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Tax-free cash is king

My last article outlined three pension topics to finish my series on topical retirement planning issues. Most of that article elaborated on the definition of dependent within pension schemes and annuities but I briefly moved on to the relevance of tax-free cash.

Technically Speaking, Keith Popplewell

In this article, I will spend more time on the tax-free cash issue before discussing the relevance of tax-free cash to commutation factors with regard to transfers from final-salary pension schemes.

As regards tax-free cash generally, I suppose I can do little better than to mention a recent meeting between myself and my neighbour, Ray, who had asked me to assess his overall pension situation. There were five money-purchase plans of varying value and with providers of varying quality.

Adding together all the current and projected funds “achieved” a total of around 80,000. Unfortunately, Ray is 63 and so has little time to rectify this shortfall and must continue to work until he drops, more or less.

Ray then asked me to convert this fund to an equivalent pension. Using the annuity options he specified, this was 5,000 a year. Quite apart from Ray’s problem of future lack of income, I mentioned that he would not in any case use the whole of his fund to buy a pension as he should take the maximum available amount of tax-free cash.

Those of you who have ever been in this situation with a client can anticipate Ray’s answer: “But I do not want tax-free cash. I need the highest income I can get.”

I tried to explain in general terms why he should still take the maximum lump sum and then, if he really did not need that immediate money, reinvest it somewhere even in a purchased life annuity. Tax relief and all that.

Ray could not grasp my point so I decided I would have to fall back on a properly calculated comparison, nicely laid out to give us both the best chance of getting on to the same wavelength. I am not suggesting Ray lacks intelligence. I am using this example to illustrate how we financial advisers are perhaps unable to explain some technical issues properly. So, on to the numbers. If Ray were to use the whole of his 80,000 fund to buy a pension, he would be paid a gross amount of 5,000 a year, as I have already noted. Assume now that Ray’s entitlement to the full amount of basic state pension, income from investments and an ongoing part-time income from his business use up his nil and lower-rate tax bands. All his 5,000 pension will be liable to tax at the basic rate (22 per cent) and his net income from the pension annuity will be 3,900.

Against this, I showed Ray his net income position if he were to take the maximum amount of tax free cash and buy a purchased life annuity, as shown in Table 1.

I have assumed that the purchased life annuity rates are the same as pension annuity rates. They are not but the issue remains valid.

The increase in net income using the tax-free cash route is 250 a year from 3,900 to 4,120. An additional 250 a year might not sound a lot of money to most people but it represents an increase of 6 per cent and would make a difference to Ray’s quality of life. The increase would obviously be much higher for funds of a more realistic value.

However, I would like to depersonalise this from Ray’s situation and recalculate the numbers for a higher- rate taxpayer, still using a fund of 80,000. The gross annuity of 5,000 would yield a net income of 3,000 after 40 per cent tax if bought directly from the fund. Table 2 shows the situation through the tax-free cash route.

For a higher-rate taxpayer, the comparison is therefore even more marked. A net income of 3,000 from an annuity bought entirely by the pension fund rises to a net annual income of 3,400 from the tax-free cash route – a staggering 13 per cent net increase.

Now, I am aware of the (at least almost) universal awareness among financial advisers of the benefits of taking the maximum amount of tax-free cash from money-purchase pension schemes at the date of vesting but I would pose a few questions. First, do we always remember to apply these principles when dealing with a client approaching the vesting date? Second, do we always ensure we are in touch with the client before the vesting date, able and willing to ensure he receives the benefit of our advice? Third, do we all appreciate the true extent of the net benefit to the client from the purchased life annuity strategy, in cash or percentage terms?

Finally, how certain are we that the client fully understands what is proposed and the extent of the benefit we secure for him through our knowledge and endeavours? I would speculate that, for most financial advisers, there will be one or more of these questions which should give food for thought.

Over the last couple of decades, I have found that many clients who initially wanted the highest level of pension income subsequently use the tax-free cash to invest otherwise than in a purchased life annuity. Perversely, although attracted to the tax-free cash route by the kind of comparisons I have noted here, most want to consider other reinvestment options and do not bother with a purchased life annuity.

As I outlined in my last article, the issue of tax-free cash has massive application to assessing preserved pensions in final-salary schemes when considering a transfer to a personal pension. I noted that the projected level of tax-free cash following a transfer is often higher than that available from the existing scheme.

The net benefit to the client is not accounted for in transfer analysis systems. This means the client might be tempted to retain his benefits in his existing scheme in ignorance of the potential benefits of transferring, both in terms of flexibility and provable increase to his net income.

This would not apply to most clients where a transfer is clearly not recommended but could apply to many where the transfer decision might be marginal. This is all down to the knowledge and application of the transfer specialist, along with the linked topic of commutation, as I will conclude in my next article.

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