Private Pension Reforms 2015
Currently, people’s access to their pension pots is restricted. It is possible to access up to 25% of pension savings as a tax-free lump sum but the options available for the remaining 75% depend on the person’s level of income.
If you and are over 55 years old and have a guaranteed income of more than £12,000 per year in retirement there is no limit on the amount you can withdraw from your pension pot each year. This option is known as Flexible Drawdown.
If you have an income of less than £12,000 you can take income from your pension, although the maximum amount you can withdraw each year is restricted (to 150% of an equivalent annuity). This is known as a Capped Drawdown.
People aged 60 years and over with pension pots of less than £30,000 can take this all in one lump sum. This is known as Trivial Commutation. All three of these options are classified as income and taxed at the marginal rate of income tax (0%, 20%, 40% or 45%).
Those who do not qualify for the above options can draw down their pension, but rather than being subject to income tax it is subject to a 55% tax rate. This high tax rate strongly incentivises people to purchase an annuity, an insurance product which provides an income stream for the rest of your life. The majority of those reaching retirement age (75% according to the Treasury) buy an annuity, providing them with a guaranteed income.
This will change in April 2015 when the above restrictions will be removed, and people aged 55 years and above will be able to access their entire pension savings in whatever way they wish. So people could take their pension savings out in one lump sum, access it in parts, or purchase an annuity. Importantly, whatever way people decide to access their pension, they will not face a 55% tax rate. Instead, it will be treated as income and taxed accordingly.
The changes give people more freedom and flexibility in how they access their pension savings. For example, a person over the age of 55 will be able to work fewer hours and have more leisure time while maintaining their level of income, by drawing down from their pension savings to make up for lost wages. Currently this is not a viable option for the majority of people and only those who are eligible for trivial commutation, capped drawdown or flexible drawdown can avail without facing a 55% tax rate.
With this greater freedom comes greater risk. By taxing drawdowns at 55%, the current system encourages people to purchase an annuity, which gives them a guaranteed level of income for the rest of their life. The removal of the 55% tax rate means that people may be more likely to spend their pension too early and not leave enough for later life.
While people in this position will still have the state pension to fall back on, it is proposed that the depletion of pension assets would be considered ‘deliberate deprivation’ which gives Health and Social Care Trusts the right to refuse to pay for a person’s long term care needs. Long term care costs can include the provision of carers, meals, transport, home modifications and equipment that enables people with care needs to stay in their own homes or, if their needs are more serious, access to a residential care home. Under these rules if a person who is about to go into a care home is seen to have transferred capital (such as savings or other assets) to someone else, reassigned ownership of a property to another person, or made extravagant purchases the Trust will view them as still possessing this capital or property (which they term as ‘notional capital’), and will include their full value in the person’s financial assessment for care home fees.
In order to help people manage their pensions well, government are introducing a requirement on pension providers to arrange access to free and independent guidance. However, this will consist of a one-off piece of advice at the point of the person’s retirement, when more regular access to advice may be necessary. And even if people try to be prudent and do take out an annuity, there is a concern that the ability of annuties to provide a decent income is on the wane. Low interest rates and longer life expectancy have meant lower annuity payments since 2008, as Figure 1 shows.
It is difficult to know if annuity incomes will recover in the future. Interest rates will have to rise at some point, and the presumption would be that the returns on investments and pensions will also rise. However the greater flexibility in accessing pension pots is likely to lead to a fall in demand for annuities. Indeed in March 2014 relatively minor flexibilities were introduced and sales of annuities subsequently fell by 40-50% This fall in demand could lead insurance companies to offer less generous annuity deals, in turn making this market even less attractive for companies providing annuities.
It is expected that following the changes in 2015, more people will draw down their pension, resulting in a £1.1bn boost to tax revenues by 2017/18. However as the Institute for Fiscal Studies states, this will reduce future revenues commensurately, which is highlighted in figure 2.
Currently, unused pension savings which have been neither drawn down nor used to purchase an annuity are taxed at 55% when passed on at death, with no tax-free band. After the changes come into effect, when someone dies under age 75 the recipients of their unspent pension cash will not pay tax on it; and where someone dies over 75 the money passed on will be subject to the recipient’s marginal rate of income tax.
This may result in larger inheritances being handed down, reproducing inequalities from one generation in the next. Private pensions are already subject to tax reliefs with an estimated value of £35 billion in the 2010/11 tax year. Over their lifetime, an individual is entitled to tax relief of up to £1.25 million. Because people with more income tend to have more money to save, it is primarily higher earners who benefit from this tax relief. As The Economist comments, while a tax relief skew “is inevitable (the rich have additional money to save, after all), there does not seem any… need to increase their tax advantages”.
There is a concern that the changes could have detrimental effects on the wider economy. The money used to purchase annuities is invested in bonds, issued by companies which require capital for business expansions. If the annuities market were to dry up, businesses may become more reliant on more restrictive and expensive borrowing from banks. In addition, retirees may use their pension savings to speculation on property, thereby contributing to another property bubble.
HM Treasury (A) (March 2014) Budget 2014: support for savers announced
HM Treasury (B) (July 2014) Pension Reforms: nine things you should know
HM Treasury (C) Budget 2014: greater choice in pensions explained
This article was written for the Centre for Economic Empowerment by Niall Quigley .