Spending the kids’ inheritance

I’ve already written about the direct income tax consequences of using 2015’s pension freedoms to draw down a private pension as a single lump sum.  To refresh, anyone opting to withdraw £200,000 as cash from their pension post 55 can expect to pay a minimum of £49,627 in income tax.  For sure you avoid the previous 55% rate, but you still end up paying as near 25% as makes no difference in income tax.

However, there are also more subtle tax implications to consider.

The most important relates to one of the freedoms that caught out virtually the entire pensions industry.  Not only were pension savings exempted from the penal exit taxes, but pension pots could also be passed on free of inheritance tax at death.  If you are unfortunate enough to die before the age of 75, but crucially after the pension freedoms are introduced next April, your entire pension fund can be passed on to your loved ones, or possibly even your spouse and children, entirely free of tax.  It doesn’t even need to be kept as a pension.  It will be a lump sum completely free of tax to be spent at the recipient’s absolute discretion.  Nice!

Even should you achieve the average life expectancy of 78.9 for a man or 82.7 for a woman, your pension pot can still be passed on intact. Any income drawn from the pot by the, hopefully suitably grateful, recipients would be subject to taxation at the recipient’s marginal rate.  However, it is relatively simple to organise your affairs to keep any drawn income within tax-efficient limits.

Many advisors and higher net worth individuals have been quick to appreciate the subtler estate planning implications of the proposed changes. In a nutshell, from next April, it looks like it will be possible to pass on a pension pot significantly in excess of the £1,250,000 lifetime limit with no inheritance tax payable and only a relatively small tax penalty on any sum exceeding that limit.  Effectively very large estates can be passed on from generation to generation, free of IHT, via accumulated pensions. If the recipients are prudent in drawing an income from this legacy, which they can do at any age, the sum will be largely kept intact for future generations. Richard Evans wrote an excellent piece on the possibilities of intergenerational pensions that effectively allow you to ignore the £1.25 million lifetime limit.

All this is very exciting if pensions and estate planning float your boat.  However, there are two important caveats.  The first is that the rules keep changing.  The second is that the freedoms could be reversed after May’s General Election.  My best guess though is that whoever wins will instead take the easy and sensible option of restricting tax relief on pensions contributions to the basic rate.

However, taking the freedoms at face value there are further implications.  If leaving a legacy is important to you, you should think long and hard about whether to drawdown a pension as cash.  I mentioned the income tax implications in my opening paragraph. However, as soon as money leaves your pension it also loses an important exemption from inheritance tax.

Consider the same £200,000 as used in the example above , which you might be earmarking for property investment.  After deducting the minimum of £49,627 of income tax, you are left with £150,373.  If you were to die with that sum still forming part of your estate (i.e. having invested it in the aforementioned property), it would attract a further 40% inheritance tax charge.  This, not unreasonably, assumes that your home and other assets already exhaust your £325,000 personal allowance.  This would leave just over £90,000 to be passed on upon your death, less than half the £200,000 that could have been inherited tax free had you left the pension as it was.

Getting back to the proposed changes, of course your first priority should be that you have enough money to live comfortably in retirement.  Indeed SKI-ing (or spending the kids’ inheritance) is precisely what many intend to do.  However, if you do have sufficient resources for your own needs, and it is important to you to leave a legacy, a crucial part of that planning might be the new IHT exemptions for private pensions.

Take care out there


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Pensions Freedom – the lessons from history

Fortunately it was the English who were dishing out the lessons against the Australians at Twickenham last Saturday. However, one lesson we would all do well to learn from Australia relates to the consequences of freeing pensions savers from the obligation to buy an annuity.

As the whinging poms stand on the verge of gaining some very significant pensions freedoms, the lessons of history should not be ignored. In 1993 Australia took a very similar step. More than 20-years later a root and branch examination of Australia’s financial system revealed some interesting statistics on how Australians have used their freedom.

The Murray Review, published in July, found that roughly half of those retiring in Australia take their pension as a lump sum. Of this group 44% used the money to pay off housing and other debts, to purchase a home or to make home improvements. A further 28% used the money to repay a vehicle or holiday loan or to buy a holiday or new car. The somewhat worrying result of all this is that a quarter of those who possibly regarded themselves as being reasonably well off at 55, had run out of cash by the time they were 70. The report also suggested that for some, even the mere knowledge that they were due a lump sum, caused them to overspend before they retired.

The inescapable conclusion is that a significant minority of people require more help than is currently available to rise to the challenge of providing for their retirement. It is an enormous step to go from living from month to month, or even week to week, to being given one lump sum and being expected to make it last for the rest of your life.

The need for financial education has never been greater.

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How to spend it!

One of the biggest concerns I hear from people about retirement is how to turn pension savings into income.  When I were a lad there were final salary pensions for the lucky few with everyone else more or less compelled to acquire an annuity, if indeed they had any pension provision at all.

Whilst this wasn’t an especially flexible state of affairs, it did have the virtue of simplicity.  It meant that people didn’t need to think too deeply about their pensions if they didn’t want to.  For sure the financial outcome was often less than ideal, but the relative lack of interface with the financial system suited many people just fine.  Somewhat depressingly though, even as people were encouraged to shop around for the best annuity deal, as recently as 2010, a depressing two-thirds purchased their annuities from their existing pension provider.

Against that sort of backdrop it isn’t hard to imagine that the recently announced pension freedoms will actually cause some people considerable stress.  Previously the decision was largely taken out of your hands so there wasn’t quite the same scope to “regret” your choice once you were committed.

Next year, however, imminent retirees will be painfully aware that the path of least resistance, an annuity, is very likely not their best option.  At the same time though, they will be faced with the responsibility of how best to provide themselves with a pension for life from their savings: a weighty burden.

So what are the investment issues?

First up, the new freedoms change the investment horizon.  Previously someone just a year from retirement, and the associated annuity purchase, would be extremely risk averse.  They would be looking to protect their fund from an unfortunate, last minute slide in either investment valuations or annuity rates.  However, while an essentially zero return is fair enough over a few months, or even a year, the average length of retirement is already close to 20 years, which is an altogether different proposition.

This brings us to the second issue, that of investment returns.  With responsibility for the investment of what, even for those with relatively small pension pots, is still a large sum in nominal terms, zero returns over a period of two decades are both unconscionable and impractical.

The problem is that those with the smallest pots, and thus those in most need of strong investment returns, are precisely those who cannot afford the risk of a significant loss.  For them the attraction of a guaranteed annuity is likely to be proportionately greater, than for someone who is less risk averse.

For people with greater resources, and therefore more flexibility, the option to increase the weighting towards riskier assets increases pretty much exponentially. As alluded to above, this though brings with it the bewildering prospect of how to invest a considerable sum of money for both income and capital appreciation, which is the third issue.

In the past this was usually a fairly straightforward choice between bonds that pay a fixed, but generally low, coupon and equities which offer a variable, but potentially greater, return: or some combination of the two.

However, next year’s pension freedoms will significantly change things.  For a start, it will shortly be theoretically possible to withdraw your entire pension at 55 and invest it (or spend it) outside the traditional suite of pension products.  It is already possible to invest more liberally within a SIPP (self-invested personal pension) or a SSAS (small self-administered scheme), but there are still constraints and total withdrawal is currently a costly option from a tax perspective.

However, relieved of the punishing 55% tax exit fee, some people are intending to withdraw their entire pension pot next year and many appear intent on investing heavily in property.

Whilst I am hardly in a position to counsel against property as an investment, being a landlord myself, there are at least three serious issues that have to be considered first.

1) Tax.  While the 55% Death Tax or Pension Withdrawal Tax is set to be scrapped next year, pension income is nevertheless treated as taxable income, less the 25% tax-free cash sum if applicable.

Thus to withdraw £200,000 from a pension to fund a property investment, even assuming no other income is taken or earned in that year, will cost £49,627.

This is made up as follows:

£50,000 Tax Free Cash Sum

£10,000 Personal Allowance

£31,865 Taxed at the basic rate of 20%  £6,373

£108,135 Taxed at the higher rate of 40% £43,254

Grand Total  £49,627

This actually slightly understates the tax owing as, for simplicity’s sake, I have ignored the fact the the personal allowance is progressively withdrawn for those earning in excess of £100,000.

2) Illiquidity.  While property may yield an income, it is not certain (voids, costs etc) and your capital isn’t easily available for drawdown.

3) Returns.  Contrary to popular belief, buy-to-let investing isn’t generally a massively profitable undertaking.  If it were then many more developers would be building properties specifically to let, rather than selling them on to release their capital.  At the same time, the major source of property investment return for moms and pops is capital appreciation, not rental cash flow.  However, paper profits can only safely be realised by selling the property and, even then, you’ll very likely generate a capital gains tax liability.

The higher returns come from gearing, which is jargon for having a mortgage.  This not only makes your cash go further, but the mortgage interest is also tax deductible.  Someone investing purely for pension income though will very likely not have a mortgage, which will help in terms of cash-flow, but cuts the return on assets employment (i.e. your net rental income compared to your equity in the problem).  Either way though, investors will still need to do their own research to make sure the numbers stack up and that they have a viable business proposition.

I’ll revisit the subject of property as a pension investment in the near future as I know that many of you are interested.  More generally though you can see that the new pension freedoms present people with some very considerable challenges in areas which many have traditionally shied away from.  This is compounded by the advice gap I highlighted in an earlier post, whereby those with less than £250,000 of investable assets can sometimes find it difficult to get expert financial advice at any price.

Take care out there


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The advice gap

I guess it’s appropriate to kick off a blog on personal financial education by discussing what makes people seek advice in the first place.

Although I consider myself fairly savvy on matters financial, I am nonetheless perfectly happy to seek the advice of professionals where I require their expertise.  Sometimes it can even be the reassurance of confirming my own understanding of a situation.

In an ideal world everyone would have access to unbiased and affordable financial advice.

Unfortunately many, including some earning substantially more than the national average salary, fall into the so-called “advice gap”.  These people need financial advice, but aren’t considered wealthy enough to be financially viable for advisors to provide them with a fee-based service.

This is one of the unintended consequences of the government’s Retail Distribution Review, which was designed to protect investors and savers from opaque commission structures on financial products.

How this works in practice though is that many high street financial advisors have withdrawn face-to-face services from those with less than £100,000 of investable assets.  Indeed it is not uncommon for the threshold to be as high as £250,000: an impossible hurdle for many earning even pretty decent money.

According to the Financial Conduct Authority the average cost of financial advice is between £75 and £100 per hour, while an initial review could easily cost £500.

Even if you were able to afford the fee, it is quite possible that, if your means are limited, the advice might be totally unsuitable.

If you rock up saying that you are concerned about retirement income, you will be sold a pension, regardless of whether this is actually the best solution for you.  If you have a low income you might find that your expensively acquired pension pot will achieve little more than rendering you ineligible for certain benefits, such as the pension credit top up.

This is why it is important to be able to make many of the more basic financial decisions for yourself and where financial education can help.

The good news is that this isn’t necessarily as difficult as people fear.  Many of the concepts are pretty straightforward if expressed in a form that is not designed to automatically channel you towards a particular financial product.  There is also an abundance of material out there if you only know where to look.

Going forward the idea is to regularly post on key issues related to understanding personal finance.  These will be interspersed with tweets on the latest developments in the news in what is becoming quite a fluid situation.

These are early days, but over time I’ll be building a body of work that will allow people to confidently make many of their own critical financial decisions.

Take care out there


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