Comment on recent FTAdvisor article on pension freedom

FT Advisor last week published an editorial about how Pension Freedom was “not working”.  In the comment section I ventured that Independent Financial Advisors might be leaving themselves vulnerable if they have a policy of always declining transfers from Defined Benefit (final salary) schemes into Defined Contribution arrangements, such as a SIPP.

Most people would be best advised to stick with their final salary pensions.  However, if leaving an inheritance is important to you, and, crucially, you have sufficient other resources from which to draw an income, a transfer could make sense.  This is because a defined contribution pension, in many circumstances, can be left to descendants free of inheritance tax and now, thanks to Pension Freedom, without paying the 55% Death Tax.

By systematically denying pension savers this opportunity, IFAs will almost certainly be giving their clients advice they know to not be in their client’s best interest.  See the article and my comments (stuarttrow) at  http://www.ftadviser.com/2015/08/12/opinion/jeff-prestridge/pension-freedom-is-not-working-yO5nD7v50HKTbGIFGVtXXO/article.html

 

 

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A Bird in the Hand

Two recent pension surveys caught my eye last week.  The first suggested, somewhat unsurprisingly, that retirees prefer a guaranteed income to an equivalent sum of savings.

 The report was based on lifestyle survey data and the analysis contained a lot of squiggly charts and tables of data.  The upshot though is that increasing guaranteed income appears to encourage social participation (and other activities associated with the feeling of wellbeing) to a degree not matched by merely increasing wealth.

The survey was conducted specifically to investigate issues relating to the pension freedoms introduced in April of this year.  These gave many retirees an alternative to simply purchasing a guaranteed income in the form of an annuity.  Effectively the freedoms present investors with a choice between a fixed income for life (an annuity) and investing, at their own risk, to provide an uncertain level of income.

It’s not hard to see where the stress comes from.  Producing an acceptable income from savings has always been a challenge, one that eludes many “professionals”.  The current low rate environment exacerbates this problem.  Add in a generalised lack of financial self-confidence, not to mention the intimidating “mystique” surrounding investment, and it’s easy to see why most pension savers are happy to let others take responsibility for their retirement income.

However, even leaving aside the emotional and educational aspects, uncertainty creates real risk and people are prepared to pay significant sums to avoid it.  Indeed the entire premise of insurance industry is that people will pay more in premiums than they’ll ever claim from their insurance policies.

Another way of looking at this is from the perspective of an annuity provider.  Previous blog entries on this site have illustrated just how expensive it is to buy an indexed-linked pension compared with a level annuity that pays a fixed income for life.  Adding indexation sees the provider assume the risk of protecting their clients from future inflation.  Even ignoring inflation, providers still run the unquantifiable risk of longevity.  It is this, combined with current low interest rates, that make annuities appear such poor value.

Another survey indicated that typically only 6% of retirement income comes from savings.  48% comes from benefits or the state pension, whilst private pensions chip in 42% on average.

These two surveys would appear to support each other inasmuch as savers’ lack of comfort with cash, as opposed to a secured income, suggests that they “value” savings less.  Of course there may be practical issues that limit an individual’s ability to save.  However, it is a shame that the flexibility of savings is underappreciated.

The slight irony is that the various regulatory developments that have occurred since the vast majority of these private pensions were accumulated have indeed made private pensions a more rational choice as a means of long-term saving.  With the 55% Death Tax removed, pension pots can be passed on intact and sometimes entirely tax free.  That is a significant advantage  compared with seeing your entire pension pot disappear upon the death of you and your partner, simply because you wanted to remove all income uncertainty from your life by purchasing an annuity.

The inescapable, and somewhat unfortunate, result of all this is that pensions have become even more complicated and daunting than ever.  Annuities remain an option, but the opportunity cost of buying one has increased substantially now that pensions can be spent or passed on at the pensioner’s absolute discretion.  In many ways a pension is better than a trust.  The pensioner remains in control of the funds for their lifetime, but can pass them on to their direct descendants tax free.

Ironically this inheritance tax advantage may cause investors to leave their pensions intact and instead rely on non-pension savings for their retirement income.  Which neatly brings us full circle to people’s aversion to saving!

Take care out there

PensionMan

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The meek shall inherit the earth (if their parents are rich enough)

Until relatively recently the tide had been running very much against inheritance tax planning.  Successive governments had closed loopholes and negated time-honoured strategies to make what was once dubbed a “voluntary” tax more and more difficult to avoid.  Over the past year though those lacking the gift of immortality have been presented with two very valuable estate management tools.

The first I have already discussed at length.  Abolishing the so-called pensions “death tax” allows pension funds to be passed from generation to generation, only being taxed at the beneficiary’s marginal income tax rate when cash is withdrawn.  Technically a pension fund could always be passed on free of the reviled IHT.  The problem was that the so-called death tax (arguably the ultimate exit charge) of 55% more than made up for the IHT exemption.

Last week’s budget though added another tool to the estate planner’s armoury, namely the potential to shelter the family home from IHT.  Currently we all “enjoy”, although I’m not quite sure that is the correct verb, an IHT allowance of £325,000.  For a couple that sums to £650,000 with a relatively recent innovation being that that allowance can be passed on to the surviving partner upon the first partner’s death.  Thus, combined with the fact that trusts tend to be less favourably treated these days, the default option for many married couples is to leave everything to the surviving spouse who will then proceed to give away as much as possible once their own needs have been met (utilising gifting rules and seven year potentially exempt transfers).

What Mr Osborne added last week was a further IHT allowance per person specifically associated with the family home.  This will start at £100,000 in 2017 and steadily rise each year until it reaches £175,000 in 2020/21.  Thereafter it will rise in line with the Consumer Price Index.  When complete it will exempt a £1,000,000 family home entirely from IHT, although everything else will then be taxed at 40%.

The tax planning opportunity comes where people have more modest homes and are relatively cash rich.  Granted this doesn’t apply to everyone.  However, if you are looking to leave a little something to the kids or grandchildren, it might be worth considering “upsizing” the family home if that is an option.

Let’s put some figures on that.  A married couple with a home worth £650,000 could upsize (or at least upvalue) to a pad worth a million.  Think luxurious penthouse apartment with a stunning cityscape view!  This would potentially save their heirs £140,000 in inheritance tax by sheltering an additional £350,000 in the family home.

Those still looking to downsize will be able to do so by utilising another innovation, the “inheritance tax credit”.  This preserves the new allowance for those downsizing so long as the bulk of the estate is left to direct descendants.  The hope is that this will encourage retired individuals to free up larger houses for growing families.

It’s only fair to point out that once the family home reaches beyond £2,000,000, the additional allowance is withdrawn at the rate of £1 for every £2 of value.

Additionally you will not be surprised to hear that not only does the Chancellor giveth, but he also taketh away.  The cost of all this IHT largesse is that those earning more than £150,000 will see their annual pension contribution allowance stepped down in increments from £40,000 to £10,000.

The upshot though is that families now have two new and very powerful tools to shelter considerable funds for future generations: private pensions and the family home.  The caveat, of course, is that the law is so fluid that any beneficial change could easily be reversed with expensive consequences.  I suspect though that these two particular changes will be preserved going forward, even if future governments feel the need to temper pension freedoms generally going forward.

Take care out there

PensionMan

 

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Keeping your options open

A recent study by Friends Life indicated a significant shortfall between the income people expected to need in retirement and what their savings were on track to deliver.  The study broke the numbers down on a regional basis and showed that savers in the North East and South West were likely to be the least disappointed.  Nationally though people expected to need £409.10 per week, but were likely to have to make do with far less than that: £312.40 to be precise, a shortfall of £96.69 a week.

The more encouraging survey finding though was that people were planning to accumulate a “basket” of products and sources of income to fund their retirement.  Whilst the recently introduced freedoms have made pensions significantly more attractive, the lesson of recent history is that a variety of income sources provides the best chance of optimising your affairs to provide the most resilient and tax efficient income in retirement.

Indeed I touched on this a couple of months ago when discussing “Taking a tax-efficient income in retirement”. So when 29% of pre-retirees surveyed indicated that they intend to supplement their retirement income with a savings account and 18% plan to use a cash ISA, this is an indication that people are thinking flexibly. ISAs share a number of the tax advantages of pension. Crucially, even though the inheritance tax advantages are far more limited, ISA withdrawals are free of income tax. This makes them excellent vehicles to top up income if your level of pension drawdown is close to pushing you into a higher tax bracket in any given year. Indeed ISAs the arguments for drawing down ISAs first are persuasive precisely for the reason that they are income tax free, but aren’t easily passed on the future generations.

One particularly interesting aspect of the survey is that whereas 17% of people approaching retirement were thinking in terms of either downsizing or selling their property to unlock funds, only 4% of retirees have actually used funds from this source.

This would rather suggest that most savers will be a little more circumspect about investing their hard-earned pension pots in buy-to-let properties than the recent hype might suggest. BTL though might be a viable proposition for excess funds not already enjoying the tax advantages of a pension. That though is a story for another day.

Take care out there

PensionMan

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Taking a tax-efficient income in retirement

I’ve had a few conversations with people off line following my last post on the inheritance tax implications of #pensionfreedom.  What I’d like to do here is illustrate a few of the other implications in terms of how they affect different savings vehicles.  Before I do so however, it is important to note that Pensions Minister Steve Webb has stated that pensions should not become “a vehicle for inheritance tax planning”.  This suggests that it is at least possible that some of the recent pension freedom proposals might not actually see the light of day.  Worse still they might be reversed following May’s election.

So with that rather large pinch of salt, I’ll launch into what pension freedom, as currently proposed, implies for savings as I understand things to be.

To quickly recap, and generalise horribly, if you die after April 6th, but before the age of 75, your pension pot can be passed on to whomever you have nominated, free of inheritance tax.  Furthermore the pot will be theirs to spend as they please entirely free of income tax too.

Should you die after 75 the pot can still be passed on IHT-free, but tax will have to be paid at the recipient’s marginal rate if they require cash.  It is also worth remembering that the post 75 Death Tax reduces from 55% to 45% in April, but isn’t removed altogether until April 2016.

So how does this compare with other investments?  Recent ISA rule changes allow ISAs to be passed on between partners without losing their tax wrapper.  Previously ISA proceeds could be passed between couples, but, from the date of the first death, they would lose their income and capital gains tax advantages.  That new benefit is lost though on the second death and ISA assets become part of the couple’s estate for inheritance tax purposes, just like any other non-ISA savings.

So what we have effectively from the perspective of someone who has just retired is:

Private pension: Income is taxed at a person’s marginal rate and, if an annuity is not taken, 25% of the pot is generally available income tax free.  Zero IHT.

ISA: Zero income and capital gains tax.  Remember that assets can always be passed between partners free of inheritance tax regardless of tax wrapper.

Other assets outside ISA/Pension wrappers (bank deposits, investment funds, property etc): These generally enjoy no IHT exemptions and are subject to income and capital gains tax at the investor’s marginal rate.

These tax differences have implications for the order in which a pensioner might most efficiently derive an income from his or her savings, whilst maximising any possible legacy should their funds survive them.

All other things being equal it would make sense to utilise those resources deriving the least inheritance tax protection first.  It’s not quite that simple of course.  In certain circumstances it might make sense to combine income from non-wrapped and ISA sources in order to ensure that your marginal income tax rate is no higher than it needs to be.

Thus to cut a very long story short, the general idea would be to start to take your income from a combination of non tax-exempt assets, mixing in ISA income along the way.  This is because ISAs have income and capital gains tax advantages during a couple’s lifetime, which disappear entirely upon the second death.

The last port of call might be your pension (assuming you opt to drawdown rather than simply buy an annuity at retirement).  This is especially attractive to your loved ones due to the removal of the death tax.  It does highlight though the importance of making nominations of desired beneficiaries and, importantly, keeping these updated to reflect any changes in your personal circumstances.

This, of course, is all very simplistic, but does at least provide a few points to consider when deciding how to produce a retirement income from your assets.

So until everything changes yet again,

take care out there

PensionMan

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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

PensionMan

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IHT – the ultimate wealth tax

In my previous update I mentioned that I would explore some of the Personal Finance implications of a shift of emphasis away from the taxation of income and towards taxing assets and wealth. The ultimate wealth tax is the Inheritance Tax, or IHT for short. A few years ago IHT was commonly regarded as being “voluntary”, inasmuch as it was generally perceived as being pretty easy to avoid. The great and the good could employ various trust or business-related strategies to avoid the worst ravages of this attempt to take a second bite out of a lifetime of taxable earnings. Most of the rest of us were unaffected as the thresholds were proportionally higher in real terms.

Things aren’t as straightforward anymore. While the Conservatives pledged to raise the inheritance tax threshold to £1 million, the promise has gone the way of many political sweet nothings and the current £325,000 threshold has been frozen until at least 2018/2019.

IHT revenues have been rising steadily, bringing in £3.4 billion last year, an increase of around 10% on the previous year’s take.

The frozen threshold, and rising house prices, mean that more and more estates are falling into the clutches of the tax. At the same time HMRC is seeking to limit the extent to which trusts can be employed to circumvent the tax.

What this is likely to mean is that the only effective tool for limiting the vulnerability of your estate to inheritance tax is to give away your assets while you are still alive. Even this is not entirely straight-forward because a) it simply passes on the problem to a future generation and b) while you might avoid IHT, there are often capital gains tax implications when assets are given away or sold.

All of this will require detailed (and expensive) financial advice with considerably less scope for your advisors to come up with something “special”.

One possible consequence though is that it will provide an additional incentive for people to downsize their homes in good time, while also keeping a more careful eye on the capital gains implications of any investments they might have.

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A step closer to higher UK interest rates

This morning it emerged that two members of the Bank of England’s Monetary Policy Committee voted for an increase in interest rates at August’s meeting.

A bit of background first.  Base rates have been at a record low of 0.50% for more than five years.  Immediately before the crisis began in 2008, the base rate stood at 5.75%.  Those of us with a few more miles on the clock will vividly remember base rates of 14.875% or even 17%.

With unemployment falling fast and UK growth the strongest in the developed world, ordinarily interest rates would be considerably higher than they are currently.

A large part of the reason why rates haven’t already risen is that wage growth remains subdued, barely matching inflation.  As a consequence, in real terms (i.e. adjusted for inflation), many workers have yet to feel the benefit of the economic revival.

However, many of those who had mortgages prior to the crisis have been able to refinance at significantly lower rates, often saving themselves hundreds of pounds a month in the process.  If you were also fortunate enough to live in the South East, you’ve very likely benefitted from considerable appreciation in the value of your property.

This begins to get to the heart of why current policies are unsustainable over the longer term.  Those with assets and access to credit have generally done very well.  Those without either have found things pretty tough.

You only have to read the comment sections in even the higher brow newspapers to appreciate the disaffection this has caused.

The upshot is that it is inevitable that policy will shift from monetary stimulus, which favours those with assets and credit, to fiscal measures that attempt to capture a portion of that action for the Treasury.  The idea being that budgets can be balanced by increasing taxation on assets perceived to be less economically productive, such as property.

The political attraction of taxing assets and wealth is immense, especially if it also allows governments to lift the peddle on austerity and/or cut rates of basic income tax.

We’ve already seen significant increases in top-end property stamp duty, whilst the proposed Mansion Tax is merely the thin end of a wedge which will herald the biggest change in taxation policy in a generation.  Promised increases in the inheritance tax threshold have also gone by the wayside.

From a personal finance perspective it is very likely that the costs associated with property ownership will increase significantly and these will need to be covered in retirement.  Equally tax planning will become both more important, and also more difficult to achieve.

In my next few updates I’ll explore some of the personal financial issues raised by this brave new world.  In the meantime though:

Take care out there

PensionMan

 

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