With no consultation but with rapid implementation, the Budget announcement of “the most far reaching reform to the taxation of pensions since the regime was introduced in 1921” has certainly taken the pensions industry by surprise.
The changes will have a profound effect on the public perception of pensions and, it is hoped, will see an increase in savings levels.
As is now well known, from April 2015, on reaching age 55, individuals will be able to access their “defined contribution” pension funds without restriction and without the need to buy an annuity. The whole fund may be taken in one go.
However, the fundamental tax treatment of pension funds remains unchanged in that 25% of the fund is tax free and the remainder is taxed as income. Taking any reasonable sized pension fund as a single income payment will push most people into a higher income tax bracket with elements of the pension fund potentially taxed at 40%, 45% or even 60%. The likely increase in tax flow to the Treasury coffers is not lost on the Chancellor.
At the same time, the Chancellor announced that all those taking their pension will be entitled to a free face-to-face meeting to discuss their options. Although a good idea in principle, and a considerable improvement on retirement illustrations running to 20 pages, it is not clear how this will work or how it will be financed.
People do need to understand the “risks” of retirement; the two key risks being longevity and inflation. The British public can be a pessimistic lot and prone to seriously underestimating their life expectancy. The Pensions Minister recently announced that those retiring will be told their average life expectancy.
The potential tax liability and the realisation that retirement might last for many years ought to temper enthusiasm for drawing down the pension fund too quickly.
Much has been made of the fact that people will no longer have to buy an annuity but the risk of living ‘too long’ has to be addressed. There remains a strong case for an element of guaranteed income in any retirement provision. It is unfortunate that annuities come across as being solely responsible for impoverished pensioners and the obvious explanation - that people do not save enough - is often ignored.
Fortunately, the new flexibility and the potential of a reasonable lump sum should encourage people to save more to their pensions. In the right circumstances, a pension plan is now an alternative to an ISA as a way of saving for a lump sum.
For example, saving £300 per month gross for 15 years adds up to a pension fund of £54,000 (ignoring growth, etc.).
If the fund is drawn in full in a year when there is no other income, on current tax rates, the net payment is £47,900.
For a worker paying 40% tax (and so able to claim 40% tax relief on £300 per month), the net aggregate cost is £32,400.