Pensions freedom – all it’s cracked up to be?

Pensions freedom – all it’s cracked up to be?

A big change in legislation in 2015 saw people having better access to their pension pots. Wealth management consultant Michael Fryer puts this decision under the spotlight.

“What then is freedom?” asked Marcus Tullius Cicero, one of Rome’s greatest orators and prose stylists. “The power to live as one wishes.”

While I’m certain Cicero wasn’t referring to UK pensions legislation in his statement – considering it was expressed during the Consul of Rome in 63BC – however, it nevertheless seems apt when you consider former Chancellor of the Exchequer George Osborne’s change to pensions legislation back in April 2015.

The introduction of so-called “pension freedom” – where defined contribution scheme members could access their funds freely – gave individuals the freedom to tailor their pension income to their specific needs in retirement. Sure, this can be particularly helpful when members have unexpected life events, or circumstances change – but is it without a catch?

Change for the better?

Prior to April 2015, those with defined contribution pensions commonly withdrew 25% of their fund as a tax-free lump sum and then purchased an annuity – a guaranteed income for life. However, while an annuity offered a secured income, it did not provide an option to alter the level of income drawn if circumstances changed in retirement.

Sure, if some element of flexibility was required, capped drawdown could also have been used – however, the income that could have been withdrawn was limited to the level imposed by not just Government Actuarial Department rates, but also the size of the fund and the age of the member.

Since April 2015, the pension income market has been revolutionised, mainly thanks to ‘flexi access drawdown’ – a type of pension freedom for defined contribution pension scheme members who require access to their pension funds.

Here, the member has complete freedom to draw as much of their pension fund as they wish. Of course, the tax-free lump sum element is still limited to 25%, but this can be taken in whole or phased to meet a members’ capital or income needs.

The remaining 75% continues to be invested, with the aim of providing capital growth and or income to the pension scheme. When these funds are subsequently drawn as income, they are subject to income tax at the member’s highest marginal rate.

If this applies to you, it is important to note that once you withdraw income, you will become subject to the money purchase annual allowance, meaning you may only contribute up to £4,000 per tax year to money purchase pension schemes. However, this does not apply if you only take tax-free cash.

The good

Flexi access drawdown undoubtedly offers unprecedented access to money purchase pension schemes. In fact, as you may already know, it is possible to take the whole pension fund in one go – subject to income tax at marginal rates on 75% of the fund. However, it is best used to draw a variable level of income sufficient to match an individuals’ needs at that time. It can be particularly helpful if you wish to phase your retirement or take a variable level of income – perhaps you have income from other sources, or you simply wish to bridge the gap until you reach state retirement age.

Tread carefully

If the idea of drawdown is appealing to you, it’s understandable you may be tempted to withdraw a high level of income in the early years of retirement when perhaps leisure, travel and lifestyle are a priority. However, if this becomes the norm, be warned – the yield from the residual fund may not keep pace with the income being withdrawn from the pension, leading to – in the long term – erosion of the fund. That’s why it is important you have regular reviews with your wealth management consultant to a) ascertain the sustainability of the pension fund, b) understand the impact of the withdrawals already made and c) learn of the effect of investment returns on the residual fund.

Using flexi-access drawdown can also help you minimise income tax liabilities, as the amount drawn can be continually altered in accordance with your overall income tax exposure and the availability of allowances. However, if a substantial withdrawal is taken, it could push you into a higher tax bracket, which only further highlights the need for advice and careful planning.

In the event of your death during flex-access drawdown, your pension death benefits can be paid to dependents or a nominee, who can inherit the residual fund. If your death occurs prior to age 75, the residual fund can be paid as an income or lump sum to beneficiaries free of any tax. The right to purchase an annuity is retained, and if this is exercised, your beneficiaries will receive a tax-free income for life.

If death occurs post age 75, your residual fund can still be paid to beneficiaries as an income of lump sum – however, the recipient will be liable to income tax at their marginal rate.

Weighing things up

While the availability of flexi-access drawdown is undoubtedly a better fit than capped drawdown or annuity purchase for the majority of clients – including you – it must be stressed that having free reign to access a pension fund does come with great responsibility.

The level of income withdrawn must be balanced, not only against the size of the fund, but also investment returns and life expectancy. This will ensure it is nor depleted prior to death.