FOOL'S EYE VIEW
Get Ready For The Pensions Upheaval!

By Cliff D'Arcy
June 2, 2005

The UK pension scene is set for massive changes when 'A-Day' arrives at the start of the next tax year, 6 April 2006, which means that you have around ten months to get ready.

At present, there are eight rulebooks for different kinds of pensions. However, these will all be abolished and replaced by a single piece of legislation that covers all UK pensions. Most of us stand to benefit from this overhaul, but a few workers and pensioners will lose out. Here are six tips on making the most of this brave new world:

1. It may be worth delaying your retirement

If you're in a company pension scheme and have plans to retire before next April, it may be worth sitting put in order to take advantage of the new rules. After A-Day, you can withdraw up a quarter (25%) of your fund as tax-free cash. The current limits are based on either a multiple of your salary or a multiple of your initial pension, depending on which type of scheme you're in. It's worth checking with your employer to see if you'd stand to gain by delaying.

Also, there's a further benefit if you've made additional voluntary contributions (AVCs) – extra payments into your fund. At the moment, this pot must be used to buy you an income but, after A-Day, it too can form part of your 25% tax-free cash. The same rule applies if your scheme has opted out of the State Second Pension – this element of your fund can also generate tax-free cash come A-Day.

If you set up or joined your pension before 1989 (or later, in a few cases), you may be able to take out more than a quarter of your fund as tax-free cash. However, you could lose this right if you leave your job or transfer your pension to another employer or provider, so tread carefully! One way to preserve this entitlement is to transfer your pot into a 'Section 32 contract', but take professional advice before pursuing this option.

A-Day will benefit members of company pension plans in another way, as they can take out a self-invested personal pension (SIPP) alongside their company scheme. After A-Day, SIPPs can invest in a wide range of assets, including residential property (see below), unquoted shares, and alternative investments, such as antiques, art, vintage cars and wine. So a vintage-car collector could set up a SIPP purely in order to buy his collection, or use pension tax relief to subsidise further purchases!

Finally, A-Day will allow you to opt for 'phased' retirement, as you will no longer have to stop working for your employer before drawing your company pension. What's more, you can draw down your pension in stages, allowing it to start small and build up over time. However, the minimum retirement age, currently 50 for most people, will be increased until it reaches 55 by April 2010, which may force some workers to call it a day before A-Day!

2. You'll be able to contribute more

As things stand at present, members of final-salary company pensions can pay in up to 15% of their earnings. For workers with a money-purchase company pension or personal pension, there are contribution limits based on age and earnings. For example, as I explained in this recent article, I'm in the 36-45 age bracket, which means that I can contribute up to a fifth (20%) of my earnings into the Fool's Stakeholder pension scheme.

However, the good news is that A-Day scraps these limits: from 6 April, you can pay in all of your earnings – 100% of your salary – into a pension. (There is an upper limit of £215,000, which gradually increases to £255,000 by April 2010, but this is of little interest to most of us!) Also, in your year before retirement, there is no limit, so you could catch up on missed contributions by whacking a huge sum into your pension just before calling it a day!

Among millions of others, my wife stands to benefit from this rule change. Each year, her company gives her an annual bonus, a chunk of which goes into her company pension as a one-off lump sum. However, under the present rules, she can only put 15% of her total earnings into her pension scheme, so much of her bonus ends up being taxed at 40%. After A-Day, she can contribute her entire salary to her pension if she wishes, so her entire bonus can go into her company pension. Excellent news!

3. You'll have a wider choice of investments

At present, investors in self-invested personal pensions can invest in property, but only in commercial property. At present, a SIPP can borrow up to three-quarters (75%) of a property's value, so a £100,000 fund could buy a £400,000 property. However, after A-Day, this borrowing limit falls to half (50%) of the fund's value, so a £100,000 fund could only afford a £150,000 property. So, for example, if you are a business owner looking to use your SIPP fund to buy your business premises, you may need to complete this purchase before A-Day to avoid losing out.

Another plus is that, from 6 April, SIPPs can buy residential property. So, you could use your SIPP fund to buy a holiday home, buy-to-let properties, or even your 'principal private residence', also known as your family home!

However, this will only appeal to a minority of pension investors, as strict rules apply. If you put your family home into a SIPP, you either have to pay tax on the benefit or pay a market rent to your SIPP. So, if your home could be rented for £1,000 a month, you must either pay a grand a month to your SIPP, for which this is a tax-free income, or pay tax at your highest rate on this 'benefit in kind'. This would be £220 a month for a basic-rate (22%) taxpayer; £400 a month for a higher-rate (40%) taxpayer.

One survey indicated that three out of five SIPP holders (60%) are keen to use their pension fund to invest in property. However, many investors may lose interest when they discover the risks and restrictions. As with all investments, it's sensible to diversify (spread your money around), so putting your entire SIPP fund into property – perhaps even a single property – is a concentrated and high-risk gamble. Do you really want your pension nest egg in a single basket?

What's more, you may find it hard to sell when you want to, which could prevent you from retiring when you want to. Also, a slump in property prices could mean your retirement taking a big hit, or being forced to wait until the housing market recovers. Furthermore, you could put your home into a SIPP as a one-off pension contribution, but only if your annual salary is at least equal to the value of your home, and your home is worth no more than £215,000), which is most unlikely.

In any event, only workers with large pension funds or incomes will be able to become property investors via SIPPs. A SIPP can only borrow up to half of its value to invest in property, so you'd need a fund worth £110,000 to buy a house worth £165,000, which is around the average house price.

4. You could take a higher income

The current regime allows personal pension holders (and some company scheme members) to avoid buying an annuity (a pension income for life) by keeping their pension invested and withdrawing income. However, these 'income drawdown' schemes limit this income to no more than the annuity that you could buy on the open market. After A-Day, this income limit rises by a fifth, to 120% of the annuity income, and income drawdown will become an option for all pension fund members, although it is only likely to appeal to people with pots worth £100,000+.

5. You could leave your pension to your family

At present, holders of money-purchase pension plans have to buy an annuity by their 75th birthday. This means that they are forced to surrender their entire pension pot in return for a guaranteed income for life. Thanks to falling interest rates and investment returns, annuity rates these days are about half what they once were, so many pensioners object to being forced to hand over their pension pot to an insurance company.

After A-Day, you can avoid buying an annuity by using an alternatively secured pension (ASP). With an ASP, you keep your pension invested and can draw an income worth up to seven-tenths (70%) of that paid by an annuity. However, you're not forced to draw any income at all, so you could leave it to roll up tax free if you don't need it. Once again, it's likely that only well-off savers will have this option, as they may have other sources of income to subsidise their living expenses.

When you die, your fund can be used to provide a pension to your spouse or dependant child (who can be up to 23 if s/he is in full-time education). With an ASP, even if you don't have any dependants, it is still possible to leave your pension to another family member or friend. On your death, your pension assets can pass to other scheme members, although this may attract Inheritance Tax. Once they reach 55, the beneficiaries can take out their 25% tax-free cash and use the remainder to buy a retirement income.

6. You could face a 55% tax bill - ouch!

HM Revenue and Customs is introducing a cap that will restrict the maximum value of your pension fund. This 'lifetime allowance' starts at £1.5 million and rises over four years to reach £1.8 million. Each of the pensions that have accrued during your life will count towards this overall limit, and every penny over this amount will be hit with a 55% tax. Yikes!

Obviously, most workers' pensions will be worth a fraction of this amount, so the vast majority of us won't have to worry about this penalty. However, high earners and those nearing retirement should contact pension trustees to make sure that they won't fall foul of this rule. For example, an employee who has a final-salary pension worth £95,000 a year would be hit by this punitive charge, because the taxman would judge this pot to be worth twenty times this income, or £1.9 million.

However, few of us could dream of a pension this large, so only long-standing senior employees need to worry! In any event, there are several ways to dodge this 55% tax, which involved registering your fund before April 2009 for 'primary' or 'enhanced' protection from the tax. This is a bit complicated, so I won't go into it here.

Let's hope that the new rules help you to become a wealthier pensioner!

More: Visit the Fool's Pensions centre | More about A-Day | Buying property via a SIPP.