Give me (pension) freedom …
Photo by Rhys Kentish on Unsplash
In which our intrepid pension adventurer applies her magnifying glass to ‘the pension freedoms’ to find out exactly what they are and what you can do with them.
You may have heard about pension freedom and be wondering what it is. Or, you may be wondering what you can do with your pension when you retire.
Boring-but-necessary disclaimer. I'm not a financial adviser and no-one should assume anything I write here is financial advice. It only reflects my experience of looking into my pension and pensions in general.
Age factor
First, to do anything at all with your pension savings you have to be 55 or over (and it’s likely to be 57 in future). Pensions are designed to be long-term savings and if you try and get at them early horrible things will happen.
Seriously.
Take money out of your pension savings before you’re 55 and HM Revenue & Customs will yell ‘Unauthorised payment!’ and slap a massive tax bill on you. You could lose almost all the amount you took out.
This is a known scam. Fraudsters will try to tell you there are loopholes that mean you can avoid the unauthorised payments tax, even if you’re under 55 – but to take advantage of the loopholes, you have to transfer your pension savings to them. Guess what? There are no loopholes.
Freedom, 1-2-3
There are three main pension freedom options.
Freedom #1: Guaranteed income
Freedom #2: Adjustable income
Freedom #3: Cash
You might be able to combine two or more of these options.
But - these pension freedoms are only available if you’ve got a defined contribution (‘DC’) pension.
Defined what?
It’s what most pensions are nowadays. You (and your employer, if it’s your work pension) pay contributions which are invested. The idea is they grow into a pot of money for you to use as retirement income (have a look at my What species of pension is this? blog for more details).
The pension freedoms don’t apply to defined benefit (‘DB’) pensions. Rather than being a pot of money, these pensions offer an income for life worked out on your salary and how long you built up the pension for. To use the pension freedoms, you’d have to give up that offer of an income for life and turn your DB pension into a pot of money by transferring it into a DC pension. This is a serious step no-one should take without regulated independent financial advice.
For the rest of this blog, assume we’re only talking about DC pensions.
Freedom #1 Guaranteed income
Before the pension freedoms were introduced in 2015, this was the only option for most people. You hand your pension savings over to an insurance company and they pay you an income for the rest of your life. The technical name is annuity.
There’s a lot of choice with annuities. You can choose increases or no increases, different types of increases (for example, fixed at 2% a year or in line with inflation), and a pension for your partner if you die before them. There are even annuities that will give you a higher income if you’ve got health problems, so aren’t expected to live as long as a healthier person. And before buying your annuity, you can choose to take up to a quarter of your pension savings as tax-free cash.
Guaranteed income for life sounds good, no? But as always, there’s a catch. The amount of yearly income you get from your annuity can look very small compared to the size of your pension pot. Choosing anything other than a non-increasing annuity for yourself will make your income smaller still. And whatever type of annuity you choose, you can’t change it once it starts to be paid.
In fact, one of the reasons for the pension freedoms was concern that annuities, which had been getting more expensive for years, weren’t good value for a lot of people.
Tax? The income from your annuity is liable for income tax, like any other type of income.
Freedom #2: Adjustable income
In theory this is easy to understand. You invest your pension savings and take income out as and when you want it. The technical name is income drawdown. To get an adjustable income you have to put your pension savings into a product called flexi-access drawdown.
Tax? The income you take out is liable for income tax like any other income. You might be able to pay a smaller amount of income tax by keeping close to, or below, your personal allowance (the amount of income you can earn before you start paying income tax – it’s £12,500 for the 2020-21 tax year). And, you can take up to a quarter of your pension savings as tax-free cash before you start using the rest for adjustable income.
I think of this as the Spiderman option – with great power comes great responsibility. You have total control over your pension savings. But, you also have the responsibility of managing your savings so they last for the rest of your life. You have to be careful not to run out of money.
And there’s investment to think about. You want your money to keep on growing so it lasts the rest of your life – but there are no guarantees with investment, which is why we have the warning ‘the value of your investments can go down as well as up’.
Having said all this, you’re not stuck with adjustable income for the rest of your life. At any time, you’re free to use whatever’s left in your pension savings to buy a guaranteed income.
Freedom #3 Cash
You can take cash out of your pension savings whenever you like once you’re 55. You can either take cash in chunks, or take all your pension savings as cash at once.
In theory, this sounds brilliant. Lots of cash! Pay off your mortgage! Buy a new car! Go on a big holiday!
In practice there is, of course, a catch. Tax. When you take cash out of your pension savings – whether you take a chunk, or all of it at once – only a quarter of it is tax free. The rest isn’t. You’ll be liable for income tax on the remaining three-quarters.
It gets worse. The taxable cash is added to the rest of your income for the year. What if this pushes you up into a higher tax bracket? You’d pay even more tax.
There’s another catch. Supposing you want to carry on saving into your pension? One of the great things about pension saving is tax relief – your pension contributions aren’t liable for income tax. You can save the whole of your salary into your pension and still get tax relief, as long as the total contributions in a tax year – from you and your employer, if it’s a work pension – are lower than an amount called the annual allowance. This is normally £40,000 a year. But taking cash out of your pension savings can reduce it to £4,000 a year. That’s a bit of a difference …
(Fun fact: this type of cash has one of the worst technical names I’ve ever heard – Uncrystallised Funds Pension Lump Sum, or UFPLS as it’s snappily known. Believe it or not, I’ve seen UFPLS used in pension communications aimed at normal people.)
Freedom medley
If you’ve got enough money in your pension savings, you might be able to combine two or more of the pension freedoms. For example, you might use some of your pension savings to buy an annuity for guaranteed income, then invest the rest and use it for adjustable income.
How to choose?
That is the question. It’s also the problem. Choosing which of the pension freedoms to take is entirely up to you. This sounds great - but very few people know enough about pensions to make a good choice. You’ll often see ‘Get independent financial advice’ recommended. But many people can’t afford this kind of advice.
There is a free government service called Pension Wise which offers guidance on the pension freedoms. I’m going to test it out as part of my #PensionAdventure and report back in a future blog. Watch this space!
#LoveYourPension