Most of us look forward to the point in our lives when work becomes optional and we can spend time with family and friends or simply enjoy the things we have never had the opportunity to do during our working lives.
Due to the complexities of the pension market, few of us understand (or even have the time to find out about) changes and forces within the industry which shape our financial futures. However, those who are simply hoping to rely on the state may be in for a rude awakening.
It could be that you wish to either start planning for retirement, want to ensure your existing arrangements will meet your needs, or plan to retire soon, and want to consider all options available.
Pensions are among the most tax-efficient and effective ways to save for retirement, but working out how much to save and deciding which type of pension is best often feels like a complicated business.
The good news is that from 6th April 2006, so-called “A-Day”, life got easier for retirement savers as the government brought in a new simplified set of rules, effectively shelving the eight previous tax frameworks for pensions.
The changeover means it ought to be easier than ever to begin calculating how much you need to be saving for your future. The new rules also give savers far greater freedom in how and when pension benefits are to be taken.
The government provide tax relief on the contributions you make to your pension. This means that if you are a lower rate taxpayer and you contribute £78 to your pension the government will provide an additional £22 in tax relief meaning £100 will go in to your pension scheme. The news gets better for higher rate tax payers as the tax relief on pension contributions is made at the highest rate of tax you pay so in order for £100 to go in to your pension pot a contribution of £60 is all that is needed.
Certain elements of pension simplification create even more generous tax breaks for some savers. For example, the old rules did not allow the plan holder to take tax-free cash from some schemes. Under the new legislation up to 25% of the value of the fund can be taken as a tax-free lump sum in many cases.
Simplification ought to take some of the mystery out of pensions, but with the new flexibility come new dilemmas for would-be savers, as well as those already building up their retirement nest eggs.
For this reason, many would do well to discuss with an Independent Financial Adviser (IFA) what steps they might need to take due to the new rules and how it affects their personal retirement planning. If you need advice, we can research and make appropriate recommendations from the whole of the pensions market.
In the sections below we break down what has changed and what pension simplification will mean for your retirement saving options.
(Please note the information provided within this section is based on our current understanding of government legislation, and that levels of tax relief available are subject to change.)
A-DAY: THE MAIN CHANGES
Following the changes in April 2006 the old limits on the amount that could be put into a pension scheme were removed. You are known allowed to contribute an amount equal to 100% of your earning or a maximum of £215,000 per year. In addition it is also possible for those who either do not have earnings or have a spouse or partner who do not work or have low earnings to contribute up to £3,600 per year.
The maximum amount that you are allowed to contribute has been set at £215,000, this will increase each year as follows
2006/2007 £215,000
2007/2008 £225,000
2008/2009 £235,000
2009/2010 £245,000
2010/2011 £255,000
The single allowance rule does away with the sometimes baffling calculations individuals faced under the old tax regulations in order to work out what they could pay into their pensions.
It is hoped the end of complicated calculations removes one of the barriers preventing people from saving more.
A further move designed to encourage us to save more is the greater ease with which people can save into a number of different pensions at the same time under the new rules, compared with the old.
That said, within the contribution limits, the onus is still on individuals to work out how much they ought to be saving and how much they can realistically afford to put aside.
It remains as important as ever to strike the right balance between saving enough for retirement whilst not leaving yourself either short of cash each month. In addition you also need to allow for “rainy days” and unforeseen emergency expenditure.
We will be able to steer you through this sometimes tricky path and find the right balance, by looking at your retirement savings as part of your overall financial situation.
They will also help you work out how much you can afford to save and what you should be aiming to put aside over the years and importantly, how much you will need to save now to maintain the quality of life you want in retirement.
Research in 2005 by the Association of British Insurers indicated that more than 60 per cent of people are not confident that they will have enough money to live comfortably during their retirement. With the right advice, you need not be among this number.
Anyone planning for their retirement, however distant, ought to recognise that the Government is looking to discourage people from retiring early. The earliest age pensions can be taken increases from 50 to 55 in 2010. Anyone planning to retire early in the next five or so years will almost certainly need to speak to us to work out how the change will impact upon their plans.
MORE TAX-FREE CASH
Under the old pensions rules some plans, such as certain occupational schemes, allow savers to take more than 25 per cent of their fund as tax-free cash when the time comes to take the benefits. However, others, such as Additional Voluntary Contribution schemes do not allow any tax free cash to be taken.
Legislation now allows all pensions policyholders to take 25% tax-free cash from the fund built up after 6th April 2006, regardless of the kind of scheme. The amount those in occupational schemes will be able to take as tax-free cash may depend on the trustees changing the scheme rules, meaning individuals may need to contact their pension scheme trustees to establish the situation.
Permitting all pension policyholders to take 25 per cent tax-free cash levels the playing field between different pensions. This means it will be a good idea to re-consider which pension arrangements are the most attractive to you.
LIMITS ON THE SIZE OF YOUR PENSION
There is a limit on the amount of money built up within your pension. In the tax year 2006/2007 this amount is £1.5million, with the threshold expected to rise over the years to allow for the impact of inflation.
Proposed lifetime allowance limits
2006/2007 £1.5m
2007/2008 £1.60m
2008/2009 £1.65m
2009/2010 £1.75m
2010/2011 £1.80m
This is also the maximum amount that can be paid out as a tax free lump sum to your beneficiaries in the event of your death, giving much greater flexibility to provide death benefits via pensions.
Introducing one lifetime limit for pension fund size effectively bins the sometimes complicated calculations savers could be forced to work through under the old pension rules.
A further innovation under the new rules is that the value above the lifetime limit will be subject to a new tax charge known as the lifetime allowance charge, or recovery tax, which will be charged at up to 55 per cent.
This measure is aimed at curtailing the amount of tax relief an individual can receive as a result of pension planning.
A pension fund of more than £1.5 million might sound like the preserve of the very rich, but it is likely that many individuals will be in danger of breaching the lifetime limit and potentially facing a 55 per cent tax charge.
This is because the lifetime limit relates to your entire pensions savings, including any Personal pensions, Occupational Pensions, Free-Standing Additional Voluntary Contributions or Additional Voluntary Contributions. Many people who think they are well below the lifetime limit might have more than they realise when the total benefits are calculated.
This means it will be essential for certain pension savers likely to be on the brink of the lifetime limit to keep on top of the size of their total pension fund as they build it up.
Dealing with the paperwork and calculations may seem daunting, but a pensions IFA will able to project realistically the value of retirement savings into the future.
PROTECTING YOUR PENSION
Some pension savers who have already exceeded the £1.5 million pension threshold are recommended to seek professional advice on how to shield their savings from the lifetime allowance charge or, alternatively, how to maximise tax breaks under the current rules.
It is possible to register your pension fund value built up before this date to protect it against the lifetime allowance charge and pension savers have until April 2009 to do this, although the sooner you understand your options the easier it will be for you to plan accordingly.
The first thing you may want to consider if you are at or near the lifetime limit is getting a valuation of your entire pension savings, before considering putting certain protective measures in place, which will shelter the fund from the lifetime allowance charge.
Generally speaking, there are two levels of protection available.
So-called ‘primary protection’ is available to pension funds over the £1.5 million lifetime limit on A-Day,
Primary protection will shield the value of your pension you have already built up and can potentially allow it to continue to grow in line with any increases in the lifetime limit without triggering the recovery tax charge.
‘Enhanced protection’ is available to any fund regardless of its size. Roughly speaking, this shelters not just the current value of pension savings, but also the full value of future investment returns, without incurring a tax penalty. This is provided that no further contributions are made or, if you are in a final salary scheme, that your benefits do not increase above certain limits and no new benefits are built up in respect of your employment after A-Day.
Most experts agree ensuring you have a plan in place to protect your savings in preparation for pension simplification is an area where you will almost certainly need advice and struggle to do-it-yourself. Anyone with a pension fund exceeding £1million will almost certainly need guidance.
NEW OPTIONS ON PENSION BENEFITS
If you have a money purchase pension (where the value of the pension fund at retirement is based on the amount paid in and how much this has grown by,
eg: a Personal Pension), then when you come to retire your income is normally secured by the purchase of an annuity (compared to final salary schemes where income can be paid out direct from the pension fund).
An annuity is effectively a promise to pay you an income for the rest of your life and is sometimes described as ‘insurance against living too long’, because with an annuity, your income from it lasts as long as you do.
Individuals are compelled to take benefits from their pensions by age 75; however the new pensions rules offer far greater flexibility over how benefits are taken.
For example, from 6th April 2006 we saw the introduction of new types of annuities.
‘Limited period annuities’ permit you to buy annuities in smaller chunks, each spanning a five year term, while the rest of your fund can be left invested. This will give individuals more choice on when to buy annuities and also allows them to maintain more control over their pension fund.
New ‘value-protected annuities’ respond to one of the key criticisms of annuity, that is, if you die very shortly after buying an annuity, your family loses out on your life’s savings because the money is absorbed by the collective fund of an insurance company’s annuity policyholders.
If you die ‘early’ your money is effectively absorbed and re-distributed among those who live longer.
Roughly speaking, under value protected annuities, if on death the money used to purchase the annuity has not been used up by an individual and they are under age 75, the balance can be paid to the policyholder’s estate after a tax charge of 35 per cent has been deducted.
However, it is essential to stress this potential benefit will be reflected in the rates for protected value annuities, which could be notably lower than on regular annuities.
‘Unsecured pensions’ will also be introduced after A-Day. This is similar to income drawdown under the old rules, where investors do not buy an annuity, but can take the tax-free cash sum and leave the remaining fund invested and income is taken from the invested fund and returns. Unsecured pensions can be used up to age 75 and policyholders can take up to a maximum amount up to 120 per cent of the annual income payable from a single life, level annuity. There is no minimum amount.
Under the new pension rules, once you reach age 75 you will have to purchase an annuity, if you have not already done so, or go for a new option called an ‘alternatively secured pension’ (ASP).
Although less attractive to pension members who need to rely on their pension income, for some ASPs can work as a ‘family’ pension plan with your spouse, children and yourself as members, providing the facility to pass pension assets to your children's pensions, for example.
Under ASPs, your spouse or dependants can either buy an annuity or continue to draw an income from your fund after you die. If there is no spouse or no dependants, the pension value or assets can be paid to another member of the pension scheme or a charity.
Using an ASP arrangement looks particularly enticing if you have invested in a property within your pension, but again, it must be highlighted that the Inland Revenue will prevent these sorts of set-ups becoming a way of avoiding inheritance tax, so caution and professional advice are recommended.
OTHER PLANNING OPPORTUNITIES
Within the pension simplification rules there are many other planning opportunities for individuals, whether you are self-employed or within a company pension scheme, and whether you have any existing pension provision or not.
If you have old pension schemes which are no longer active, perhaps because you left the employer who provided the scheme, or if you have a pension contract you are not familiar with, you could be well advised to seek out advice about the possibility of transferring or at least optimising the benefits of these pension funds.
Also if you have a small pension fund or funds, it is may be possible that you can take out the whole sum as a lump sum, rather than buy an annuity. The limit for 2006/07 is £15,000, which equates to 1 per cent of the lifetime allowance.
We can help you with your pension planning by answering the following questions:
How much should I save into my pension?
How much can I save without incurring a tax penalty?
What are extra options under the new rules and are they appropriate to me?
What are my options when I come to take benefits from my pension?
Now the tax treatment for all types of pensions is similar, how can I tell which are best suited to my needs?
Is there any action I ought to consider taking ahead of the rule change to safeguard my benefits and make the most of tax breaks under the old regulations?
For further information on the subject contained in this guide, please contact us.
