Planning for Retirement
In 2006, an event heralded as ‘A-Day’ was the supposed moment when ‘once and for all’ the rules for pension saving were simplified and everyone would be able to calculate how to make the most of their retirement arrangements. Sadly, that dream has proved elusive, with successive governments continuing to tinker with the regulations, resulting in some savers feeling overwhelmed by the complexities. Nevertheless, despite the changes, pensions still represent one of the most tax-efficient ways to save for retirement. So, the aim of this article, is to help you understand the available options.
What is a pension?
At its most basic, a pension is simply a savings scheme that offers very attractive tax benefits if you agree not to touch the proceeds until you are older. In other words, you hand over your money which is invested, its value (hopefully) grows and, at the end of the savings term, you withdraw the proceeds and use it to pay for goods and services. In this case, however, you usually cannot touch the proceeds until you are at least 55, and under the current rules, you are restricted in terms of what you can do with the proceeds once you reach that age.
The different types of pension
The Basic State Pension officially came into being as part of the National Insurance Act of 1946 and was designed to provide a minimum amount of income during retirement. During year 2016/17, the basic state pension for a pensioner who reached state pensionable age before 6 April 2016, and who has met the minimum National Insurance (NI) contributions, is £119.30 per week. Additionally, if you also contributed to the State Earnings-Related Pensions Scheme (SERPS) - or, more recently, to the State Second Pension (S2P) - you may also receive an earnings-related ’top-up’ to the state pension. The amount received depends on how much you earned and how much you contributed.
However, if you reached state pensionable age on or after 6 April 2016, you will qualify for the new “single-tier” state pension. Starting rates for this are from £155.65 per week; however, claimants may receive more or less than this, depending upon their National Insurance contributions.
Claimants are able to obtain a forecast for your state pension from the Department of Work & Pensions (DWP) at www.gov.uk/state-pension-statement
Unsurprisingly, the state pension alone will not facilitate a luxurious retirement, and for this reason - together with the UK’s increasingly ageing population - means the Government is finding it more difficult to meet even these levels of payment. Consequently we are all being encouraged to make additional investments towards our retirement.
An occupational pension is a savings scheme for company employees, into which your employer may make some or all of the contributions on your behalf. These could be ‘defined benefit’ schemes (also known as ‘final salary’ schemes) in which the amount you receive depends on the number of years’ service you gave to the company. Alternatively - and these days more likely - they will be ‘defined contribution’ schemes, in which you and/or your employer will make a fixed level of contribution, the final value of which will depend on how well the underlying investments have performed. Thanks to volatile stock markets and additional regulation, the days of final salary pension schemes are generally considered to be all but over - apart from some employees within the public sector, or those with unchangeable employment contracts in the private sector.
Until recently, company pension schemes and contributions into it were entirely voluntary. However, from October 2012, all but the smallest of employers became obliged to automatically enrol their employees in a qualifying, in-house pension scheme or into the National Employment Savings Trust (NEST). Employers now have to make a minimum contribution, rising to at least 3%, of an employees salary no later than 2019. In exchange, employees will also have to make contributions, rising to 4% by 2019. The Government also have their part to play in the new regime, and by way of tax relief, will contribute another 1%. For individuals employed in smaller companies, this might represent their first opportunity to become involved in formal occupational pension planning. For larger companies, however, these minimum requirements might already have been exceeded.
Small self-administered pension schemes (SSAS) are generally implemented to provide retirement benefits for a small number of a company’s directors and/or senior/key staff. They can be open to all employees and their family members, even if they don’t work for the employer, with member numbers capped at 12. Contributions may be made to the SSAS by members and/or the employer with each receiving tax relief on contributions, subject to certain conditions. A major benefit of SSAS is that the employer has increased flexibility as to where the scheme’s assets are invested, including investing in assets not generally available for many other types of scheme to invest in. For example, a SSAS could purchase the company’s trading premises and lease these back to the company. Or, subject to certain terms and conditions, could lend money to the company and purchase the company’s shares.
A SSAS can also borrow money, subject to terms and conditions, for investment purposes, i.e. the SSAS may raise a mortgage to assist with the purchase of the company’s premises by the scheme and the mortgage repayments may then be covered, in all or in part, by the rental income that the company pays the SSAS.
Personal pensions are schemes organised by the individual for the benefit of the individual, no matter who you work for, for how long or how much you earn - the decision on level of contribution is down to the saver (subject to annual contribution limits) who also decides where the money is invested. So, the more you put in, the more money you have to invest for your future - and the better your underlying investments perform, the higher that value will be.
There are three basic types of personal pension.
Stakeholder pensions: The simplest pensions, these are designed to encourage lower earners to save for their future. As they are subject to restrictions on charging, they can be a cheap and efficient way to start saving. Because of the cost limits, the range of investments maybe restricted, as may some of the additional options, but most savers will usually find index tracker-type funds and multi-asset managed funds to suit their basic needs.
Individual personal pensions: These pensions offer access to a range of different funds. Some come with additional benefits that make them easier to manage if you are looking for a scheme beyond a basic managed or tracker fund, or wish to switch around different types of investment. They are not subject to the same charging restrictions as stakeholder pensions, so fund choices are wider. These types of scheme generally cover pension requirements for most people.
Self-Invested Personal Pensions (SIPPs): These are the most sophisticated of personal pensions and allow a huge amount of investment flexibility if you are very active in your investment allocation or adventurous in your choice. SIPPs allow investors to access funds, shares, bonds, gilts, property and cash - and occasionally more complex investments as well - so they allow savers to build a portfolio specifically tailored to your needs and make adjustments to that portfolio whenever and however. Because of this however, SIPPs are comparatively expensive to other types of less flexible schemes.
In some cases, however, charges have reduced and a new generation of ‘low-cost’ SIPPs have emerged, which offer the same switching and management flexibility but without the same level of access to the more esoteric investments. So, if you do not need them or do not have the time or experience to take proper advantage of them, you might be wasting your money by paying for such a product.
Building a Portfolio
Choosing a type of pension is important but the greatest impact on your longterm wealth will be the contributions you make and the underlying investments you choose. The choice of investments available within pensions has evolved since the days of traditional life office products with a selection of one or two balanced funds. Now, most pensions offer a sufficiently broad choice of investments for you to build a truly individual portfolio.
It may feel as if the rules on pensions can change with the seasons but some basic elements have remained constant in recent years. Investors receive income tax relief on their contributions into a pension scheme (up to certain limits) and the income and gains made by that fund accumulate free of additional tax while the money remains invested. However, sweeping new changes introduced in April 2015 have expanded the range of options on retirement, meaning much more freedom as to how and when you access your pension pot to suit your own personal circumstances.
So, what are the new options?
- Purchase an annuity - this will provide a steady, predictable income stream, and there are various add-on options i.e. protection against inflation. However, annuity rates are low and so do not necessarily offer good value.
- Flexi-access drawdown - you can take up to 25% of your pension pot tax-free, and reinvest the balance to generate a regular, taxable income. However, the resulting income is not guaranteed and you could run out of money.
- Withdraw your entire pot as cash in a single transaction - this option is attractive if you wish to access your pension pot quickly, whether to spend or reinvest. However, only 25% of each withdrawal is tax-free with the remaining 75% subject to income tax, so you could incur a substantial tax charge.
- Take lump sums when you choose - this spreads your 25% tax-free allowance. However, your pension provider might restrict the number of withdrawals you can make in a year, and you could incur a tax bill if your withdrawals push you into a higher income-tax bracket.
- Alternatively, you can leave your pension pot untouched until a later date, allowing it to continue to grow. And, of course, you can mix and match these various options, depending on your own specific requirements.
Before you take any action, however, you should ask yourself the following important questions:
- How old are you, and what is your state of health?
- Do you want to stop working straightaway, go part-time, or keep working as before?
- Do you have a spouse and/or dependants?
- What are your goals, aspirations and attitude to risk?
- If you have a strategy in mind, what are the tax implications?
How and when you choose to access your pension pot is a serious decision that will affect the rest of your life. Therefore, it’s vital to take expert professional advice. Talk to your financial adviser; alternatively, Pension Wise is a Government service that provides free, independent guidance on your options, but does not provide recommendations or advice. Visit www.pensionwise.gov.uk for more information.
Annual contribution limits
During the current tax year (2016/17), the maximum amount you can invest into your pension (personal or occupational) is 100% of your earnings or £40,000 (this may be reduced for individuals with total income above £110,000) whichever is the lower. You should receive tax relief on the entire investment up to that limit for individual contributions. Tax relief on employer contributions is given by allowing contributions to be deducted as an expense when calculating their profits provided they are ‘wholly and exclusively’ for the purposes of the employer’s trade or business. However, if you try to invest more than £40,000, you may have to pay tax on the excess. This limit, incidentally, applies to the combination of both employee and, if applicable, your employer’s contributions. You can, however, carry forward up to three years of unused allowance to subsequent tax years meaning that for this tax year contributions of up to £170,000 may be made.
The lifetime allowance applies to the total value of all private and workplace pensions (not state pensions) that you build up over your lifetime, including the investment growth that you have achieved. For 2016/17, the lifetime allowance is valued at £1m. If your pension fund grows above this value, you will be liable to tax charges on the excess. These charges are quite onerous - 55% if the amount over the lifetime allowance is paid back to you as a lump sum and 25% if the amount over the lifetime allowance is taken as some form of income. Therefore, if you already have a large pension fund - even if it has not yet reached the limit set by the lifetime allowance - you have to consider whether there might still be some investment growth to come. As an example, if your pension fund is valued at more than £1m and you have ten years still to go before you plan to retire, it might be time to stop contributing and find another home for your savings.
The value of investments and the income from them may fall as well as rise and you may not get back the full amount you invested. This is intended to provide information only and reflects our understanding of legislation at the time of writing. Before you make any decision, we suggest you take professional financial advice.*
For further advice please contact a member of the team below.