Pension Advice Made Simple

Understanding the risks under the new pension rules

The media is full of coverage about the overhaul of the rules governing access to pensions that come into effect this month.

Most of the coverage focuses on the many benefits that the new system will provide: primarily, the fact that people who withdraw their pension under the new system will have more freedom than ever before, in deciding how they will use their pension pot. However it was recently highlighted that the new system also presents a number of risks.

The team here at Unlock My Pension have poured over the new rules and regulations governing access to pensions. This post points out some of the key risks that should be kept in mind when following the new rules.

Is there a knock on impact of cash withdrawals?

Under the new rules if you have a ‘defined contribution’ pension pots (the kind where what you get as a pension income depends on what you have paid into it over the years), you will have more freedom than ever before to decide how to use your pension. Historically you would have been quite limited in terms of how you could use your pension: most people would decide to buy an income for the rest of their lives via an annuity. However under this month’s new rules, you have options:

  • You could withdraw the entire value of your pension pot now, and use the cash yourself; or
  • You could withdraw 25% tax free as a lump sum, and leave the rest invested.

These options do give greater choice, but they also have new consequences. If you decide to withdraw the more than 25% of your pension now as a cash sum (perhaps to try and pay off existing debts), this will be subject to a higher rate of income tax. The tax that you could be liable to pay can be as much as 60%, which may well exhaust a significant proportion of your pension pot.

Another consequence of withdrawing any monies from your pension pot, is that it may affect your entitlement to welfare benefits. It was recently announced by the Department for Work and Pensions that where people are receiving any kind of means-tested benefit e.g. Housing Benefit or Income Support, this will be adjusted according to the level of pension income they are receiving. This is because pensions, for the purposes of the DWC are a form of ‘income’, which may mean that your benefit entitlement is reduced.

Getting rid of an annuity: a good or bad decision?

The new rules mean that you are no longer limited to buying an annuity with your pension pot to provide an income. However many people will have already done so. Under the new regime, if you have already purchased an annuity you will be able to sell this back with a view to receiving a cash lump sum.

The Government understands that many people may decide to opt to retain their annuity, but also wants to extend the option to everyone as annuity rates have become less favourable in recent years and some may feel that they have not received a good deal. Alternatively, given recent economic hardship, many people may want to sell their annuity and use the cash to help members of the family. The difficulty however is that in receiving a cash lump sum, you will automatically be placed into a higher income tax bracket. As a result you may receive a lesser cash payment than your originally expected. Worse still, the payment that you ultimately receive may not reach the value you expected leaving you with a greatly reduced pension pot.

The pension pot: is it an investment or not?

The new regime throws into sharp light the many investment options that are available to people when withdrawing their pension.

Some may be considering withdrawing their pension pot – in small or large quantities – with a view to placing it into what they may think as a more lucrative investment e.g. property. It is important to keep in mind that while pensions are not free of taxation, they do enjoy more tax protection than non-pension investments: pensions are in themselves a kind of investment. There will be capital gains tax to consider as well as the issue of dividends to consider with non-pension investments e.g. property. The fact of the matter is that non-pension investment may not always be as predictable as you would like, meaning that you may ultimately end up with lesser money than if you had not looked to invest the fund.

The overhaul of pension rules in the UK has at its core, the principle of freedom of choice. The UK Government is allowing people to have more freedom in how they utilise their hard earned savings. However it is important to note that these new freedoms, while exciting also have their own consequences. These should be considered carefully before making any drastic changes to your pension pot.

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    Options for investing your pension

    If you have been following the news on pension reform in the media recently, you will have noticed that there has been a lot of discussion on pensions.

    Words like ‘drawdown’ and ‘investment’ have been used very frequently.  The difficulty however is that a lot the discussion is quite difficult to understand, particularly in terms of the new options for making pension pots work harder.

    At Unlock My Pension we have taken a look at some of the options available to people under the new rules, and this post gives an overview of the different investment products available.

    What do we do by ‘investing’ our pension?

    It may sound stranger but under the new pension rules, you now have a lot to consider in terms of what to do with your pension.  Unless you are fortunate to have been participating in a ‘final salary’ pension scheme, you will likely only be entitled to a pension that you yourself have been paying into over the course of your lifetime.  You would then have purchased an annuity from an insurance company with this fund, providing you with an income in your retirement.

    However under the new rules you may want to think more on making your pension work harder for you.  You have the option of, as opposed to buying an annuity, taking 25% tax-free as a lump sum and leaving the remaining monies in what is known as a ‘Self-invested personal pension’.  This is where your pension is placed into a financial plan that is a mixture of shares, funds and investment trusts.  You can then take an income from the growth that these investments enjoy.  This is called ‘drawdown’.

    What options are available?

    As mentioned earlier a Sipp is normally a mixture of different kinds of investments, and there are several different products available on the market:

    1. Multi-asset income funds

    As the name suggests, these products normally include a variety of different ‘assets’.  The pension pot will in all likelihood be spread out across shares, bonds and even property.  These funds can be particularly useful as they increase the potential for the fund to see growth: the pension fund is not placed in a single asset.

    The point to bear in mind is that different funds will be administered by different organisations who will have particular expertise on the likely growth that could be expected for the investment of the pension fund.

    2. Target date funds

    These products are not dissimilar to multi-asset income funds in that the pension fund will normally be distributed into a variety of different assets.  However the placing of the assets will change as the investor or saver (you) get older.  The term ‘target date’ refers to the year that you as an investor expect to start drawing an income from the fund.

    3. Investment trusts

    Arguably one of the more well-known products, investment trusts are actually companies that are featured or ‘listed’ on the Stock Exchange.  They will use the investment that you make (your pension) and invest in them in the shares of other companies.

    Depending on your particular circumstances, one or another kind of Sipp may be preferable.  However there is an important point to keep in mind.  Many regard a Sipp as a welcome alternative to purchasing an annuity for an income in retirement because they believe that:

    (i) annuities do not always provide a good return and;

    (ii) invested pensions will, by and large, provider a greater return via growth than any annuity.

    If you do decide to explore a Sipp as opposed to purchasing an annuity, you may well avoid a less than favourable return that a particular annuity would provide.  However you also expose yourself to another risk.  Investments are by their nature risky endeavours and their success or failure depends entirely on the economic market: you may well see tremendous growth in your investments, but you could also lose a significant sum.

    The UKs overhaul of pension rules presents an exciting opportunity for you to take hold of your pension savings and have real freedom of choice, in terms of what is done with your hard earned savings in your retirement.  However you should take care of your pension pot, whatever you decide to do with it.  Annuities offer a degree of predictability but may not offer be good value, while investments have the potential for both great gains and great losses.  We at Unlock My Pension this that it would be wise for you to take the advice of an experienced advisor who regularly deals with pensions before making any decisions.

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