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The pensions revolution – what does it mean?

30 September 2014

So many people have been asking me about the new pension changes and what they might mean, I have put together a quick Q&A to address some of these with my comments.  Hope you find it of interest.  There are profound implications for pension products and pension savers – as well as for regulators of course, to make sure people understand what this all means for them.

  • If in good health, perhaps you shouldn’t buy an annuity before age 75
  • Look for an annuity with guarantees or value protection
  • Pensions have become the most attractive form of savings
  • This benefits ordinary savers, not just the wealthy
  • More money will go into pensions
  • ISAs may switch to pensions
  • More money will stay in pensions
  • Auto-enrolment more attractive than before
  • Pensions can pass down the generations
  • Guidance must explain the tax benefits and signpost to advice
  • FCA must ensure customers are properly protected

The latest announcement of tax free inheritance for pensions, on top of the Budget reforms already announced, will have profound implications for the future of UK private pensions.  It is not putting it too strongly to say that there is a totally different outlook for pension savers in future.  This has implications for millions of us, young or older, and it is vital that the new environment is properly explained and understood.  So much change has happened which runs entirely contrary to decades of traditional UK pensions thinking that many will find it hard to get their head around the new landscape.  Here is quick Q&A to start the ball rolling and hopefully help you appreciate what this might mean going forward.

1.        Will these reforms make pensions more attractive?

Unquestionably yes.  Pensions are the most tax-favoured and attractive long-term savings vehicle for almost all of us.  You could say pensions have become sexy – even exciting!  With the new freedom and flexibility, you can save in a pension fund, get tax relief at your top marginal rate, all gains you make are tax free and then any money you don’t use from your fund while you are alive will go tax-free to the next generation.  Even your own home suffers inheritance tax, but your pension passes on tax free.

2.       Do the reforms just benefit the wealthy?

Absolutely not.  In fact, that’s part of the beauty of the new landscape.  Pensions are now good for the average earners who can enjoy the kind of freedom and flexibility that used to only apply to the very wealthiest.  If you had huge sums in a pension fund before, you did not need to buy an annuity or be limited by capped drawdown, you could use flexible drawdown to take money whenever you wanted, and you could afford not to touch the fund before age 75 so it would pass on tax free to the next generation.  Those who had smaller amounts were denied these freedoms but in future they will be available to all.  Whether your pension fund is large or small, the Government will not restrict what you can do once you reach age 55 and everyone under 75 can pass on the funds totally free of tax, while everyone over 75 can pass on unused funds to give pensions for the next generation – which will be tax free until they are drawn down and face marginal income tax rates.  This ensures many of the advantages that the wealthiest had can now be enjoyed by every pension saver (assuming their pension company allows them to!)

3.        Does this have implications for auto-enrolment?

Yes, huge implications.  The reforms are likely to mean many more people will stay auto-enrolled and opt out rates should be dramatically lower than previously expected.  It also means we should think about auto-enrolling those earning under £10,000 as well, because they are most likely to need the extra savings. As pensions are now so much more flexible and suitable for savers, with the best tax advantages, the reforms make auto-enrolment a ‘must-have’ for many more workers.  This is likely to mean higher costs to both employers and the Exchequer than previously forecast.  Auto-enrolment is a ‘buy one get one free’ offer.  Each £1 the worker contributes immediately doubles to £2 in their pension – due to the employer contribution and tax relief. This is far more powerful than even higher rate tax relief.

4.        What does this mean for annuities?

There are several implications for annuities of the new pension landscape.

·         More annuities with guarantees, so money can pass on tax free on early death

·         More annuities with value protection, as previous sales were hampered by the 55% death tax

·         People who are in good health should perhaps delay annuity purchase to age 75

·         Standard annuity sales will fall sharply – more impaired or underwritten annuities.

Annuity sales should fall sharply, many will be better to wait till age 75 and the providers will need to offer more guarantees or value protection.  Clearly, the reforms will mean the sale of standard annuities, that has dominated the Defined Contribution pensions market for many years, should decline sharply.  This is long overdue.  Annuities have been sold to people who should never have bought them, or who bought the wrong type of product and the Regulator failed to protect customers properly.  The tax system now favours income drawdown and, because of the tax advantages of inheriting pension funds if the saver dies before age 75, there will be a real incentive to delay annuitising until later ages.

5.        Won’t people just rush out and spend all the money as soon as they can get their hands on it?

Of course, there is that risk, but firstly I trust people who have been responsible enough to save for their retirement to be responsible enough to manage their funds in later life too.  Secondly, with the latest announcement of the scrapping of the 55% inherited pensions tax, there is a real incentive now for people to leave their money inside their pension fund for as long as possible.  While any funds passed on were taxed at the penal 55% rate, there was a penalty on keeping money in pensions.  Now, in contrast, there is a real reason to hang onto your pension money as long as you can.  It grows tax free while in the pension, it’s there if you need it, but if you don’t spend it can pass on tax free.

6.        Are there implications for care funding?

Yes, there is now a much more realistic chance that pension funds can help pay for later life care needs, for which no funding has been put in place and which many more people will require.  There is a looming crisis in the funding of elderly care, with neither the state, nor the private sector having prepared for this adequately.  These pension reforms could kick-start care funding by encouraging people to leave money in their pension funds and then, if they need care, they have the money to pay for it.  The state will not pay and cannot pay for all.

7.        Does this have implications for ISAs?

Actually yes.  The fact that pensions have become so much more tax favoured now suggests many people could benefit from switching ISAs into pensions.  The ISA is not free of inheritance tax, it does not get tax relief up front, there is normally no employer contribution and the freedom to spend ISAs has now been at least partially extended to pensions.

8.       Will this benefit families?

Yes, this new pensions landscape means people can pass their pensions onto their loved ones and pension savers will know that their hard earned savings can benefit the next generation if they don’t need or use that money themselves.  The Government is providing real incentives for people to help their children and grandchildren and improve inter generational wealth sharing.  The old system would see insurance companies pocketing the unused funds of most pension savers.  Now their families can benefit instead.

9.  What does this mean for products?

We will need new types of product – annuities sold from a later age and with more guarantees, so they can be passed on to loved ones.  Different products for accumulating pensions, rather than current lifestyle funds that just assume savers will buy an annuity at a preset age.  The default will be drawdown, or keeping money invested in the pension fund, rather than buying an annuity so providers need to help savers with better returns for longer periods of time.

10.  What about the implications for guidance and regulation?

The new landscape makes guidance even more important than ever.  Explaining the tax implications of the pension saving, the implications of taking money out too soon, the tax benefits on death, the benefits of doing nothing and of leaving money invested if still working will all need to be understood.  The guidance should signpost people to full advice too.  In addition, the Regulator must make sure that customers are properly protected.  These reforms are great, but only if people can take advantage of them.  Providers must not be allowed to mislead customers into buying unsuitable products, as has too often been the case in the past.

4 comments

1 PC { 09.30.14 at 5:06 pm }

Anyone reading this should compare it against Martin Lewis’s blog on moneysavingexpert about the same issue. My own worry is that OMO proved too complex for 60% of people, and now it’s even more complicated and risky. So while the (majority) less wealthy and less financially savvy should benefit, in our hearts we know they won’t.

2 Deb { 09.30.14 at 6:22 pm }

Thanks for this refresher and a succinct explanation of the changes.

3 Dion Prideaux-Reynolds { 10.01.14 at 12:56 pm }

Excellent Q&A on the proposed changes and potential ramifications.

4 dearieme { 10.02.14 at 12:36 am }

“The old system would see insurance companies pocketing the unused funds of most pension savers.” No; the old system saw annuity holders who died young subsidising annuity-holders who outlived them: that’s the mutual insurance aspect of annuities. Now the subsidy for the long-lived will vanish. In other words there will be a wealth transfer from the long-lived to the children of the short-lived. I’m not saying that is necessarily bad; in fact it might be a good idea. But we should be clear that that is what is going to happen.

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