Last year, arguably the most radical reform in the pension landscape was when pension freedoms came into force. There were worries that pensioners would withdraw pension pots and spend lavishly on luxury items such as Lamborghinis. Indeed, according to the FCA, 28% of pensioners withdrew their whole pension pot within the first three months of pension freedoms. However, as a trend, these were pots smaller than £30,000; larger pots were put into drawdown arrangements. In this blog, we will have a look at how people are adapting to pension freedoms and what further changes may happen in the future.
To recap: what is pension freedoms?
Since April 2015, pensioners were no longer required to buy an annuity to support their retirement. Pension freedoms provided a greater degree of flexibility as it allowed you to decide how you wanted to take your pension. The table below shows the options you can take at retirement and the definition of them.
||What does this mean?
|Taking an annuity
||Option to take 25% tax free cash and use the rest of your pension fund to purchase a secured lifetime income
|Uncrystallised Fund Pension Lump Sum (UFPLS)
||Taking a series of lump sums with 25% of each lump sum tax free, the rest added to your marginal rate
|Take your whole pension as a lump sum
||Encashing the value of your pension fund in one go – again the first 25% tax free, the rest being taxed at your marginal rate
|Taking out a flexi access drawdown
||Option to take 25% tax free cash and to put the rest of the funds in a drawdown product to supply an income whilst remain invested in the market. The income is not secure as it is dependent on how much money you have left in the drawdown pot and the market performance
Alternatively, you can take a combination of the above options that suit your personal circumstances.
Income seeking environment – what are retirees doing with their money post pension freedoms?
The table below shows that there is a decrease in the amount of pensions being accessed but interestingly there seems to be a revival in annuity sales. According to the ABI, annuity sales are increasing and nearly on par with drawdown products albeit annuity sales are still lower than pre pensions freedom. In addition, cash withdrawal is slowing down with £660m being paid out in Q4 2015 compared to £1.3bn in Q2 2015. This could suggest that having a secured income is important at retirement and people are opting for a later retirement as they recognise growing the pension pot is essential to supplement later stages of retirement.
Moreover, the data also shows that people with smaller pots tend to take their pension as a lump sum (with the average amount being £15,000) but larger pots are being used to access an income product – be it an annuity or drawdown product. One explanation why withdrawal of small pot pension is popular could be because it is not their main pension fund. This group may have a generous final salary scheme and are withdrawing their whole small pension pot for other purposes e.g. to pay off their mortgage or to help their children’s university fees.
||Total - 9 months since reforms
||£1.3bn paid out in cash lump sums, an average payment size of just under £15,000
||£1.2bn paid out in cash lump sums, with an average payment size of just over £15,000
||£660m paid out in cash lump sums, with average payment of just over £14,000
||£3bn paid out in just over 213,000 cash lump sum payments, an average payment of nearly £15,000
|| £1.2bn paid out, an average payment of nearly £4,200
||£970m paid out, an average payment of nearly £3,000
||£730m paid out, an average payment of nearly £3,200
|| £2.9bn paid out, an average payment of £3,500
|Annuity sales (approx.)
|Drawdown sales (approx.)
|Source: ABI pension freedom statistics
These statistics suggest that people are planning for the long term and securing a regular source of income is a priority in retirement.
Adapting to pension freedoms
New fund launches that target the retirement market
One of the major changes that came out of pension freedoms was that it made it much easier to go into drawdown. This means that you are able to remain invested in the market whilst taking an income and this has opened up an opportunity for funds to target this market.
A traditional multi asset fund may have just been a mixture of equities and bonds but has evolved in recent years as producing income has been the focus in many investors’ eyes. Multi asset funds can maximise returns whilst protecting capital in downturn conditions as it spreads risk by diversifying the asset classes it invests in. This type of fund seems to prove popular with retirees who are looking for maximising returns in a risk adjusted strategy. In the newer multi asset fund launches, we have seen funds that are targeting risk, inflation, retirement date or income as their main objective. This space is work in progress as fund providers try to create a product that will suit the investors’ needs.
We have published a blog on the overview of income opportunities
and will be taking a closer look at the above products later in the year.
Pension scams are on the increase
Unfortunately, the pension freedoms have also meant there has been a sharp increase in pension fraud cases. Research from Citizens Advice has found that 88% of the sampled population are missing warning signs of a pension scam and although 76% thought they would be able to identify a scam, only 12% were actually able to. This suggests fraudsters are using highly sophisticated methods such as offering free pension advice and generous investment returns to entice plan holders and swindle their entire savings. The golden rule to remember in cases like this is that if it’s too good to be true, it often is.
Pension green paper – tax relief in the spotlight
In July 2015, the Government published a consultation paper on pension tax relief – its aim was to review the current tax relief system and see whether any changes were needed. Broadly speaking, the current tax relief system works on an “exempt, exempt, tax” principle – you don’t pay tax when you contribute or the growth on the contributions but get taxed (on monies received).
Following the consultation, two popular suggestions were made; one of them was to make the percentage of tax relief universal across all tax bands. In effect, basic tax rate payers would get a boost but higher and additional tax rate payers would face a cut.
The other method was to make the tax relief system on a “tax, exempt, exempt” principle – this means contributions are taxed on the way in but the growth and monies received are tax free. This is a similar approach to how ISAs operate and the advantage of this system is that it is widely understood by the general public therefore should encourage saving. However, because contributions are taxed on the way in, there is less money in the pot to benefit from the power of compounding.
In general, the Government’s spending in tax relief has been on the increase and it’s estimated that this totalled £34bn in 2014-2015. One of the reasons why George Osborne was said to have favoured this system was because it would have saved the Government the upfront tax relief costs.
It was widely expected that the Chancellor would announce any changes in the March 2016 Budget. However, changes to tax relief were postponed as he thought the public needed more time to adapt to pension freedoms. We will be following this topic closely and will write an update if and when changes happen.
Pension update since budget 2016 – indication on the future of pension
Although the Chancellor postponed changes in tax relief, in March 2016, we saw the introduction of the Lifetime ISA (“LISA”). This is a new form of ISA that is available if you are between 18-40 years old. With the LISA, you can primarily save for two purposes: to purchase a house if you’re a first time buyer or for your retirement. There is no minimum or maximum contribution but there is a 25% bonus applied up to £4,000 each year (maximum bonus you can get each year is £1,000). If you are saving for your retirement, you can take the money out at 60. Withdrawing prior to 60 is possible but will incur a 5% exit fee as well as losing any growth/interest accrued on the Government’s bonus and the bonuses itself.
This is an interesting proposal and shows great flexibility for the millennial generation who are struggling to simultaneously save for their first property and pension. This is also one of the first glimpses of an ISA style pension. Effectively, when you save in a LISA, it is on a “tax, exempt, exempt” system where money going in is taxed and money withdrawn is tax free. This gives us the indication that the future of pensions could potentially operate under this principle. Consultancy firm PWC found that ISA style pension was the most appealing method of saving and so it should face little resistance from the younger generations (which is the audience the LISA is aimed at) if tax relief is abolished.
Currently, you can take benefits from your pension at 55, but with a LISA it is from 60. The discrepancy of when you can take benefits from your “pension” between the two schemes suggests that the minimum pension age will be increased to 60. There was a consultation in March 2014 which proposed to increase the private pension age from 55 to 57 in 2028. This is in line with the increase of State pension age from 65 to 67. Thereafter, the State pension age will be linked to life expectancy and the private pension age will be 10 years below the State pension age. Although this is not implemented until 2028, further consultations may mean changes to the current proposal.
LISA can counteract the benefits of the auto-enrolment scheme. Currently, employers must offer a pension scheme with a minimum employer’s contribution (dependent on the size of the business). All eligible employees are automatically enrolled but there is a risk that people will choose to opt out of this scheme and save into a LISA instead (the familiarity of an ISA and the advantage of being able to withdraw money from a LISA before retirement). The main disadvantage of doing so is that you will forgo employer’s contributions. The LISA will be rolled out in April 2017 and it’ll be interesting to see how the LISA will coexist with auto-enrolment and whether it is a foundation for an ISA style pension in the future.
Pension freedoms is still in the early stages of its regime – it is encouraging to see that the data suggests people are responsible with their money, however, it is difficult to assess whether pension freedoms will work in the long term. Australia has experienced a pension freedoms style system for many years but has found that the majority of the retirees were outliving their retirement pot. Last year, it was then recommended that a comprehensive income product should be offered at retirement. Therefore, the measure of the UK pension freedoms’ success will be whether retirees can maintain a sustainable income throughout retirement. As well as encouraging and engaging people to save for their future, it will also depend on market conditions as this can affect the size of the pension pot.
With these changes comes greater responsibility and it is clear that the Government wants to put more personal responsibility back in the hands of the investors when it comes to planning for their future. Therefore, it is important to have access to financial education at an early age as well as having support throughout the process of retirement. There is no doubt that more pension changes will materialise and we will keep a close eye on this topic.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.