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Pensions flexibility: capital reinvested vs annuity

Can re-invested pension capital match the income available from a lifetime annuity? Nigel Orange technical support manager (Pensions), Canada Life Limited illustrates the potential sting in the tail for savers through a client case study

The Chancellor caught just about everyone by surprise with the announcement that from April 2015 individuals will be able to cash in their entire pension pot and do what they like with the proceeds, flash cars and exotic holidays being some of the ideas (although said tongue-in-cheek). However, the freedom to spend our retirement fund as we see fit may come back to haunt us.

The wisest way to accumulate and then spend our retirement savings has never been a precise science and nothing announced in this year’s Budget will make decisions any easier. What has changed is that the number of options has increased and this is good news for advisers. It will also drive innovation into new retirement products but this may take slightly longer.

The situation pre 6 April 2015

On the accumulation side of the see-saw, saving in a pension remains the most tax-efficient way of saving for retirement for the majority of individuals. Making the most of a client’s tax allowances is important and, depending on earnings and pension input periods, contributing or using up the Annual Allowance should be the first priority.

For those able to contribute higher amounts, the carry forward facility can still allow total contributions of £190,000 (£40,000 this year and 3 x £50,000 from the previous three years). Carry forward is extremely useful for company directors who direct the company to make contributions on their behalf, especially when profits are good. An individual’s earnings do not count in this instance, so potentially much larger contributions can be made.

From April 2015, taking more than 25% of your DC pension savings as cash will mean you have a reduced Annual Allowance of £10,000 unless it’s a pot under £30,000. Those taking flexible drawdown will also have a £10,000 allowance – better than they have now which is zero! Finally, those already in a capped drawdown arrangement as of 5 April 2015 will keep their £40,000 allowance provided any withdrawals do not exceed the capped limits.

Maxed out pension contributions

Much depends on the level of risk and the capacity for loss an individual is prepared to accept but some tax-efficient options are available; such as ISAs, Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs).

For retirees uncomfortable with the risk of VCTs or EISs, investing surplus funds into an offshore or onshore investment bond could also be a simple and tax-efficient way of providing for retirement, utilising the 5% deferred tax allowance.

However, for the masses, the Pensions Annual Allowance is simply a meaningless figure and has little relevance. Many individuals have preferred to save in an ISA or a building society simply because of ease access to get their savings back in full. The change in rules from April 2015 will alter attitudes to saving in a pension, even though there will be a sting in the tail. Time will tell if the increase in the ISA or NISA (new ISA) allowance may have been designed to house all the new cash available from pension pots.

A set of interim measures was announced in the Budget to ease us all into the new world, such as increasing the amount of triviality lump sum payment amounts, small pension pot numbers and drawdown GAD limits.

Case study: The three options

The object of the example below is simply to show that when income is the key driver for a client, unless they are prepared to risk capital, matching the income available from a lifetime annuity will be quite difficult if cash is taken from the pension pot and then reinvested. Let’s look at what could be a typical case; the options, the taxation implications and importantly the consequences of each.

Mr O has a DC pension pot of £50,000, is aged 65 and is working on a part-time basis with income of £15,000, he is married and neither Mrs O or Mr O have ISAs. He is a basic rate taxpayer.

The aim is to end up with an additional net income of £1,800 each year, matching the income available from a lifetime annuity.

Option 1

Annuitise and secure a lifetime guaranteed income

• Capital spent

• High income secure for life

• £37,500 net of the tax-free lump sum

• Lifetime annuity income £2,250 @ 6% annuity rate taxed at marginal rate

• Net income of £1,800 guaranteed for life

The income is for life and guaranteed. At first glance, the downside of this option is that the capital is spent upfront and therefore unavailable to be passed on to members of the family. This is true, however, the alternative would be to invest the capital sum but if money is passed on at any stage then income will fall as it would unless the investment was asset backed. All clients will have different and varying circumstances to take into account and may have other forms of retirement income in the background.

Option 2

Invest pension proceeds in an ISA / NISA using both partners’ allowance

• All capital available

• Low yielding income – cash

• £37,500 is available after taking tax free lump sum.

This will be taxed at marginal rate leaving a net £28,323 for reinvestment. This figure is arrived at by calculating the tax paid on total income minus personal allowance.

• £28,323 would yield a yearly income of £850 assuming 3% interest (the best rate of interest today in a cash ISA)

• Initial yearly capital withdrawal required to arrive at a net income of £1,800 = £950

• Based on above figures capital depletion will happen at age 86

The client takes his cash from the pension (including tax-free element) spends the tax free lump sum paying off his mortgage and buying a new car and reinvests the taxable part for income in similar assets to those underpinning an annuity that is, fixed interest. Reinvestment into a NISA would be the most tax-efficient wrapper assuming sufficient allowance. This option is not likely to work well for most individuals because they will run out of capital by around age 86 and even though the client has modest earnings of £15,000, part of the cash sum will suffer higher rate tax.

Option 3

• Transfer to a pension drawdown

• All capital available

• Low yielding income – cash/deposit

• £37,500 left in pension wrapper – no immediate tax

• £37,500 yields income of £938 @2.5% net (reduced yield taking into account higher charges associated with drawdown) £750 after income tax at marginal rate

• Capital withdrawal required £1,050 net – grossed up £1,313

• Net income of £1,800 (£1,050 + £750)

• Based on above figures capital depletion will occur at age 86

In this example the capital lasts no longer even mitigating the initial tax hit, but on-going charges will be higher in a drawdown compared with a NISA and the income is taxed so it is likely the client will run out of capital at a similar time.

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