How The New Pension Freedoms Work
For years, retirement saving has meant pretty much one thing: building up a pension pot and then converting that pot into an annuity, which paid an income for life.
And even with the introduction of income drawdown as an alternative to annuities, that remained pretty much the standard retirement route for most people. Build up a pension pot; convert it to an annuity.
It was very much a ‘safety first’ choice: in retirement, your pension lasted as long as you did, eliminating the prospect of an impoverished old age due to exhausted savings. On the other hand, converting your pension pot to an annuity meant there was nothing for your heirs to inherit.
Cue the pension freedoms introduced in April 2015 — which are arguably the biggest change to personal pension legislation ever.
Security vs. inheritance
Over-exaggeration? Not really. For decades, the so-called ‘nanny state’ had tried to protect citizens from the consequences of their own folly.
That’s why, until 1995, annuities were the only option on offer. And if you delayed taking out an annuity — seeing a chance to pass your savings to your heirs — the government compulsorily did it for you, once you got to 75.
No longer. Under the new pension freedoms, the old rules have been swept away, opening the door to some interesting alternatives.
Income retains its allure
Indeed, as former pensions minister Steve Webb famously remarked at the time that the new freedoms were announced, there’s now nothing to stop retirees spending the lot on a Lamborghini if they so wished.
Few have done so, it seems. According to investment giant Fidelity, fewer than one in 20 retirees are ‘cashing out’, with most of those being people with small pots anyway — for whom the new freedoms make such an option more attractive.
Instead, the evidence suggests that most pension savers and retirees are being cautious. They still want an income for life. But they are aware that the new pension freedoms offer new ways to derive that income — and they want to make sure that they’re choosing the best option for their own particular circumstances.
Exercising your rights
At which point, it’s necessary to sound a warning.
Although you’re legally entitled to take advantage of the new pension freedoms, that’s of little value unless your pension provider offers them.
And a good many don’t — seeing in them additional cost, complexity and compliance issues.
Can you compel your provider to offer them? No. And don’t expect the government to take up the cudgels on your behalf: it has already said that it won’t do this, and that the decision to offer the new freedoms is up to individual providers.
What to do? Simple. Move your pension to a provider that does offer them, and the list of these is growing all the time.
So what exactly do the new pension freedoms actually allow retirees to do? Apart from blow the lot on that fabled Lamborghini?
Take income through an annuity.
This is still an option, although far fewer people appear to be doing it. You get a guaranteed income — but your heirs get nothing. You can withdraw 25% tax-free, if you wish, or leave it invested for a higher income.
Take income through drawdown.
The new rules sweep away the former annual ‘cap’ on drawdown income, so that you can take out as much as you want. That’s the good news. The not-so-good news is that yes, there’s a risk of your pension savings expiring before you do, plus you’ll be taxed at your highest marginal rate on the money that you do withdraw. Again, you can withdraw 25% tax-free, or leave it invested for a higher income — which could grow over time. And don’t forget, drawdown income is liable for taxation at your highest marginal rate.
Take periodic lump sum payments.
This is the really new part of the pension freedoms, allowing retirees to take a succession of lump sum payments through the Uncrystallised Funds Pension Lump Sum (UFPLS) option, while their pension savings continue to grow. Each payment can be as large or small as you like, and each benefits from the 25% tax-free allowance. If you do buy that Lamborghini, this is how you’ll do it. But watch out: the withdrawn cash that isn’t tax-free is liable for taxation at your highest marginal rate.
Deciding what to do
What to do? Carefully consider the choices open to you, to start with, and don’t hesitate to take independent impartial advice, such as the free personal advice available from the government’s Pensions Advisory Service. The rules underlying the new freedoms are complex, and you’ll want to make sure you don’t fall foul of them.
With drawdown, for instance, there’s the option of continuing to add to your pension savings from earnings, if you’ve only taken the 25% tax-free cash. With UFPLS, there isn’t — there’s simply a £4,000 Money Purchase Annual Allowance.
That said, the new freedoms do — as promised — turn your pension savings into something much more like a bank account, in terms of freedom of access.
And — importantly — there’s nothing to stop you taking a ‘mix-and-match’ approach to how you withdraw your money. Part-annuity, part-drawdown? Something else?
There are more decisions to make, to be sure. But don’t forget that it’s your retirement, and your savings — and the new pension freedoms allow you to make those decisions.