With less than six months to go until pension flexibility goes live, the benefits and challenges are slowly becoming clearer. Greater freedom means people with defined contribution schemes will take more responsibility for their decisions.
However, given those decisions have tax implications and determine whether income will last throughout retirement, understanding the range of options is important. As Towry head of retirement planning Andy James puts it: “Careful planning will be essential to ensure greater flexibility does not end up a curse.”
Barnett Waddingham partner and head of DC Mark Futcher says many people made inappropriate decisions when their only choice was an annuity. “Lots of people bought single life annuities. How can you educate them when they have a new raft of options? Advisers will have to be experts in pensions and taxation.”
So, what are the options?
From April, people will be able to take their entire pension pot as cash from age 55. The obvious concern is that some may withdraw it all in one go, spend it and then fall back onto the state. But while some recognise this temptation and point to the tax the Government will receive if people do cash in, others believe people who have saved all their working lives to build up their pension pot are unlikely to waste it.
Indeed, the tax implications may deter people from blowing it in one go but only if they understand that, while 25 per cent will be tax-free, the rest is subject to income tax at their marginal rate.
However, LV= head of pensions Ray Chinn points out that people might cash in their pension over a number of years to keep within the lower marginal rate of income tax. He expects people with smaller pension pots to be more likely to cash in, perhaps to pay off debt. “People with smaller pots tend to be those who are not getting advice and they may not realise the full implications of taking it as cash,” he says.
Perhaps the biggest news to come from the pensions shake-up is the fact nobody will have to buy an annuity from April. The drawbacks of annuities are well documented, with tales of people being locked into low-rate standard products, not shopping around and their pot going to the insurance company rather than relatives. However, if a client needs a guaranteed income for life, annuities provide that certainty.
“For those who either do not have the risk tolerance to maintain investments into later life or simply do not have sufficient funds invested to make drawing income directly out of their pension cost effective, an annuity will likely still be the best option,” says James.
Broadstone executive and retirement services director Matthew Brown agrees. “If you could benefit from an enhanced annuity due to health or lifestyle reasons, the income received could appear quite attractive,” he says.
But Alliance Bernstein head of DC distribution Tim Banks says research shows annuities are bought at the wrong time in the wrong way. He believes people aged 65 to 75 can get better returns elsewhere without making a one-off irrevocable decision, keeping control of their money to pass it on after death. Although innovation is expected in the annuity market, capital adequacy requirements on insurance companies could stifle it or mean these products are expensive.
The rules on drawdown will be relaxed from April, with capped and flexible drawdown ceasing to exist, replaced by flexi-drawdown. “You might need £50,000 or £100,000 to make drawdown cost effective but you can invest in riskier assets and have 20 or 30 years to draw it out. You should get better returns over the long term,” says JLT Employee Benefits chief actuary Hugh Nolan. “People can take what they need, when they need it, which is great for the early years.”
But the risk of living longer or dying earlier than expected means deciding how much to drawdown is difficult. People currently in capped drawdown and still contributing need to weigh up whether using the new pension freedoms is worth losing their current £40,000 annual allowance.
“As soon as they take more than their capped amount they are caught by the new £10,000 money purchase annual allowance,” says Brown. He wonders how many people will make a withdrawal without realising they are hamstrung to a lower annual allowance because they have not taken advice.
Once the changes come into force, people may choose to blend or mix and match the various options, perhaps starting off in drawdown if they have a big enough pension pot and then taking an annuity later in life. The removal of the 55 per cent tax charge on death benefits is also attractive. However, St James’s Place Wealth Management divisional director, pensions, Ian Price points out that the new freedoms do not change the fundamentals: people still need an income to live on and options will ultimately depend on their individual circumstances.
Concerns about access to advice, whether the guidance guarantee will be up to the job and whether the industry will be ready in time may take the shine off pension freedoms for those making their retirement decisions next year.
P-Solve head of DC Britt Hoffmann-Jones says: “I feel most sorry for people who are not financially literate – and that is the vast majority of DC savers.”