Retirement is changing, and people are living and choosing to work longer. The UK pension system needs to change to reflect that those in retirement have different needs, and will require a more diverse set of options than has previously been available. The UK government believes that with the right consumer guidance and support, people should be able to make their own choice about how and when to spend their pension funds.
From April 2015 the 320,000 people that retire each year with defined contribution pensions (mainly personal pensions and SIPPs) will have complete choice over how they access their pension. The government has already introduced flexible drawdown of pension savings for those who meet a minimum income requirement in retirement, and removed the requirement to buy an annuity by age 75.
In the 2014 UK Budget the Chancellor of the Exchequer announced further radical reforms. From 2015, pensioners will have complete freedom to withdraw as much of their pension as they like and will not be forced to buy an annuity.
Annuity purchase is where your pension fund is exchanged for a guaranteed income, payable for life, no matter how long you live. However, many people dislike annuities, either seeing them as offering perceived poor value for money as they are linked to government gilt rates or being concerned that, on their death, their remaining pension assets pass to the insurance company. The big problem with annuities is that annuity rates today are less than half what they were 15 to 20 years ago. Back in the late 1990s and early 2000s, pensioners could look forward to collecting annuity rates of 10% a year. However, thanks to falling interest rates and Government gilt yields, annuity rates these days are much lower.
The alternative to an annuity is income drawdown. The income is not guaranteed, since it is drawn from the fund which remains invested. However, you can choose how much income that is drawn or you can choose to take no income at all.
Income drawdown allows you to keep your pension fund invested and not buy an annuity. Currently, you can have your 25% pension commencement lump sum (previously known as tax free cash) and from the remaining fund you can take an income if you require, to a maximum of the Government Actuaries Department (GAD) rates (currently up to 150% of GAD). GAD rates have changed twice over the last few years, originally 120%, dropping to 100% on 6 April 2011, lifted back to 120% on 26 March 2013, and increased to 150% of GAD in the 2014 UK Budget.
GAD rates determine income limits and must be reviewed every three years (previously 5 years) so the increase to 150% of GAD this year is a welcome relief to many pensioners who due to drop in investment returns and the maximum income allowable under GAD rules have suffered financially.
The UK pension system is undertaking its biggest reforms in almost a century in an attempt to promote freedom, choice and flexibility. So what are these changes and how will they affect you as a UK pension holder, no matter where you live?
YOU CAN HAVE IT ALL!
From 6th April 2015, members of UK defined contribution pension schemes such as Self-Invested Personal Pensions (SIPP) and personal pension plans will be able to withdraw up to 100% of their pension fund at retirement (minimum age 55) regardless of whether they are UK resident or not.
CAUTION:
This is fantastic news (on the face of it). However, care is needed. Ultimately, pensions are designed to provide an income in retirement, so draining your pension by taking amounts over the current 25% pension commencement lump sum limit will impact on the ability of your pension fund to provide an income for the whole of your retirement. This may result in you becoming reliant on the State for your income should your pension fund be drained completely.
Consideration should also be given to the impact on your potential inheritance tax liability for any amounts taken from your pension. Should you choose to take additional amounts from your pension fund you may leave your beneficiaries exposed to inheritance tax in the event of your death. Whilst held within your pension structure, your pension fund is in a tax free environment. Once outside of your pension structure, for instance, held on deposit or in an investment, the fund is exposed and included in your estate for inheritance tax. So what the Chancellor deems as offering more flexibility for pensioners is in fact going to increase the tax you pay in two ways:
Income tax is payable on the excess taken over 25% of your fund at your marginal rate in your country of residence. The full amount of the withdrawal will be added to your income for the year.
UK Inheritance tax is payable on any amount over your nil rate band on savings held outside of a pension fund.
When approached with caution, in most cases, investors will pay no tax, as most will stay within the confines of the 25% tax-free limit in order to ensure that they maintain a pension fund value with the ability to provide an income for life in addition to protecting their assets from unnecessary tax for their beneficiaries on death.
LOOP HOLES
The UK government spends £22.8 billion a year on pensions tax relief and is keen to ensure that tax relief is used for genuine pension saving rather than to reduce the tax an individual pays on their current earnings. New tax rules will be put in place to ensure that individuals over the age of 55 do not use the new flexibilities, which are intended to provide people with greater access to their retirement savings, to avoid tax and national insurance contributions on their current earnings by diverting their salary into their pension with tax relief, and then immediately withdrawing 25% tax-free. Those in flexible (not capped) drawdown who currently have an annual allowance of £0 for additional pension contributions and those who choose to draw down more than their tax-free lump sum from a defined contribution pension will be able to benefit from further tax-relieved pension saving, and make further tax-free contributions to a defined contribution pension of up to £10,000 per year.
DEATH BENEFITS
UK Pension funds are subject to special tax treatment on death where the fund passes to your estate in the form of a lump sum. HM Treasury impose a 55% Recovery Charge on the fund, on the premise that people with these funds are likely to have had higher rate tax relief along the way.
On death after taking benefits (even if you have only taken your pension commencement lump sum and not taken an income) the options are:
Maintenance of the drawdown arrangement for your dependent
Return of fund less the 55% ‘Recovery Charge’ on funds held in drawdown
Full fund pass over for the provision of a dependents pension (annuity)
Donation of fund to charity with NO TAX
So funds can still pass to a dependent free of this tax so long as the money is being used for the provision of income.
Most disconcerting is that death benefits for all defined contribution pensions are subject to the 55% tax charge. However, on 27th March 2014, The Government announced consultations to amend legislation to the current tax rules that apply to pensions upon death. They believe that the 55% tax charge is too high and are engaging with stakeholders to review these rules. It is unlikely though, that this charge will be reduced below the current UK inheritance tax rate of 40%.
COMPANY PENSION SCHEMES – HURRY, TIME IS RUNNING OUT FOR SOME
From 6th April 2015, transfers out of unfunded public sector pension schemes will be prohibited which could be bad news for NHS, teachers, fire-fighters, police and armed forces whose schemes fall into this category and whose members will therefore be denied the right to transfer in order to protect the Exchequer and taxpayers. For public service schemes, the majority of which are unfunded, the contributions of members and employers are used to pay for pensions in payment, with any surplus requirements met by taxpayers through payments from the Exchequer. As there are no ‘funds’ for these pension schemes, any decisions to transfer would represent an upfront direct cost to the Exchequer and ultimately UK taxpayers.
Transfers from the Local Government Pension Scheme (“LGPS”) will still be permitted as it is a funded scheme as will transfers from private sector defined benefit schemes. However, these will be subject to additional safeguards. Those with Additional Voluntary Contributions (AVCs) will also be able to access these flexibly, subject to their pension scheme rules.
That said, special care is needed when considering the transfer of any company pension scheme. In most cases the guaranteed benefits provided by the company scheme outweigh the potential gains of a private scheme or QROPS.
However, there are instances where clients do decide to transfer their company pensions due to their individual circumstances, for instance:
Concern that your company pension scheme is underfunded which means that the scheme trustees can ‘change the rules’ and therefore the level of your retirement income (many company pension schemes are underfunded, with average funding levels currently between 85% and 87%).
You wish to start taking an income from your pension fund before the scheme’s normal retirement date.
You want/need the pension commencement lump sum (previously tax free cash) before the scheme’s normal retirement date.
There is no spouse’s pension available within the scheme (we have recently come across a Teachers Pension that falls into this category due to the rules applicable at the time the client was a member of the scheme).
There is a spouse’s pension available but the income will reduce upon your death (this is the case for the majority of company pension schemes).
You are not married and do not like the idea of the pension dying with you. For instance, you would like to leave your pension fund to your children or your new partner (once children are over the age of 18 there are no benefits payable to them under company pension scheme rules).
If you have a short life expectancy.
If you prefer wealth to an income stream.
“transferring from a defined benefit pension is unlikely to be in most individuals’ best interests, although in some limited cases a transfer may be the best option.” (George Osborne, Chancellor of the Exchequer July 2014)
THE MINIMUM RETIREMENT AGE IS INCREASING
From 6th April 2028, the minimum retirement age will increase from 55 to 57. This means that anyone who is under the age of 40 now will not be able to take benefits until age 57 (apart from public service schemes for Fire fighters, Police and the Armed Forces whose normal pension ages reflect the unique nature of these occupations).
SMALL PENSION FUNDS AND TRIVIAL COMMUTATION
The trivial commutation and small pot rules will continue to apply to both defined contribution and defined benefit schemes. These rules now allow individuals to take up to £30,000 of total pension savings (previously £18,000) as a lump sum, or a £10,000 small pot (previously £2,000) as a lump sum regardless of total pension wealth. The number of personal pots that can be taken under these rules has increased from two to three. The age at which an individual can make use of these rules will also be lowered from 60 to 55 and these withdrawals will be charged at an individual’s marginal rate of income tax.
SO WHAT IS THE IMPACT OF THESE PENSION REFORMS ON QROPS?
Currently the new pension reforms do not apply to Qualifying Recognised Overseas Pension Schemes (QROPS) but the UK government have signalled that changes to the UK pension tax rules will have implications for QROPS. The government has said that it will “consider these implications further to ensure that the rules relating to QROPS are appropriate when the new system comes into force”.
For those who remember the issues over full encashment of UK pensions in jurisdictions such as New Zealand not too long ago, changes to QROPS rules allowing full encashment would be a massive U-turn for the UK government, who have never allowed this mechanism in QROPS before. However, the Government are unlikely to want to disadvantage QROPS holders so we await further information over the coming months in this respect.
Please take a look at our website – www.speedfinancialsolutions.com for further information and contact us (Tel 951 315 271 or 951 318 529) – we are happy to discuss your own situation in more detail. One of our advisers will be happy to come and spend some time with you either in your home or at our office to explain and go through your options, so do call to make an appointment.
Andrea Speed Principal Speed Financial Solutions 4 September 2014