pension has been lost unnecessarily.

But it gets (temporarily) worse!

As the pension income is being paid on what is known as a ‘Month 1 Basis’, it will suffer tax immediately at an overall rate of 45% or £178,624 plus advice fees making a grand total cost of £181,124. This is because only one twelfth of the personal allowance and tax bands can be used against this massive single payment. The personal allowance is completely wiped out by this and then the income breaks through the additional higher rate tax band of £150,000, causing the excess to be taxed at almost 45%. It is because the allowances and the basic and higher rate bands have been restricted to only one twelfth of their annual value and everything else applied at the unlimited 45% band, that the tax bill at this stage is nearly 45% overall.

The difference, between what is due under normal rules and what is due under the month one rules, of £10,361 can be reclaimed on the self-assessment tax return but for a period of time the individual bears the effect of the negative cash flow.

If the pension were taken gradually as income, of say 5% per annum, drawing down the tax-free cash each year over twenty years, the tax would have been £880 per annum or £17,600 over the first 20 years, saving more than £150k! This would be a rate of tax of only 5.9%.

Of course one should add the cost of obtaining the advice that would lead to this saving. In this case £2500 seems to be a bargain by any standards!

On a much lower pension fund of £40,000 the total tax due would be £1,200, a tax rate of only 3% with a single income payment (including the 25% tax free cash) of £33,643. However, where this is taxed on a month 1 basis, the tax is nearly ten times what is should be and £11,116 payable immediately. The balance of £9,917 reclaimed on self-assessment tax return. That’s a 28% tax rate, but most of it repayable. Importantly still, taken gradually as income at say a 5% drawdown, the tax would have been nil! That doesn’t seem such a big deal. But the cost of Advice is still likely to be £2500, pretty steep for a relatively small fund, but required where the pension flexibility rules are being utilised.

Clearly with good financial advice, planning and some common sense, the tax bill can be kept low, assuming that is that the individual can control their natural urge to spend, spend, spend!

Ultimately though, it is clear from the Governments own predictions that that is not what they expect will happen and they at least are hoping for some excellent returns from your pension!