Deciding between drawdown and annuities – 23 years before retirement…

I had planned a completely different post today. But, like a moth to a naked flame, I’m drawn to another post on pensions. This time, on deciding between drawdown and annuities. The catch is, you’ve still got 23 years till retirement.

The question posed comes from a This Is Money post:

I’m only 34 but my pension firm wants me to decide NOW between drawdown and an annuity – can it do this?

http://www.thisismoney.co.uk/money/pensions/article-6023907/How-choose-pension-drawdown-annuity.html

The post is a regular series where readers can send in questions to former Pensions Minister Sir Steve Webb. I found this one particularly interesting because it’s a question I’ve had to answer, and I suspect a large proportion of readers have also had to answer (perhaps without their knowledge!) On the face of it, it seems absurd that a 34-year-old should have to ‘choose’ between drawdown and annuities. Let’s have a little dig in.

The question

I’m 34, make regular contributions into a defined contribution company pension, and until recently have pretty much ignored it.

I logged on to have a look at the provider’s new portal and noticed I had a new range of options which boil down to me choosing now if I think I’ll be wanting to take an annuity or a drawdown pension.

What it doesn’t tell me is how this choice affects what I might get when I hit the magic age. Which is the least ‘risky’? If I say drawdown, but later decide annuity, does that put me in a worse position than if I flipped it around?

Should I be trying to split the pots – I’ve got a couple transferred in from other places? What if drawdown doesn’t exist in the future? What if some magical new pension option appears?!

I’m not looking for the differences between the options at retirement, more about the investments which will be made now. Help?

What brought about this madness?

Steve’s response is, of course, bang on the money – I’ll do my best to paraphrase. This mad situation comes about for two reasons.

First, the ‘choice’ arises because of pension freedoms. Before 2015, almost everyone would have to use their pension pot to buy an annuity. Since the freedoms, savers can opt instead for drawdown.

Second, when you contribute to a pension and haven’t explicitly chosen an investment for it to go into, it will go into a default fund. When everyone had to buy an annuity the fund would use something called lifestyling (or glide pathing). This is where, in the years before retirement, the fund moves out of equities and into bonds. This is to cut the volatility of your pension pot in the run-up to taking an annuity.

Here’s an example from one of my pension schemes:

This is for an ‘annuity’ type retirement:

Lifestyling

This is all very sensible, lifestyling before an annuity is one of the few things most pension experts seem to agree on. But given that you no longer need to buy an annuity, and can opt for drawdown instead, the game changes.

If you’re opting for drawdown, there is strong evidence that you don’t really want lifestyling (or at least, not as much of it). That’s because you will continue to keep investing your pot after retirement, and will want to keep benefiting from growth in your investments.

What happened

Companies will make a decision for all pension scheme members. This is reflected in their choice of default fund.

Most companies now assume that savers will take drawdown. So they changed their default fund from one that used lifestyling into one that did not. Not all companies did this, and the default fund may continue to use lifestyling.

What you do about it

You have the choice as to whether you intend to buy an annuity or opt for drawdown. If you select to go into drawdown, your investments will likely not be lifestyled. You can change this ‘notional’ choice at any time pre-retirement (although you should check your scheme rules).

You can also usually actively dictate what happens to your investments in two ways.

In the first way, you stay in the default fund but you select whether you want lifestyling or not, and the percentage of your pension contributions that go into a lifestyle investment option.

In the second you instead pick which funds you invest into (and not the default fund). Your pension scheme will offer a list of different investment options and you can ‘pick and mix’ between them.

Does it matter?

If you’ve elected to stay in the default fund (the first option above), you won’t see any practical difference in your investments until about 10-15 years before retirement. As shown in the chart above, when I would get within 10 years, the investment proportions changes. It’s around that time when you should really start thinking about whether you want to drawdown or take an annuity with your pension pot (or a mix of the two). Have a look at two previous posts of mine on drawdown and annuities on each option.

A word on default funds

If you haven’t actively selected what funds you want your pension contributions to be invested in then you are likely invested in the default fund.

Unfortunately, this is not always a good thing. The default fund doesn’t mean ‘standard’. In fact, it is a lottery whether your default fund is any good or not (link – FT google result).

It is absolutely worth taking the time to find out more about your default fund and the other fund options available to you. Generally speaking, low-cost, passively managed equity funds are what you are looking for. With these funds, you are invested in higher return assets but with higher risk. However, very few investments are absolutely certain and even government bonds can go up and down in value.

A final question

I want to round off this post with a final question:

Why do I have to make these decisions?

I’m really interested in investing and pensions (I suspect many readers are too). But most people find pensions boring and confusing. Should people have to make these kinds of decisions? As I mentioned before, I think it’s better to make saving and investing as painless as possible than to encourage forced and painful engagement.

The reality is very few people will choose the funds into which their pensions invest. The government and the financial services industry have reluctantly come to the conclusion that it’s better for people to be saving something, anything, even if it’s not perfect than to be saving nothing. Faced with bizarre questions like the one in this post today, most people will (quite sensibly!) run and hide.

Unfortunately, it is rare to find open Defined Benefit schemes. The true beauty of these schemes is not the (usually) higher retirement benefits. Rather, it’s that those savers did not need to make any investment decisions for their pension. They could get on with doing what they are paid to do and leaving the scheme to deal with the complexities of investing.

Then again, that probably means more readers for my blog…

All the best,

Young FI Guy

Pension costs and transparency inquiry

The Work and Pensions committee is launching their pension costs and transparency inquiry (link)[1]. According to the committee, they are seeking your views on whether the pensions industry provides sufficient transparency around charges, investment strategy and performance to consumers:

The Inquiry will examine whether enough is being done to ensure individuals:

  • get value for money for their pension savings;

  • understand what they are being charged and why;

  • understand the short- and long-term impact of costs on retirement outcomes;

  • can see how their money is being invested and how their investments are performing;

  • are engaged enough to use information about costs and investments to make informed choices about their pension savings; and

  • get good-value, impartial service from financial advisers.

Eight Questions

I became aware of this latest inquiry from Henry Tapper, founder of the Pensions PlayPen and a director of First Actuarial. The inquiry has asked for submissions to eight questions, which I copy from Henry’s blog (link) [2] with his highlighting:

  1. Do higher-cost providers deliver higher performance, or simply eat into clients’ savings?
  2. Is the government doing enough to ensure that workplace pension savers get value for money?
  3. What is the relative importance of empowering consumers or regulating providers?
  4. How can savers be encouraged to engage with their savings?
  5. How important is investment transparency to savers?
  6. If customers are unhappy with their providers’ costs and investment performance/strategy, are there barriers to them going elsewhere?
  7. Are independent governance committees effective in driving value for money?
  8. Do pension customers get value for money from financial advisers?

Paul Lewis weighs in

Paul Lewis (of, among others, Radio 4 Moneybox fame) was quick to offer his pithy answers.

For the most part, I agree with Mr Lewis. Here are my responses to those eight questions.

Do higher-cost providers deliver higher performance, or simply eat into clients’ savings?

They do not deliver higher performance – FACT. The evidence from the FCA is unambiguous: “there is no clear relationship between charges and the gross performance of retail active funds in the UK”. The FCA produced a comprehensive, detailed analysis of this (link)[3]. This is the same for not only individual savers but also for institutional pension schemes investing hundreds of millions or pounds.

Is the government doing enough to ensure that workplace pension savers get value for money?

No, the government isn’t doing enough. The FCA has found time and again that people do not have trust in pensions (link)[4]. It’s not possible to think you are getting value for money if you think you are getting mugged off. In fact, the government isn’t doing enough to help people save full stop. 2% contributions for auto-enrollment will not leave anyone with enough in their nest egg to worry about value for money.

What is the relative importance of empowering consumers or regulating providers?

You can’t put it in the consumers’ hands and expect them to correct deficiencies in the market. The providers have the ability and funds to make life easy for consumers. Besides, this isn’t the right question to be asking. I’m sure readers of this blog are very interested in their finances and investing, but most people aren’t. They don’t want to be empowered, they want someone to make it easy for them so they don’t have to worry about something they’re not interested in.

How can savers be encouraged to engage with their savings?

I echo Mr Lewis: Do savers need to be engaged? Do they want to be engaged? I think the answer to both is: No. It’s better to make saving and investing as painless as possible than to encourage forced and painful engagement.

How important is investment transparency to savers?

Very. Lack of transparency leads to lack of trust. Lack of trust leads to lack of saving. It’s important to remember that opacity comes from somewhere. It is a symptom of a market that is too complex and not focused on consumer outcomes.

If customers are unhappy with their providers’ costs and investment performance/strategy, are there barriers to them going elsewhere?

Yes. Both in time and money. But most importantly, in hassle. It can be utterly painful to switch providers and you often have a nerve-wracking wait while your money is being transferred in the ether. These are savers life savings yet time and again providers flout the transfer guidelines. ISA transfers that should take 30 days, can take half a year. This has been a problem for years and the regulators have done little about it. It’s all well and good encouraging savers to shop for the best deals, but if doing so is painful, then savers will not do it. (link)[5] (link)[6]

Are independent governance committees effective in driving value for money?

Somewhat. But IGCs (link)[7] will naturally be focussed on compliance as their number 1 priority. Value for money will always be a distant second. So when there is any ‘doubt’, bureaucracy is followed and improving investors’ outcomes is sidelined.

Do pension customers get value for money from financial advisers?

Rarely. That’s because it’s not cost-effective for most IFAs to offer non-regulated services. It’s these services: planning, asset allocation, behaviours, guidance that are the biggest determinants of financial success or failure. The regulatory regime forces IFAs to focus on products and makes it non-cost effective for the most people to access financial advice (the ‘advice gap’). IFAs need to buy food for their family too (and cover their insurance and compliance costs), we can’t expect them to reduce their prices to a loss or do it for free.

Your thoughts!

You can send your own responses to the committee, and I urge you to do so. (link)[8] The committee opened up responses on its ESA/PIP inquiry and received a flood of submissions that greatly contributed to the committee’s findings.

I would really like to hear your thoughts – please do leave a comment on your responses to some or all the questions.

 

All the best,

Young FI Guy

 

Links:

[1] – https://www.parliament.uk/business/committees/committees-a-z/commons-select/work-and-pensions-committee/news-parliament-2017/pension-costs-17-19/

[2] – https://henrytapper.com/2018/08/05/thinking-the-unthinkable-franks-at-it-again/

[3] – https://www.fca.org.uk/publication/market-studies/ms15-2-3-annex-4.pdf

[4] – https://www.fca.org.uk/publications/market-studies/retirement-outcomes-review

[5] – http://www.thisismoney.co.uk/money/experts/article-6002491/TONY-HETHERINGTON-leaving-investment-service-Smart-idea.html

[6] – https://www.telegraph.co.uk/finance/personalfinance/savings/11512350/Shambolic-Isa-transfer-errors-continue-to-hit-savers.html

[7] – https://www.fca.org.uk/firms/independent-governance-committees

[8] – https://www.parliament.uk/business/committees/committees-a-z/commons-select/work-and-pensions-committee/inquiries/parliament-2017/inquiry11/commons-written-submission-form/

The Annual Allowance

A few weeks ago I wrote about the Lifetime Allowance (LTA). The LTA was brought in on A-day (6 April 2006) when there was an overhaul of UK pensions. (It’s worth having a read of that piece for some of the background history).

At the same time, the Annual Allowance (AA) was also introduced. The AA is very much the Ashley to the LTA’s Mary-Kate (or if you prefer, the Ronnie to the Reggie).

So in this post, I’m going to look into the Annual Allowance and ‘square the circle’.

What the Annual Allowance is and why it exists

The Annual Allowance for 2018/19 is £40,000. What happens is this: if your total contributions into your pensions are greater than £40,000 you will have to pay a tax charge. This tax charge is the top marginal income tax rate on the excess above the AA.

As I mentioned in my Lifetime Allowance post, when you put money into a pension the Government provides tax-relief. The underlying principle under the pension tax-relief system is that you defer taxes.

With the Annual Allowance, the Government is basically capping the amount of tax relief they will give you in a year. In effect, the Government is saying: “you’ve got enough from us, you’re on your own now”.

This seems quite reasonable in principle – should the Government be subsidising the pension savings of the very rich? In general, I agree with this principle. But there are some issues.

Firstly, people don’t earn a consistent salary over their career. They are likely to earn much more in later years – and therefore, contribute much more to their pensions.

Secondly, as we saw with the Lifetime Allowance, lots of Government tinkering has (in my view) resulted in some unintended consequences which feel like they defy the spirit of what is trying to be achieved (more on that later).

Before we jump in, it’s very important to note that the Annual Allowance operates separately and differently to tax relief rules. Let’s quickly touch on the tax relief rules.

Tax Relief

Currently, tax-relief on gross individual pension contributions is limited to £3,600 or 100% of relevant UK earnings per tax year. Importantly, there is no carry forward of unused tax-relief.

Annual Allowance

The Annual Allowance works differently. It’s based on ‘Pension Input Amounts’ – the total of all pension contributions. These are tested over ‘Pension Input Periods’ which (historically) are not necessarily the same as tax years. The AA can also be carried forward. The AA also varies depending on how much you earn and whether or not you have taken some pension benefits.

History of the Annual Allowance

The Annual Allowance came into existence on 6 April 2006, known to those in the pensions industry as A Day. A Day is the Pension expert’s equivalent to the birth of Christ – things are either pre-A Day or post-A Day.

Prior to A Day there were a number of rules and limits to how much could be contributed to an individual’s pension.

The starting Annual Allowance was £215,000, increasing up to £255,000 in 2010/11. It was then dramatically slashed down to £50,000 in 2011/12 before being cut further to £40,000 in 2014/15.

Annual Allowance over time
Annual Allowance over time

Source: Royal London

You’ll notice some asterisks by some of the figures.

Due to the dramatic change in the Annual Allowance in 2011/12, a one-off pension ‘straddling’ adjustment was available. I won’t delve into the detail, but if 2011/12 is relevant for your AA, remember that there are some special rules that applied (your financial planner or accountant will help with the calculations).

In 2015/16 the Government aligned pension input periods to tax years. Before then, pension input periods and tax years were not necessarily aligned. The Government adjusted the Annual Allowances so that for the period 6 April 2015 to 8 July 2015 the AA was £80,000, for the period 8 July 2015 to 5 April 2016 the AA was zero. But you could carry forward the lower of £40,000 and £80,000 less what you input between pre 8 July; minus what you input post 8 July. In effect, you could get up to £80,000 in AA.

With the introduction of pension freedoms in 2015, the Money Purchase Annual Allowance (MPAA) was introduced to further limit the amount of tax-relief available for those who have accessed some of their pensions. In 2015/16 and 2016/17 the MPAA was £10,000 before being reduced to £4,000 in 2017/18.

Finally, In 2016/17 the Government introduced the Tapered Annual Allowance (TAA), potentially reducing an individual’s allowance to a minimum of £10,000 (more on that later).

How it works

The Annual Allowance is assessed each tax year.

Inputs

The first step is to calculate the total pension contributions in the relevant Pension Input Period.

For defined contribution pensions this is calculated as:

DC Annual Allowance Input Calculation
DC Annual Allowance Input Calculation

For defined benefit, it’s a little bit more complicated:

DB Annual Allowance Input Calculation
DB Annual Allowance Input Calculation

Here’s an example DB input calculation from the HMRC tax manual:

Tina is a member of a final salary scheme giving her a pension of 1/60th pensionable pay for each year of service. At the start of the pension input period Tina’s pensionable pay is £80,000 and she has 31 years pensionable service. At the end of the pension input period Tina’s pensionable pay has risen by 5 per cent to £84,000 with 32 years pensionable service.

Tina does not have any other pension arrangement.

Step 1: Calculate opening value

Annual Pension: 31/60 x £80,000 = £41,333.33

Multiply by factor of 16: £41,333.33 x 16 = £661,333.28

Increase by CPI (say 3%): £661,333.28 x 1.03 = £681,173.27

Step 2: Calculate closing value

Annual pension: 32/60 x £84,000 = £44,800

Multiply by factor of 16: £44,800 x 16 = £716,800

Step 3: calculate pension input amount

Closing value – opening value = £716,800 – £681,173.27 = £35,626.73.

Therefore, Tina is within the Annual Allowance and there is no charge.

Carry Forward

Carry forward is available which allows unused Annual Allowance from pension input periods ending in the previous three tax years to be carried forward. It is then added to the annual allowance for the current pension input period.

It’s important to bear in mind the transitional changes in 2011/12 and 2015/16 (you can read more about the specific steps to take here at Pru Adviser: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/annual-allowance-carry-forward/#section-3)

You can find a number of worked examples of carry forward in the HMRC tax manual (link).

Also note that you don’t need to make a claim to HMRC to use carry forward.

The charge

The charge is levied on the excess of pension contributions above the Annual Allowance. So if there an individual has contributed £50,000, the excess if £10,000 (£50,000 – £40,000).

This excess is charged at the individual’s marginal rate. In effect, it sits on top of an individual’s taxable income.

Bear in mind, you must self-assess. If you’ve exceeded the Annual Allowance you’ll need to record this in your tax return.

It’s possible to get your pension scheme to pay the charge for you, under the ‘Scheme Pays’ system. This is available if:

  • The total annual allowance charge is over £2,000, and
  • The inputs are in excess of the standard annual allowance in the scheme.

Pension schemes must provide the information you need for calculating your pension inputs automatically each year. But don’t rely on your various schemes, it’s up to you. If necessary, get in contact to get the information you need.

Tapered Annual Allowance

In 2016/17 the Government introduced the Tapered Annual Allowance (TAA). Aimed at ‘high earners’, the Annual Allowance is reduced for people who have ‘adjusted income’ over £150,000 and ‘threshold income’ over £110,000 a year. The AA reduces by £1 for every £2 over £150,000 down to a minimum of £10,000.

As noted above, both adjusted income and threshold income need to be above the limits. If you are over only one of the limits, the taper doesn’t apply.

Calculating adjusted and threshold income

Both include all taxable income. The difference between the two can be summarised as: adjusted income includes all pension contributions (including employer and salary sacrifice), threshold excludes pension contributions.

Annual allowance Adjusted and Threshold Income calculation
Annual allowance Adjusted and Threshold Income calculation

Unintended consequences

Unfortunately, there have been a number of unintended consequences with the Tapered Annual Allowance.

Firstly, it’s thought that thousands of people were unintentionally snared by the change and hit with unexpected tax-bills (Professional Adviser).

Secondly, lots of individuals accruing DB pensions above the Annual Allowance have now found that they aren’t eligible for Scheme Pays (FT Adviser). Leaving some with big cash holes to fill.

Finally, I’m aware of several employers who have capped their pension contributions for high earning employers at £10,000 to avoid leaving their employees worse-off from a cash perspective. The difficulty (impossibility?) in employers knowing what other sources of income their employees have means that many have opted to just avoid the whole problem and reduce pension contributions and to pay other types of benefits in lieu. (see FT)

Money Purchase Annual Allowance

In 2015 the Government brought in the fabled Pension Freedoms. This necessitated the need to introduce a new allowance to prevent individuals crystalising a pension and ploughing the money back into a pension.

Thus the Money Purchase Annual Allowance (MPAA) was born. From 6 April 2015, an individual taking income from Flexi-Access Drawdown (FAD) or taking an Uncrystallised Funds Pension Lump sum (UFPLS) triggers the MPAA. Initially, the MPAA was at £10,000 before being dramatically slashed to £4,000 on 6 April 2017.

The MPAA triggers if an individual:

  • Takes a PCLS and income (FAD)
  • Takes an UFPLS
  • Exceeds the GAD rate in a capped drawdown (i.e. turns a capped drawdown into a FAD).
  • Takes a Flexible Annuity (depending on specifics)

It does not trigger when an individual only:

  • Takes a PCLS only
  • Remains in capped drawdown
  • Takes an annuity (non-flexible)
  • Takes a small pot (via commutation)

The Money Purchase Annual Allowance applies to DC only, but not to DB accrual. However, DB contributions are still tested against Annual Allowance. There is no carry forward of the MPAA. Note, the MPAA doesn’t replace the current AA, if applicable, the MPAA and AA will be calculated alongside each other.

Annual Allowance Planning

As I highlighted in the LTA post, paying a tax charge isn’t necessarily a bad thing. As Pru Adviser note:

Opting out to save a tax charge, even if the net benefit is better, would be a bit like a client asking their employer to stop paying their salary because there is a tax charge.

Here are some helpful steps to think about when thinking about the Annual Allowance:

  1. What benefits will you get if you keep contributing – thinking about levels of contribution, future salary increases, interaction with Tapered Allowance
  2. What will it cost (net of tax relief) to get those benefits
  3. Calculate the overall benefit receivable net of tax charges. In addition, will the scheme pay, if you’re in a DB scheme what is the commutation factor?
  4. What will the benefit be if you stopped contributing today?
  5. In addition to (4), what is the value of alternatives benefits (employer paying different benefits)
  6. What will you do instead of contributing to the pension? Will you receive more salary? Invest in ISAs or other investment vehicles? Are there differences in access and risk factors compared to the pension?

Below is an example:

Say we have two individuals, both 45% taxpayers each with a salary of £210,000 (so they have a TPAA of £10,000) with no carry forward available.

One is a member of a DB 1/60th scheme, employee contribution is 6% with scheme pays at commutation factor of 20:1.

The other is a member of a DC scheme where the employer pays 6% of salary, and employee contributions are matched 1:1 up to 6%. The scheme pays the AA charge.

Annual Allowance Planning Example

Having done the number crunching it leaves us with a few questions. For the DB member, is it worth paying £6,930 today for an extra £2,465 each year after retirement? For the same cost, the DC member gets an additional pension amount of £25,290. Is it worth the cost? Or are there alternatives which are better value? The judgment will, of course, depend on the circumstances for each individual and their financial goals and plan.

Closing – key points

  • The AA regime is a cap on the amount of tax relief the Government will give you in a year
  • It’s assessed each year on total pension contributions (yours plus employer plus third parties). The calculation varies between DC and DB.
  • It’s possible to carry forward unused annual allowance from the previous three tax years.
  • If both your ‘adjusted income’ is over £150,000 and ‘threshold income’ is over £110,000 your AA is tapered by £1 for £2 down to a minimum of £10,000.
  • If you flexibly access your pensions you will be hit by the MPAA at £4,000.
  • Paying an AA tax charge is only bad if the net benefit isn’t “worth it”

Please let me know your thoughts. Have you done any Annual Allowance Planning? Has the dramatic fall in the Annual Allowance changed what you (or your employer) have done with your pensions? Do you think the Money Purchase Annual Allowance will affect you?

Disclaimer: Please note, I’m not an FCA authorised financial adviser. This site provides information, comment and opinion for information purposes only and should not be considered financial advice. The site may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.

All the best,

Young FI Guy

The Lifetime Allowance

When I started this blog I didn’t have a set target in mind about what I wanted to write. The result is that I’ve written about all sorts of subjects from why Mrs YFG and I don’t want kids through to the technicalities in Safe Withdrawal Rates.

I enjoy writing about FI and various tangential subjects. But I’ve also really enjoyed writing about personal finance subjects. I like to learn about something, try to understand it and then have a go as explaining it in (hopefully) a concise and easy to understand way.

The most popular post on the blog so far has been on the State Pension and NI-top. Like a moth to flame, I’m continually attracted to writing about pensions. I think that’s because Pensions can be inherently complicated and finding good material on the subject is challenging. It’s also because there are some misconceptions and I want to challenge those.

Today’s subject, the Lifetime Allowance, seems to tick all three boxes. Lets start with a quick introduction.

What the Lifetime Allowance is and why it exists

The Lifetime Allowance (LTA) for 2018/19 is £1.03 million. Basically what happens is if your total pensions are greater than £1.03 million, you will get a 55% tax charge on any lump sums you take or 25% on any pension income you take (more on all that in a bit).

When you put money into a pension the Government provides tax-relief. For example, if you earn £80,000 a year you will be a 40% tax-rate payer. If you put £600 into your pension out of taxed income the government will put in £400 (40% of the total contribution) to bring you up to £1,000.

The underlying principle under the pension tax-relief system is that you defer taxes. Whilst pensions can be used to avoid taxation, generally speaking, what happens is that paying tax “going in” you pay tax later on when you draw on your pension.

It’s this principle which the lifetime allowance is balanced on. In effect, the Government is saying it isn’t in the business of giving rich people unlimited tax deferral benefits. So they created the LTA, a limit to the amount of tax deferral the Government is willing to give you.

History of the Lifetime Allowance

The Lifetime Allowance came into existence on 6 April 2006, known to those in the pensions industry as A Day. A Day is the Pension expert’s equivalent to the birth of Christ – things are either pre-A Day or post-A Day.

Essentially what happened on A Day was that a huge raft of disparate measures and rules were scrapped with new simplified rules coming into force. More than 8 different regimes were boiled down into two: the Lifetime Allowance and the Annual Allowance (more on that another time).

The starting LTA was £1.5 million. It crept up to £1.8m in 2010/11 before being drastically cut down.The 2018 budget provided some light relief, the LTA was increased by CPI (3%). However, the Government has no written commitment to continue increasing the LTA by CPI.

Protection mechanisms were introduced at each reduction in the LTA (including introduction): in 2006, 2012, 2014 and 2016. More on that in a bit.

When is the Lifetime Allowance assessed

The most important thing to remember about the LTA is that it is not assessed when you have a pension pot above £1.03 million. Rather, the LTA is assessed at specific points when you interact with your pension. These are called Benefit Crystallisation Events. There are 12 of them in total. But I’m going to focus on the 6 main ones (and Pre-A day interaction).

A few comments on the table above:

  • You can see a disconnect between how DB and DC schemes are measured. DB (BCE2) at 20 x annual pension; DC at the Annuity purchase price (BCE4) or Drawdown value (BCE1). With annuity rates at very low rates, its possible that were somebody to transfer from a DB to DC scheme that they could end up the wrong side of the LTA and incur a tax charge they may not have done if they’d stayed in their DB scheme (more on that later).
  • A similar situation exists for the QROPS transfer (BCE8) which is measured at Transfer Value. Bear in mind that since 9/03/2017 (retrospectively) QROPS transfers outside the EU incur a 25% tax charge.
  • Pre-A day pots are measured at 25 times pension or max capped drawdown. This is to account for tax-free cash taken. Pre-A day pots are measured when the 1st post A-day BCE occurs (such as, reaching 75 (BCE 5a) with a drawdown pot post A-day).

How the charge is assessed

In effect the charge is assessed by adding up all your pensions and “filling up” the LTA like a bucket. You only get a charge if the bucket starts overflowing.

You can partly dictate the order in which you fill the bucket. By taking some pensions earlier/later you can reduce your LTA charge. For example, as DB schemes are more ‘generously’ assessed compared to a lifetime annuity, it might make sense to take lifetime annuities first if possible. A lot will depend on what an individual’s scheme rules will allow.

Another thing to note is that Drawdown pensions (except Pre-A Day pots) are tested against the LTA twice. The first test is BCE 1 when the funds are first designated and then again on either:

  • Scheme pension (BCE 2), or
  • Annuity Purchase (BCE 4), or
  • reaching age 75 (BCE 5A), or
  • on transfer to a QROPS (BCE 8).

To ensure there no double counting only the increase in funds crystallised under BCE 1 are tested at the second designation.

How the charge is applied

As mentioned above there are two tax-rates: 55% and 25%.  These are commonly called the “lump-sum” and “income” rates. Its perhaps easier to think about these instead as whether the money “leaves” or “stays” inside the pension tax reigme. For example, if you take a lump-sum on drawdown, it leaves the tax regime. The excess above the LTA is charged at 55%.  If you instead take an annuity income, you take a 25% tax charge on the excess above the LTA plus any income tax (note: QROPS transfers count as a 25% LTA charge).

You might think that 25% is lower than 55% so taking income is always better. But it depends on what income tax rate you’ll be at. As an example:

  • Take £100 lump-sum over LTA: £100 x (100% – 55%) = £45 after tax
  • Take £100 income over LTA:
    • 45% tax-rate: £100 x (100% – 25%) x (100% – 45%) = £41.25 after tax
    • 40% tax-rate: £100 x (100% – 25%) x (100% – 40%) = £45 after tax
    • 20% tax-rate: £100 x (100% – 25%) x (100% – 20%) = £60 after tax

As those being hit by the LTA are likely to be high earners (40% or even 45% tax rate), there’s probably little different in overall tax rate between lump-sum and income.

In terms of how it’s charged, usually the pension scheme will pay the charge: called a “Scheme Pays” arrangement. This is because schemes are joint and severally liable for the tax, so they like to make sure the tax is paid instead of HMRC being on their back.

Protection – always use protection?

As I mentioned earlier, HRMC provided “Protections” against the reductions in the LTA. They each work a little differently. And whether, and what, protection is right for you will depend on your circumstances.

2006 Primary

  • Brought in on A Day
  • Aimed at individuals who wanted to keep accruing or saving into pension and were over the LTA
  • Eligible if Pensions > £1.5m on A Day
  • Your LTA is enhanced by a Lifetime Allowance Enhancement Factor (LAEF) to get a ‘personal’ LTA (rounded up to 2 decimal places)
  • Can keep accruing/saving into pension
  • Underpinned by an LTA of £1.8m

Example calculation:

Pensions worth £1.8m.

LAEF = (£1.8m – £1.5m) / £1.5m = 0.2 LAEF

Personal LTA = £1.8m + 0.2 x £1.8m = £2.16 million

2006 Enhanced

  • Brought in on A Day
  • Aimed at individuals who had exceeded the 2006/2007 lifetime allowance of £1.5 million, or believed they might exceed the standard lifetime allowance in the future, and were willing to cease all future contributions or limit future accruals
  • Eligible at any pension value on A Day
  • “Unlimited” LTA
  • But no more accruing (above certain limits, roughly speaking no more than higher of 5% or RPI) or making further contributions into pension
  • Had to surrender “excess rights”

Fixed Protection at 2012, 2014 and 2016 (FP 2012 / FP 2014 / FP 2016)

  • Eligible for anyone without Primary, Enhanced or other Fixed Protection
  • Eligible at any pension value
  • Fixed LTA at:
    • £1.8 million – FP 2012 – must have applied by April 2012
    • £1.5 million – FP 2014 – must have applied by April 2014
    • £1.25 million – FP 2016 – still open for application
  • But no more accruing (above certain limits, roughly speaking no more than higher of 5% or RPI) or making further contributions into pension

Individual Protection 2014 and 2016 (IP 2014 / IP 2016)

  • Eligible if:
    • Pensions > £1.25 million on 5 April 2014 (IP 2014) – must have applied by April 2017
    • Pensions > £1 million on 5 April 2016 (IP 2016) – still open for application
    • Anyone who doesn’t already have Primary Protection
  • Receive a capped and fixed Personal LTA equal to pensions value at 5 April 2014 /2016 up to:
    • Maximum of £1.5 million – IP 2014
    • Maximum of £1.25 million – IP 2016
  • Can keep saving into pensions or accruing

Valuing the benefits

To get the Pensions value for Individual Protection (and Primary Protection) you had to value each pension depending on its type:

  1. Unvested Schemes (i.e. not yet paying):
    1. Money Purchase – at market value of funds
    2. Defined Benefit – at 20 x pension plus any cash by addition
    3. Cash Balance – amount available for provision
  2. Vested Schemes (i.e. already in payment):
    1. Pre-A Day pensions – 25 x pension / Max GAD for capped drawdown at the first post-A Day BCE [*]
    2. Flexi Drawdown – 25 x Max GAD when Flexi Drawdown entered [*]
    3. Post A day vestings – value at BCE

[*] This is a bit complicated see Pru Adviser for more information: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/individual-protection-2014-2016/?advsr=4&advtsr=11&q=individual-protection

Losing Protections

Unfortunately it’s possible to lose protections after you’ve successfully applied for them. In some cases, it can be completely unintentional.

The good news is that Primary Protection and Individual Protections are almost impossible to lose. The only situation where an individual can lose the protection is if they were divorced and the pension was shared. In effect this reduces the level of protection on the pension. Under IP 2016 there is an offset mechanism which reduces the level of loss.

The bad news is that the rules are much more strict for Enhanced Protection and Fixed Protection.

An individual loses Enhanced Protection if they:

  • accrued a benefit which exceeds the permitted limit defined as the “relevant benefit accrual”;
  • contributed to a DC scheme (with some exceptions);
  • had a new arrangement (except in the case of certain transfers); or
  • made some transfers (HMRC has set of permissible and impermissible transfers).

The relevant benefit accrual depends on the scheme rules, statutory rates and the level of CPI each September. Generally speaking, it is very difficult to not exceed the limit if you an active scheme member.

An individual loses Fixed Protection if they:

  • increased their benefits in DB scheme above a certain level;
  • contributed to a DC scheme;
  • start a new arrangement under a registered pension scheme other than to accept a transfer of existing pension rights; or
  • transferred to an unregistered pension scheme (i.e. not a QROPS), from a DC to DB scheme (depending on circumstances) or from one DB scheme to another (again depending on circumstances).

An individual doesn’t lose Fixed Protection if they are subject to a pension debit (divorce). However, they will not be able to rebuild any pension fund without revoking their Fixed Protection.

DB to DC transfers – a word of warning

Generally speaking, DB to DC transfers are allowed under Enhanced and Fixed Protection. But the rights in the new scheme must be actuarially equivalent to the rights being transferred. As a word of warning for those with Enhanced or Fixed Protection, some schemes have been reported to offer transfer values out of DB schemes far in excess of their CETV (Cash Equivalent Transfer Value). Such transfers could result in the individual losing their protections. This is where seeking independent financial advice is very important.

LTA Planning – where paying more tax isn’t always a bad thing

If there’s one thing to take away from LTA planning it’s that:

Paying tax is only bad if it the net benefit isn’t worth it

To give an example, say Jane earns £50,000 and is a member of an employment scheme and the employer will contribute 10% to her scheme unless she opt-out. Here’s the maths:

Amount added to pension fund: £5,000

Lump sum after 55% tax: £2,250

Net cost as a 40% tax payer: £0

In this case, she’s getting £2,250 for free. Clearly a good deal!

 

Now say Jane’s employer will match 10% to 10%. The maths can still be good:

Amount added to pension fund: £10,000

Lump sum after 55% tax: £4,500

Net cost as a 40% tax payer: £3,000

So for £3,000 after tax she can get £4,500 in your pension. An immediate 50% return.

Now whether that will be the right call for her will depend on a few things. If she’s close to retiring, that 50% boost is difficult to beat. On the other hand, if there are ISAs or her spouses pension available then it might be less enticing. Likewise if accessing that money is a long way away. She’ll also want to consider whether she wants to pass on an inheritance to her children; in that respect, the recent inheritance tax changes to pensions can make it a very appealing option.

To round up, I quote Pru Adviser (which was a helpful source for this post):

The key point that clients need to remember is that tax is only bad if the net benefit is not deemed “worth it”. Opting out to save a tax charge, even if the net benefit is better, would be a bit like a client asking their employer to stop paying their salary because there is a tax charge.

In closing – key points

  • The underlying principle under the pension tax-relief system is that you defer taxes.
  • The LTA regime is a claw-back of this the tax deferral
  • The LTA is assessed at certain interactions with your pensions, called Benefit Crystallisation Events (BCEs)
  • How your total pension pot is valued depends on what type of pension it is
  • There are a number of protections to increase or fix your LTA, but you can lose them if you aren’t careful
  • Paying an LTA tax charge is only bad if the net benefit isn’t “worth it”

Please let me know your thoughts. Have you done any Lifetime Allowance Planning? Has the Lifetime Allowance changed what you do with your pensions?

Disclaimer: Please note, I’m not an FCA authorised financial adviser. The site provides information, comment and opinion for information purposes only and should not be considered financial advice. The site may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.

 

All the best,

Young FI Guy

Drawdown: Lamborghinis and holidays

In my previous post I set out five reasons why I think annuities don’t deserve the bad press they get. In that post I focused specifically on the positives that are often overlooked in assessing annuities. I was challenged, both here and at Monevator, on setting out a similar style argument for drawdown.

I think that’s fair. Because, for my money, drawdown gets a lot of bad press that it too doesn’t deserve. The pension flexibilities introduced in 2015 continue to get hammered for retirees blowing their money on Lamborghinis and holidays. Even when the evidence from the FCA says that’s not the case. In its 2017 interim report on pension flexibilities the FCA found that (emphasis mine):

Over half (53%) of pots accessed have been fully withdrawn: 90% of these pots were smaller than £30,000. Over half of fully withdrawn pots were transferred into savings or investments. Overall, we did not find evidence of people ‘squandering’ their pension savings.

I also want to highlight: “90% of these pots were smaller than £30,000”. The FCA picked £30,000 for a reason. That’s because before the flexibilities you could (and still can) take a small pot commutation – immediately drawing down three small pots of £10,000 for a total of £30,000 – the flexibilities made no difference. In addition, if you had a total pension pots of £30,000 or less, you could take a trivial commutation – immediately drawing down the £30,000 (trivial commutation still exists for DB pots). What the FCA are saying is that, for the vast majority of people who have fully withdrawn their pots, they did so using options that were available to them before the flexibilities (they would or could have done it anyway). The FCA are due to publish their final report later on this year.

So lets get on with it: here are five reasons why drawdown doesn’t deserve the bad press it gets.

1. Drawdown provides total flexibility

Of course, that’s the point. As I’ve noted before, there are four key factors to consider when planning savings and investments: risk, time-horizon, access and affordability. Using drawdown provides a huge amount of flexibility – and therefore access – to your savings. That access allows clients to take money from their pension to make payments they might otherwise not be able to do. Such as meeting debts, paying-off the mortgage or making capital investments in their home or business.

2. Drawdown is the best way to match a retiree’s risk profile

That’s because you can tailor the investment approach in a drawdown fund to meet your attitude towards risk and capacity for loss. We can use the assets left to target growth, income or both. After taking an annuity, your retirement income is, in effect, tied to a gilt-like investment. Whilst suitable for many people, it might not be suitable for those who have a higher risk tolerance and want growth (and not income) from their pension pot. Likewise, long-term investing is the best way to protect against inflation risk. I appreciate that non-crystallised pots would be invested anyway. But we should be conscious that, for many people, there will be a need to access some money on retirement.

We can also plan our investment approach to help with matching time-horizons. For example, we can divide pension assets into three pots for different time-horizons. A short-term pot for paying income over the next year to 2 years. A mid-term pot for balancing income and growth requirements over the 5-10 period. And a long-term pot focused on long-term growth beyond 10 years. Over time, a retiree would move money between pots to balance their assets with their time-horizon requirements and income needs.

3. Expenses aren’t flat and smooth

We may like to think that our living expenses are predictable. But in reality, they are not. Particularly in retirement where there is larger possibility of critical illness or disability. But also for happier reasons, such as: providing for children and grandchildren or doing things that might have been put off due to working full-time. In that respect, drawdown is quite suitable. You draw the money when you need to, and you don’t when you don’t need to. In short: it’s easier to match your income to your expenditure. In addition income requirements typically decline in retirement. As we get older, we spend less. With that the case, a retiree can more comfortably shift their investment focus between income and growth generation depending on their circumstances.

4. Drawdown can help with tax and estate planning

The most important aim with pension decumulation is to have enough income to cover living expenses and support an adequate standard of living level. But that may not be a retiree’s sole aim. A retiree may also want to maximise the wealth they can leave to their family. In 2015, the Government removed the 55% “pensions death tax” with a more favourable regime. This made passing down pension funds inheritance tax-free depending on age of the retiree at death. For more info: https://adviser.royallondon.com/technical-central/pensions/death-benefits/death-benefits-from-april-2015/.

In addition, some retirees will benefit from using drawdown as they can vary the income they take to keep them within certain tax thresholds (i.e. within the tax-free allowance or at nil-rate). We should be careful however, in letting the tax-tail, wag the pensions dog. There is a risk, however unintended, that in trying to cut our tax bill we end up making decisions that harm our most important financial goals.

5. With drawdown you have the money (unless you spend it)

One of the most cited criticisms of annuities is that you “give up” the capital. Whilst I don’t necessarily agree with that wording, with drawdown you keep the capital. It means it’s always there if you need it. Of course, the flip-side is that it’s not there if you spend it. You can have the money or spend it on things. If you buy things, you don’t have the money.

Final words

I appreciate that this article may feel one-sided – rest assured – it is! There are downsides to drawdown. Whether they make sense for you will depend on your circumstances. I’ve not gone into detail on the downsides. It’s very easy to find a lot written about those! And given the evidence so far, a lot of it has been overblown. There are issues with drawdown: we are poor at self-control; we struggle to understand risk; it requires continuing to make investment and financial decisions. That doesn’t mean we should discount it as an option.

I’ll probably aim to wrap this mini-series up with a third post, perhaps  directly comparing annuities and drawdown. But I do want to stress: it’s not an either/or option. Annuities and drawdown can be combined. Potentially, giving a “best of both worlds“. The best decumulation strategy will depend person to person. But both drawdown, annuities or a combination of the two may all provide suitable ways to meet your financial aims in retirement.

 

All the best,

Young FI Guy

Annuities: Is their bad press deserved?

In short: No.

I had planned-out an article with reasons why I think annuities don’t deserve the bad press that they get. But, in a fantastic guest post over at Monevator, Mark Meldon, a South West UK-based IFA, makes a far more eloquent case than I could. So instead, I’m going to cheekily piggie-back off his great post. Before you read on, I would 100% recommend you read Mr Meldon’s post on the Monevator site.

Here are five reasons why annuities don’t deserve the bad press they receive.

1. Annuities provide the best method of securing a guaranteed income for life

Mr Meldon makes a compelling case in his guest post. In doing some background reading for this post, I looked at what my regulatory body (the Chartered Institute of Securities and Investments) had to say. It was pretty emphatic:

Annuities are still the best method of securing a regular guaranteed income for life

2. Annuities are (somewhat) unfairly compared to investment products

Whenever I explain how annuities work to people, I always describe them first as a kind of insurance policy. As Mr Meldon explains:

If you buy a life assurance policy you make small regular payments to your life office and, should you unfortunately die during the term, they send you a big cheque.

The reverse is true with an annuity. Here you send the life office a big cheque and they send you little bits of money until the day you die.

[…]

We can see, therefore, that an annuity insures the annuitant against longevity risk, because of the guaranteed lifetime income stream.

You simply don’t get that with any other kind of investment – period.

In effect, an annuity is an inverse life assurance policy. Instead of paying annual premiums, you receive annual payments. Instead of a lump sum payment on death, you make a lump sum payment on commencement.

Looking at annuities from this viewpoint shows us its greatest strength: it provides protection. Specifically, it provides protection against longevity risk – the risk that you outlive your money. Longevity risk is difficult to quantify. That’s why Actuaries get paid so well and have brains the size of two watermelons. And as individuals we underestimate how long we will live. Annuities also give certainty. As we saw under point 1, annuities provide the best method of securing a guaranteed income for life. In this respect, annuities do a very good job at covering two of the important factors in saving and investing: covering your risk tolerance and matching your time-horizon.

I think an element of why annuities get bad press is because the downsides of an annuity are compared to the upsides of investing. But the converse isn’t:

  • In buying an annuity you sacrifice the ‘upside’ of an investment portfolio. This being where the insurer makes some of its money. But, you are protected from the ‘downside’ of the portfolio. Your income is the same even if the stock market tanks.
  • Annuity rates are compared to the returns from the stock market. Whilst the annuity rate is lower than you’d get from sticking your money in an equity index fund, the annuity return per year is certain. The return from the stock market is not.
  • The return over the life of the annuity is, of course, less certain. This is where people sometimes say: “I have to live X years for the annuity to pay off“. Whilst mathematically that is true, from the viewpoint of your financial goals this is less likely to be true. As I noted in my Safe Withdrawal Rate post: “For most people, [financial] success is having enough income to cover living expenses and support an adequate standard of living level.” In that respect, an annuity which covers your living expenses and provides enough income to support your standard of living is, de facto, a success.

3. We are very bad at self-control

The godfather of behavioural economics, Richard Thaler, was inspired, in part, by our lack of self-control.

The guests while waiting with cocktails for the meal, were devouring the cashews—the entire bowl half-eaten in minutes. So Thaler, worried that his guests would fill up on the salty snacks, whisked the bowl away.

He recalled that when he came back, his friends thanked him for it (and found themselves with room to enjoy a big dinner). “But then, since we were economics graduate students,” Thaler recalled, “we immediately started analyzing this. Because that’s what economists do.” Even cashews could hold the key to unlocking insights about our idiosyncratic behaviors.

Without the temptation of the nuts, he said, “We realized that a.) we were happy, and b.) we weren’t allowed to be happy, because a first principle of economics is more choices are better than fewer choices.”

I’m sure most readers manage some or all of their own investments. The urge to tinker and tweak is often irresistible. I struggle to resist the lure of the biscuit jar. An annuity takes all that off the table.

4. Annuities remove a lot of hassle

A key to life is to avoid doing things that cause unhappiness. For me, and I think a lot of people, paperwork and doing taxes will come high up their list of unpleasant things. With an annuity there is almost no paperwork once its set up. In the UK, tax is taken off at source and each year you get a P60. If you need to fill in a tax return you just bung in the number – all done. There’s no capital gains calculations, no dividend calculations, fiddling with tax sheltering, no top-slicing (*shudder*). Many readers, myself included, may enjoy managing their investments now. I’m less willing to believe I’ll be happy doing that when I’m 70/80/90+ years old. Not to mention, that as time passes by, there is no guarantee that I’ll be compos mentis.

5. There’s more to annuities than just a level annutity

There are many flavours of annuity. With different products tailored for an individual’s specific needs. To name just a few:

  • Index-linked annuities: which increase in-line the payments inline with an inflation rate or other fixed percentage. These are typically the most costly option, with the starting income  30%-50% lower than a level annuity.
  • Joint annuities: which continues to pay out after first death to, such as, a surviving spouse. These can also be used to pay out to children or other dependants. And you can also usually define what proportion is paid out on death. Bear in mind, that the longer the annuity is likely to pay out, and the proportion of income on death, the lower the starting income will be.
  • Guaranteed annuities: these pay out for a guaranteed number of years depending on the insurer. Again, the longer the annuity will pay out, the lower the starting income will be.
  • Short-term and fixed-term annuities: which pay a regular income for a specific-term. Short-term annuities can last for up to 5 years. When the term ends you can buy another annuity or invest elsewhere.
  • Investment annuities: As opposed to traditionally gilt-back annuities, you can buy investment annuities which can add a potential benefit from investment growth in the stock market (or from other investments). These give the potential for a higher level of annuity, but come with some potential downside. It’s possible to add downside protection, but again this costs more.
  • Enhanced annuities: which pay out higher rates for those with reduced life expectancy (e.g. smokers). If this is the case for you, think carefully about whether purchasing a life policy or leaving your pension pot for inheritance might be more beneficial.

In addition, you can buy an annuity using only part of your pension pot. This means you can mix and match an annuity with flexi-access drawdown, your other investments, or even to buy several different types of annuity. For example, you could use part of your pot to buy an annuity and provide a guaranteed income floor, whilst keeping part of your pension invested to generate long-term returns.

Final words

I appreciate that this article may feel one-sided – rest assured – it is! There are downsides to annuities. Whether they make sense for you will depend on your circumstances. I’ve not gone into detail on the downsides. It’s very easy to find a lot written about those! But I’ve touched on those downsides now and again. Principally they relate to the two other key factors of saving and investing: access and affordability. In some ways, you can mitigate issues with access by considering a short-term annuity option or using only part of your pension pot to buy an annuity. Affordability, is the elephant in the room. A number of the options (particularly index-linked annuities) may be unaffordable. It’s important to consider all the options available, but an annuity may be a very suitable option for you.

I’ll leave the final words to Mr Meldon:

Finally, annuities offer something priceless – peace of mind!

 

Please let me know your thoughts and comments. I’d like to hear from you!

All the best,

Young FI Guy

The State Pension NI Fiasco?

Last week This Is Money ran an article titled: “Officials admit they can’t say if your state pension top-up will work and tell savers to seek expensive financial advice” (link)

This follows several earlier articles on the “State Pension Fiasco”:

  • Couple who lost £7k topping up their state pensions finally win a ‘goodwill’ refund as HMRC stands by its baffling system (link)
  • The state pension top-up fiasco: Savers are paying to boost their incomes only to find payouts don’t rise and they can’t get a refund (link)
  • I’m being deprived of £155 full state pension despite paying NI for 45 years because I was ‘contracted out’ behind my back! Steve Webb replies (link)

The articles are all high on anger but less clear on what the problem is. In part though, that’s because the problem is quite complicated and not easy to explain. The thread that runs through each of these pieces is that the Government has done a very poor job of communicating the 2016 changes to the state pension (the “single-tier” or “new” state pension).

In this piece I’m going to try my best to explain what’s going on with the new state pension, why things are going and what you can do about it. Before all that, let’s take a potted history of the UK State Pension.

6 April 2016: the day the earth stood still…

On 6 April 2016 the Government brought in the New State Pension (NSP). The key distinguishing element of the NSP is that it is single-tier – it has only one element – for 2018/19 it pays £164.35 per week. There are no other payments or anything like that – just one amount. The concept behind it was two-fold: (i) the old pension system was convoluted, a single-tier pension is much simpler; and (ii) the new system paid the same to everyone, the state wasn’t going to pay out extra cash to “rich pensioners”. But to understand the NSP, we need to look at what it replaced.

The Old State Pension (pre-6 April 2016)

If you reached State Pension Age (SPA) before 6 April 2016 (men over 65, women over 63), you get the Old State Pension (OSP). There were two elements to it: (i) the Basic State Pension (BSP); and (ii) the Additional State Pension (ASP). To get the full BSP you needed 30 years of National Insurance Contributions (NICs) or credits. For 2018/19 the full BSP is £125.95. If you had less than 30 years then the amount was scaled down commensurate with the number of years you had accrued. So far so easy. The ASP was where things started to get complicated. First, we need to go back to 1961…

State Graduated Pension Scheme

In 1961 the government introduced the State Graduated Pension Scheme (SGPS). Designed, to reflect that some people had paid additional NICs compared to the self-employed (through the fixed rate Class 2 contribution, note Class 4 doesn’t provide entitlement to any benefits, it’s only Class 2 that counts). However, most occupational schemes contracted out of this – by paying the value of the ‘additional’ NICs out of the occupational scheme instead of paying it to the Government. In effect, very few people accrued under the SGPS.

SERPS

In 1978 something that might be a bit more familiar came along, the State Earnings Related Pension Scheme (SERPS). To cut it short, if you earned above certain limits you accrued an extra pensions entitlement to reflect that you were making more NICs. You would accrue the entitlement at a 25% rate, what’s more only your best (i.e. highest paying) 20 years counted. It sounds too good to be true, and it was. The accrual rate was too generous and in 1988 the accrual rate for those retiring post-2000 was cut to 20% and career average earnings used. Again, many people were contracted out of SERPS.

S2P

As you may have guessed, the Government again changed its mind. In 2002 they replaced SERPS with the State Second Pension (S2P). The aim of the S2P was to widen the scope of people who could get an additional entitlement and to skew benefits away from high-earners to low and medium-earners. In short, the Government created a “three-band system”: increasing accrual rates for lower earners to 40% (between certain limits) and lowering them to 10% for “middle-earners”, with the rate for higher earners, 20%, the same. The Government made a commitment that nobody reaching SPA before 6 April 2009 would be worse-off under the new system compared to SERPS. So those people received an additional accrual top-up (this principle pops up again later and is one of the causes of the current New State Pension issues).

It wasn’t long before the Government realised they once again set accrual rates too high. In 2010, the Government scraped the “three-band” system for a less generous “two-band system”. The middle and upper bands were combined and both accrued at 10%.

This lasted only 2 years until April 2012 when the Government changed the lower band to a fixed rate, and generally speaking, less generous accrual. The Government also stopped contracting out for those with a DC scheme, so only DB members could keep contracting out.

As you can probably surmise, working out your S2P requires a brain the size of two watermelons. Firstly, you split your earnings across the bands and revalue them to the tax year prior to reaching State Pension Age (SPA). You then multiply the earnings by the relevant accrual rate (including any adjustments required for SERPS). You then divide by the number of years in your working life (from age 16 to SPA).

Pension Credit

There was one final element of the Old State Pension. Under the OSP there were also State Pension Credits. In short, these were designed so that people would have a minimum floor for their State Pension (i.e. wouldn’t have a below-poverty level pension). There were two types of credit:

  1. Guarantee Credit – If you have income below £163 (single) or £248.80 (couples) and savings under £10,000 (with a few other conditions) the Government tops you up to £163/£248.80 (2018/19 figures).
  2. Savings Credit – This is a credit for those that built up savings for retirement. In effect if your income is higher than a certain level, the Government tops you up. Because the full-rate New State Pension was set above the maximum Pension + Savings Credit, the Savings Credit became no longer relevant for people reaching SPA after 6 April 2016.

To take-away, there were things in place to make sure you got a certain level of pension income in retirement.

In Summary

If there are two important themes to take away from the OSP it is this:

  • It was very complicated; and
  • Continually chopped and changed, but with a commitment that those under the SERP/old system wouldn’t lose out under the new/S2P system.

Back to the NSP

It wasn’t just the amounts and the simplification that changed on 6 April 2016. Several other rules changed, many of which caused problems:

  1. You need to have at least 10 years NICs to get anything (up from 1 year)
  2. To get the full £164.35 you now need 35 years NICs (up from 30)
  3. From 6 April 2016 you can’t claim a SP based on a spouse’s NIC record.
  4. All NIC classes (employed vs self-employed) accrue at the same rate.
  5. The Government set the principle that you couldn’t have a lower pension than your accrued entitlement to the ASP/SERPS/S2P as at April 2016.
  6. Contracting out for DB schemes ended (it had already ended for DC schemes)

Problem 1: Not all NICs are equal

Numbers 1, 2 and 3 meant that some people suddenly found themselves “short” of the NICs needed to get the new full pension. To help with that, you could make voluntary contributions. However, there are two types of voluntary NICs. Class 3 – which allows you to buy a higher level of the old BSP (and now New State Pension) and Class 3A – which bought old Additional State Pension (until 5 April 2017). These bought different things and it is entirely dependent on your contribution record whether you needed to buy Class 3 or Class 3A or both.

Secondly, and most importantly, Class 3 NICs for years after 6 April 2016 contribute to the NSP, increasing the rate by 1/35th. If you made Class 3 NICs for years before 6 April 2016 these could count towards your old BSP and not towards the NSP, and could therefore be pointless.

Problem 2: You can’t be worse off in the new system than you were under the old system

In a way this is a nice problem to have, but it means that to calculate your entitlement you need to calculate a hypothetical entitlement under the old system. I’m not being facetious here but: THIS CALCULATION IS INCREDIBLY COMPLICATED.

For those under State Pension Age at 6 April 2016, you first calculate what’s called the Starting Amount, a hypothetical based pension which is the higher of:

  1. What you would get under the old State Pension (BSP plus ASP); and
  2. What you would get if the NSP existed from when you started work (age 16).

If this amount is lower than the full NSP you can contribute Class 3 NICs from between 6 April 2016 and SPA to get the full NSP. Voluntary contributions for years pre April 2016 may or may not increase your pension depending on whether the Starting Amount is based on the Old System (1) or the New System (2). If your Starting Amount is based on the Old System and you have 30 NIC years then contributions for years before 6 April 2016 will not increase your pension.

If the amount is higher than the NSP then the difference between this figure and the NSP is called the Protected Payment. The Protected Payment is paid on top of the NSP, it increases by CPI every year and most importantly any further NIC years post 6 April 2016 will not add any more to your State Pension.

If you’ve followed all that, then you’re doing better than the first time I read about all this!

Why things have gone wrong

With all the background out of the way, we can look more carefully at what’s gone wrong. It’s generally a combination of two things:

  1. The calculations are very difficult; and
  2. The Government (DWP) have done a terrible job at communicating what the changes mean for you.

Maybe (a) or (b) on their own would be manageable, but together its caused huge problems for a lot of people. Let’s look at some common questions.

“I was contracted out for most of my working life, I’ve now lost my pension!”

Nobody has “lost their pension”. How to think of this is to imagine two big jars. One labelled private pension, one state pension. If you were not contracted out when you earned money you filled up the private pension jar through your occupational scheme and you filled up the state pension jar via NICs. If you contracted out, you didn’t pay some of the NICs that you would have put into the state pension jar and but instead your employer would give you the value of that extra state pension “you were giving up” when it came to taking your private pension (i.e. by topping your pension up). By contracting out you traded some, or all, of the state pension for a more generous private pension.

“Nobody told me this at the time!”

The contracting out decision was usually done at the workplace, not individual level. That’s because if there were mix-and-match of people with different contributions it would have been a ballache for HR to calculate. So usually all employees at a company contracted out or they all didn’t. As Sir Steve Webb (ex-Pension Minister) says: “you were probably not aware of this at the time – the National Insurance figure was simply deducted at the reduced rate from your paypacket without you realising that it was a lower rate.”

“I made voluntary class 3 contributions and it didn’t increase the state pension I’m due to get”

This can happen for two reasons, both reflect poorly on DWP/HMRC.

The first reason is that you would have made contributions for years before 6 April 2016 and your Starting Amount is based on the Old System. As I mentioned above, if your Starting Amount is based on the Old System, contributions for years before 6 April 2016 may not increase your pension. By topping up for years before 6 April 2016 you may have been topping up an already “maxed out” old Basic State Pension.

Being frank, I think the Government should take a big bit of blame on this (as well as elements of the financial press exhorting people to make Class 3 contributions). They heavily warned people that they might need to make voluntary contributions but they made it less clear on the very important “what years count” rule. This should have been in huge flashing lights for people to make it very clear what contributions earn what entitlements. For most people, the distinction of what year means what isn’t very clear and is arbitrary.

The second reason is that your Starting Amount is higher than the New State Pension. That is, you would have been better off under the old system than the new one so in effect you get paid an amount as if you were on the old system. Making class 3 contributions is therefore irrelevant.

The Government can maybe take a little less bashing on this. But the reason people get confused on this is because it is a very confusing calculation. To do the calculation you need to work out your entitlement to the BSP and ASP and this in turn may require you to calculate your accruals under SERPS. You then also need to calculate the much simpler entitlement under the NSP. So, it’s all well and good bringing in a new, simpler system but the reality is, it’s not simpler for most people, in fact it’s a lot more complicated.

This is not to mentioned other issue, Pension Credits, which may secretly kick in which would top-up your income to a level near-commensurate with NSP and make voluntary contributions not cost-effective.

What you can do about it

If you are reading this and thinking about your pensions entitlement and whether you need to make voluntary contributions then you can get what’s called a State Pension Statement from the Government. You can do so from the following website: https://www.gov.uk/check-state-pension. Alternatively, you can complete what’s called a BR19 form and post it off. You can download the form from this website: https://www.gov.uk/government/publications/application-for-a-state-pension-statement

The statement will give you a headline figure: for a lot of people this will be £164.35 (for 2018/19). This is the full New State Pension. If your figure is more than £164.35 then that means you accrued a higher entitlement under the old system, so you’re state pension is based on that (see about the Starting Amount above). If your figure is less than £164.35 then that means you have yet to earn enough NI years to get the full NSP. This means you need to make further NICs to get the 35 years required for the full NSP. You can do this in a few ways:

If your starting amount is based on the Old State Pension:

  1. If you have more than 30 NIC years then you can’t top up your pension using pre April 2016 contributions. But you can make post April 2016 contributions. Either through working, voluntary Class 3 contributions, or self-employed Class 2 contributions.
  2. If you have less than 30 NIC years then you can top up your pension using pre April 2016 contributions to a maximum of 30 years (thereafter extra pre April 2016 contributions will not add to your pension). If at this point your starting amount is still less than £164.35 you can make post April 2016 contributions to increase your pension.

If your starting amount is based on the New State Pension:

  1. You can work for the additional years required, making Class 1 or Class 2 contributions.
  2. You can make voluntary Class 3 NICs for any incomplete contribution years over the past six years by paying for the relevant missing months.
  3. If you have lots of years left until SPA, it might not be worth making voluntary contributions for gaps, as you might get the required number of NIC years through future contributions.

If your statement shows an amount less than you were expecting, or don’t understand it, then you can call the Future Pension Centre on 0345 3000 168. They will be able to explain how the figures are calculated and send these calculations to you in writing. They can’t give you financial advice however, so don’t expect them to advise you whether to pay any voluntary NICs. From what I’ve read online, the vast majority of people find them very helpful to contact.

Some closing thoughts

If you’ve got this far, thank you for reading. I appreciate this is a potentially very dry and dull topic. Whilst there has been lots written on the subject, I have struggled to find resources that pulls it all together and aren’t 30 pages long! The best resource I have found is a presentation by Royal London from 2017 (link) and on the related website (note: it’s set out for “advisers only” so use at your own risk).

Below is a diagram from the presentation that pretty much puts into pictures what I’ve set out above. Even in diagrammatic-form it’s still quite a chore (note 2016/17 figures are used in the diagram).

[edit 27/05/2018: Royal London updated the above resource for 2017/18, the link should take you to the updated slide deck. The picture above is still for 2015/16]

Some further helpful resources:

Royal London: https://adviser.royallondon.com/technical-central/pensions/general/state-pension-transition/

Pensions Man: http://www.pensionman.co.uk/learning-zone/the-new-state-pension-where-advisors-fear-to-tread/

Age UK: https://www.ageuk.org.uk/globalassets/age-uk/documents/factsheets/fs19_state_pension_fcs.pdf

Whilst I think the intention behind the move to a single-tier pension is noble, it has been poorly executed. HMRC and DWP do not have stellar reputations in being open, transparent and good communicators. Expecting them to communicate such wholesale and complicated changes was never going to be without hiccups. Another issue was trying to do too much in one go; fiddling around with NI years, contracting out changes and the extensive linking to the old State Pension. In addition, there’s stuff I haven’t even talked about, such as changes to the state pension age and bereavement allowances. In that sense it feels like the main purpose of the change, simplification has been lost in trying to achieve other (political?) motives.

Please feel free to share your thoughts. Whilst I’ve tried to ensure I’ve got everything correct, there’s a possibility (probability?) I may have made mistakes or typos in places. As always, conduct your own due diligence and if in doubt speak to an expert.

All the best,

Young FI Guy

Pensions & ISAs – the basics

I was recently asked on the the excellent Monevator website what my thoughts are on pensions and saving for the future. I hope this post can give you a rough guide to how pensions and ISAs work in the UK and give you a rule of thumb about how to start using them to achieve your financial aims! I’ve included ISAs as I think you can’t understand one without the other.

 


 

When I was 16, nobody explained the concept of a pension or an ISA (or income tax, for God’s sake – yet we teach kids about Oxbow Lakes???). The second step in sensible financial planning is understanding these concepts.

Wait! What’s the first step?

Before we start on pensions and ISAs you have to understand your first step. The first step is:

Have a financial and life aim

By that, you need to ask yourself: What do I want to achieve in life? Why do I want to achieve this? Where do I have to get to financially to achieve this?

An example:

John wants to have two children with his wife and have a stable, permanent home for him and his family to live in. He wants this because he wants to give a stable upbringing to his children.

 

Without being Captain Obvious, John’s going to need a lot of money to do this. He’s going to have to save up money to put down a deposit for his house. He also has to be able to access that money. But he might not need to access any savings for a number of years. He will also need to have a stream of income when he and his wife have kids. And he will likely need to have some level of savings for one-off expenses relating to raising his children.

This also helps us address the four key factors in saving and investment. These are:

Risk tolerence, Time-horizon, access and affordability

Risk can be defined in a huge number of ways and the financial services industry has devoted sagas to what risk means. But broadly speaking, what matters is Risk tolerence – what risks are you willing to take to meet you financial aims.

Time-horizon – this is the time you have over which to meet your financial aims. Generally speaking, the longer away you are from your aim, the easier it is for you to swallow risks.

Access – this is whether you may or may not need to access your savings and investments. Generally speaking, the higher the likelihood you will need to dip into your savings pot, the lower your risk tolerence will be (to avoid making potentially large losses).

Affordability – this is whether you can actually afford to make the savings and investments you plan (i.e. what you are able to sacrifice spending today to be able to spend tomorrow). You won’t be able to afford to save everything – so you need to start prioritising how and what to save and invest.

As you can see these four concepts are interlinked.

The Second Step: Pensions and ISAs

Pensions

If you’re faced with your first “real” job, the offer of a pension may seem daunting. In the UK, the vast majority of workers over age 21 will be offered a contributory pension arrangement (where your employer pays into a pot of money which is invested until you retire). These are called Defined Contribution (DC) schemes or in old language, Money Purchase schemes. Generally you have to wait until you’re 55 to take this money – however the Government is currently thinking about increasing this age, and it has done in the past. Until then you can’t get your hands on the money and do what you want with it. At the moment you can take the entire amount in cash thanks to the now famous Pension Flexibilities (that thing the media keeps saying about pensioners spending their money on Lamborghinis). But when you take the money out, you get taxed on it.

The first question for a millennial is then : why wait till age 55? Why not just keep the money I would have otherwise put into a pension and enjoy it now? Because of three things: employer contributions, government reliefs and compound returns.

The first benefit is if your employer contributes to your pension (i.e. you pay in 5% and they match your contributions) then you’re getting free money. Literally free money. If you don’t pay in that 5% you aren’t going to get the money in lieu- it’s a quid pro quo deal. Not paying in means you’re losing out on money from your boss.

The second benefit is that the government effectively gives you back any tax you’ve paid on your salary if you put it into a pension. There are some caps on how much relief you can get, these are (in basic terms, the allowances are very complicated and the exact allowance you may have will depend on a large number of circumstances):

  • The Annual Allowance – which means you only get tax relief on the first £40,000 you put into your pension. This gets reduced down to £10,000 for very high earners by something called the Tapered Annual Allowance (which I won’t expand on for now as it’s painfully complicated).
  • The Lifetime Allowance – which means you only get to keep your relief if, when you come to take money out of your pension, the total of all your pension pots is below £1,030,000 (for 18/19). If you go above this, then HMRC will charge you a hefty penalty tax.

The Government also give another sweetener for those willing to put into a pension, that is when you take out the money you usually get to take 25% of it tax-free!

The third benefit is that as your money is left in a pension for a very long time you start to get “compound returns”. That is, returns on returns. Over 20/30/40/50 years, the compounding effect can become enormous. This is sometimes called a “snowball effect” – as a snowball rolls down a snowy mountain side it picks up more and more snow and gets rapidly bigger. A pension’s biggest weakness – that your money is trapped for a long time – is also its biggest strength. By not being able to touch your money you can’t prevent your snowball from becoming an avalanche.

As a second option, there are Personal Pension Plans (called PPPs) and SIPPs (Self-invested pension plans). These work much like a workplace scheme, except you put money in from your after tax-earnings. HMRC then automatically add 20% to whatever you put in (you have to claim the extra 20% if you are a higher rate tax payer via self-assessment or by application). You then select your investment option from a list of available investments – which are typically much broader than for workplace pensions, particularly so for SIPPs.

But there is a big problem with pensions. That is, because your money is locked in, you are at the mercy of the rules the government comes up with. You would think that, as the government wants people to save, it would try to keep the rules as consistent and as simple as possible. Unfortunately, that is not the case. Politicians have continually meddled with pensions and its clear they will continue to do so. When I speak to people, my general guidance on this is:

Think up your rough retirement date. Say its 20 years away. Between now and then there will be at least 4 governments. Now imagine the worst possible government (for your financial aims) that you could get during that time (or Donald Trump…). If you put your money into a pension, you are completely at the whim of that government. Could you live with that arrangement?

 

Usually this scares people a bit. And at this point it is should be clear pensions can’t be the only answer. That’s where ISAs come in.

 

ISAs

An ISA (Individual Savings Account) can either be a cash ISA (an account which earns interest at a set rate) or a stocks and shares ISA (you put your money into pooled investments linked to the market). You can only invest a certain amount into any ISA/s in one year – capped at £20,000 in 18/19. The earlier you open an ISA the longer you have to build up your snowball. You can also take your money in and out whenever you want subject to the cap – however, most places now offer “Flexi-ISAs” which allow you to take money out and put it back in and not lose part of your allowance. With an ISA you don’t get tax relief on money you put in. But, money you make in an ISA is tax-free – both income and gains. In effect, its like a ghost to HMRC.

HMRC don’t like ghosts and so George Osborne came up with a bastard-child of ISAs and pensions called a Lifetime ISA or a LISA (primarily because the treasury gets to hold on to tax money for longer if you put it in a LISA). You can only put £4,000 a year into a LISA (and that counts as part of the £20,000 above). But the government gives you a generous 25% bonus on the money you put in i.e. for every £100 you put in the government gives you £25. In addition you won’t be taxed when you are able to take money out of a LISA. But the government aren’t (always) in the business of giving out free money. There’s a catch – and it’s a big one. You can’t touch the money until you are either 60 (yes, that’s older than for other pensions) or to buy your first home (and in true government fashion, there is a huge small print on what homes can actually count, so you have to be very careful if this is what you are planning). Strictly speaking you can take your money out of a LISA, but there is a huge penalty for doing so and it would be extremely inadvisable to do so. One final catch is if you are over 40, you can’t open one. Sorry – you’re out of luck.

With all that out of the way, let me present the YoungFIGuy Pension and ISA Super Table! (it’s not that super, don’t get your hopes up). Please note, and I have to say this, I’m not an FCA authorised financial adviser. The table below is a rough guide/rule of thumb for information purposes only and should not be considered financial advice. The table may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.

I have spare money and want to save and invest for my future what do I do? Note: this is rough guide – what is best for you will depend on your exact circumstances – I would always recommend seeking the advice of a personal finance professional
      Pros Cons
1 If you are employed, contribute to your workplace pension up to the amount that maxes the free money from your employer If you are not an employee go to 2 – FREE MONEY

– Generous tax reliefs

– You can’t meddle by taking money out

– Your money will be tied up until at least 55 – check access requirements

– The pension investment options can be expensive

– There are usually limited investment options

2 If you do not own or have never owned your own home and you plan to do so, max out your LISA.

(Subject to the type of home you are buying qualifying for the scheme)

If you own or owned a home, or the home you’d like doesn’t qualify go to 3 – Very Generous tax relief

– You’ll get access to your money before any pension

– Lots of investment options: from low risk to high risk

– Some homes and some situations mean you won’t qualify to withdraw to buy a home, then you can’t withdraw until at least 60 – check access requirements

– You are at risk the government changes the rules on you

– Not as widely available as pensions and ISAs

3 Max out the rest of your ISA allowance   – All income and gains are tax-free

– You can access your money whenever you want (and put it back in with a Flexi-ISA)

– Lots of investment options: from low risk to high risk

– The total tax relief is not as good as for a LISA or a pension

– You are in control, you have to have the discipline to not take money out on a whim

4 If your company offers “salary sacrifice” and they give you any national insurance savings they make by paying money straight into your pension, then contribute as much up to the Annual Allowance (AA) If your employer doesn’t offer salary sacrifice got to 5, if you’ve maxed your AA go to 7 – You get an added bonus from saving NI contributions

– Generous tax reliefs

– You can’t meddle by taking money out

As under 1
5 If the annual costs for investments in the company pension scheme are less than 0.5% then contribute as much up to the Annual Allowance If the costs are above 0.5% you can generally speaking invest for less in a private pension or SIPP – Generous tax reliefs

– You can’t meddle by taking money out

As under 1
6 Invest into a private pension or a SIPP up to the Annual Allowance if you’ve maxed your AA go to 7 – Generous tax reliefs

– You can’t meddle by taking money out

– Lots of investment options: from low risk to high risk

– Your money will be tied up until at least 55 – check access requirements

– The pension investment options can be expensive

7 Well done, you’ve saved a bollock-ton of money! At this point there are a number of tax-efficient and non-tax-efficient options available, you should speak to an Independent Financial Advisor about which ones might work best for you

 

If you have any thoughts, suggestions or questions, please feel free to leave a comment!

All the best,

YFG