Seven Winning Strategies

These are a few of the strategies I have been discussing at recent Pensions by Candlelight dinners.

  1.   Look for cheap State pension Top Up opportunities

Where you either have fewer than 10 qualifying years or some recent part years

  1.   Stagger Private Pension Withdrawals 

Use your annual tax allowances!!!

  1.    Think Carefully About Where You Take Your Income From

Consider drawing income from your ISA and leaving your pension for the kids

  1.    Expressions of Wishes

Use them to save your children tens or even hundreds of thousands of pounds in inheritance tax

  1.    Give while you’re still alive

Equity release with a fixed-rate lifetime mortgage and gift the proceeds.  Not for everyone, but can work in the right circumstances

  1.    Planning for the Terminally Ill

Capital gains liabilities disappear on death, whilst assets can be left inheritance tax free to a partner.

  1.    Marry Your Daughter’s Boyfriend

A very high risk strategy to use the spousal exemption from inheritance tax!!!!!!

Take care out there

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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



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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


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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



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Is it better to go for an index-linked pension or a steadily rising annuity

As I discussed last month, people often underestimate how much it costs to protect your pension from the ravages of inflation.  We saw, for example, that a £100,000 pension pot might typically buy you a level annuity of £5,448 a year.  This would remain constant for the rest of your life, which could easily be another 30 years.  If, however, you wanted your income to increase by 5% a year, your starting annual income would almost half to £2,815.  To put that into perspective, you would have to live until you were 90 before you broke even on your decision to opt for a 5% annual escalation.  That is six and a half years longer than the current male life expectancy.

However, a 5% annual increase is actually considerably above the current inflation rate.  Indeed over the past year the Retail Price Index has increased by just 0.9%.  Even if you go all the way back to 1981, the average only climbs to 3.85%.  In view of this, if you merely wanted your pension to increase by the rate of inflation, rather than a fixed 5%, you might expect that your starting level would be higher.  And you would be correct!  Instead of starting at £2,815 and increasing by 5% a year, you would start at £3,294 and rise in line with inflation.

Of course we’ve got no idea what inflation will be over the next few months, let alone the next 30 years.  However, if you assume that inflation going forward will be the mirror image of what it has been over the past 25 years, i.e. starting low and then building to peaks to reflect the spike in prices in the early 1990s, you come up with some interesting figures.  You would, for example, have to live until 97 before you would have been paid as much by an RPI-linked annuity as by the level annual payment.  A clearer indication of just how expensive it is to protect yourself against future inflation is that you would only have to live until 78 (having retired at 65) to be better off opting for an annual 5% increase rather than a rise based on inflation.

This illustrates two things.  Firstly it is very expensive to provide an escalating pension, especially one linked to future inflation risks.  This is because you are asking the annuity provider to effectively “insure” you against unknown future price increases.

The even more significant risk that all annuities insure you against is longevity risk.  That is the risk that you live longer than you or your annuity company have budgeted for.  An annuity will, generally, keep paying out until you die, whether that is at 66 or 106.  It is true that you can pay extra to have the income guaranteed for a minimum period of 10-years.  This means that your beneficiaries don’t lose the value of the entire £100,000 if you drop dead far sooner than you might have hoped.  However, this generally doesn’t cost that much (but I will cover this in another update).  By far the greater cost to your annuity provider is if you live on to a ripe old age.

The point is that the “insurance” element shouldn’t be underestimated, both in terms of its cost, but also in terms of its value.  One way of appreciating how much you are being charged is to consider that the average male life expectancy is 83.5 years.  If you were simply to keep your £100,000 pension pot and take an income of £5,448 (equivalent to the level annuity and assuming no investment growth whatsoever), your pot would last until you were a little over 83  years and four months old.  Basically the price you are paying the insurance company for agreeing to sustain your pension until you die is equivalent to every last penny you may have earned on your £100,000 for almost 20 years.

This is not to say nobody should buy an annuity, or that they shouldn’t have it inflation-linked.  What it is saying though is that these things cost money and you can only really appreciate how much if you delve a little deeper.

Take care out there


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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


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What price an index-linked pension?

People are often shocked at just how much an index-linked annuity costs relative to one that pays a level income for life.  Imagine if you will, you have a £100,000 pension pot that you are seeking to convert into pension income.

According to the Daily Telegraph, Aviva will exchange your £100,000 pot for a lifetime annual income of £5,448.  However, if you were to require a 5% increase each year, your starting income would be just £2,815, almost 50% less.

That begs the question, how long would you have to live before you “broke even” on your decision to opt for the escalating income?

A simple spreadsheet shows that you would have to live until you were 90 to have been paid as much from an escalating pension as you would have received from the level annuity. By that point though the escalating pension pays you an annual pension of £9,532, whilst the level annuity would, of course, remain at £5,448.  Thereafter the escalated pension moves ahead quite quickly. Indeed by the time you receive your telegram from the Queen (or King) on your 100th birthday, you would have received a total of £73,000 more from an escalating annuity.

For context the average male retirement age is 64.6 years and life expectancy at that point is 83.5 years.

Of course the real world isn’t quite this simple. Inflation, for example, invariably means that a pound received early on is worth more than one received twenty years later. Also most annuities make some sort of provision for surviving spouses. Over the next couple of updates I will delve into a few of these complexities. Even if you don’t intend to buy an annuity, inflation is still something that you will have to take account of to ensure that your savings last for your entire retirement.

Take care out there



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A taxing emergency

Plenty of people have warned of the income tax implications of next month’s pension freedoms. As I wrote last year (How to spend it), someone drawing down £200,000 from a personal pension should expect to pay a minimum of almost £50,000 in income tax. That is even if they have no other taxable income. The Daily Telegraph has summarised this in a neat little table illustrating a number of different scenarios combining non pension income and the sum drawn down from your pension. The associated article can be read here.

The tax itself will be deducted at source by the pensions company and remitted to the Treasury.

Pension Tax

What is less widely noted though is that, in the absence of a clear indication of what your tax code actually is, pension companies will apply an emergency tax code. This could easily be as high as 45%. Worse still, it will ignore any entitlement you will most likely have to take 25% of the pot tax free.

The situation arises because HM Revenue & Customs treats any money drawn as the first of a series of monthly payments. This is similar to what currently happens when pensioners draw down a regular monthly sum from their pension to live on. It is less helpful for pension freedom withdrawals, which are likely to be one-offs and involve far larger sums.

The good news is that the money isn’t lost for all time. However, the process of reclaiming it is complicated and easily misunderstood. If you have no other income apart from your State pension, you must complete a P50 form and return it to HMRC. It will then take up to six weeks to receive your refund. If you do have other sources of income you must complete a P53 form.

Alternatively you can wait until the end of the tax year at which point the overpayment should be corrected automatically. The downside of being patient is that HMRC will be sitting on many thousands of pounds of your cash. To put this in monetary terms, if you take my example of a pensioner with no other income withdrawing £200,000, the overpayment could be anything up to £40,000. The true income tax liability is an already chunky £49,000. However, applying an “emergency” 45% rate and ignoring any 25% tax free cash entitlement, could easily see £90,000 of your £200,000 being remitted to HMRC.

Take care out there


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Speaking their language – managing student loans with pensions

The biggest hurdle to overcome when selling an idea to someone is to engage their interest.  Once the connection is made you ‘re off.  Now this can apply as much to personal conversations as it can to business or sales scenarios.  Equally though, there subjects or even words that are slam dunk conversation stoppers.  Thus I often try to contain my enthusiasm should a dinner table conversation with friends drift towards the vexed subject of pensions.

 So, after an excellent New Year’s Day lunch with old friends and their university-aged offspring, I was more than happy to listen to the students around the table describe their financial frustrations and challenges.  I manfully resisted the temptation to assume a financial mother hen persona.

The conversation continued to dwell on finances giving a rather fine bottle of red time to start to work its magic.  I chanced a one liner about ways of mitigating the burden of student loan repayment.  Encouraged by the fact that eyes didn’t glaze over immediately I elaborated briefly and will paraphrase below.

To put it simplistically student loan repayments are calculated as 9% of income above a certain threshold.  In 2014-15 that threshold is £16,910.  One way to manage this would be to somehow reduce your income.  I know that sounds a bit drastic, but bear with me.

In the case of child benefit HMRC starts to claw back benefit payments from any parent earning more than £50,000.  For someone earning a little above that threshold, one way of “reducing” their income, and by so doing retain more or even all of their benefit, would be to make pension contributions.  This works because the contributions are deducted from a person’s headline salary.

Unfortunately, student loan deductions are treated slightly differently inasmuch that from calculated before deducting tax or National Insurance contributions.

All is not lost, however.  A technique known as “salary sacrifice” can be employed to barter a portion of your salary for additional benefits (usually in the form of a pension).  This then does reduce your salary for the purposes of repaying a student loan.

Of course this might not be what you want to do and some people just want to repay the debt as soon as possible, which is fine.  However, salary sacrifice can be a useful tool for younger workers who want to make an early start on their pension provision.

One further consideration for those either approaching, or actually in retirement, is that the age cap on student loans was removed in 2013.  This, combined with an increase in the income limit from 2016 to £21,000, means that any pensioner undergraduate might never have to repay their loans if their pension doesn’t exceed the threshold.  Better still, after 2016, the threshold will rise in line with average earnings.

So whilst these are two slightly off the wall financial strategies, they don’t have to be conversation stoppers



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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


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