Pension freedoms offer the flexibility needed for a long retirement, but you may need expert financial advice to get it right.
Have you noticed a recent surge in the number of pensioners powering down your local high street in Lamborghinis? Probably not, but that was the concern when new pension freedoms were introduced in April 2015, giving people much more choice over what to do with their defined contribution pensions once they reached the age of 55.
At that time, politicians worried themselves with visions of pensioners splashing out on supercars and yachts and all sorts of luxuries – which just goes to show how wrong you can be. Fears of over-extravagance have now given way to concerns that some people are just being too cautious, squirrelling their money away for a rainy day in low-interest bank accounts and without taking financial advice.
In March, the Pension Freedoms report from the House of Commons Work and Pensions Committee warned that only 32% of people accessing their pension savings under the new freedoms took professional advice. It highlighted research which had found that people who sought financial advice between 2001 and 2007 were, on average, £27,664 better off by 2012/2014 than those who did not.
The report says: “There is little evidence that people are squandering their life’s savings on Lamborghinis… if anything they are being overly conservative.
We assume the government wants people to make well-informed decisions in keeping with their financial interests. It is difficult to square that with, for example, people withdrawing pension pots to leave them resting in low-interest cash bank accounts.”
Success or failure?
So does this mean that pension freedoms are a failure? Daniel Jones, chartered financial planner at Sanlam, says: “My initial reaction was that pension freedoms would be a complete disaster. Plenty of people have a negative view of pensions and in some cases discover the income they get is not what they had expected and are disappointed. Often they have seen simple illustrations and automatically take the highest.
“So when the freedoms were announced I thought they would take out the money when they could, since they were disillusioned anyway, leading to problems in retirement. Some statistics show that people take money out of their pensions and put it into cash accounts, which is a very bad idea.
“But the flip side is that when people take advice, with proper planning they can take it in tax-efficient ways. Using cash flow modelling, proper planning and taking into account all their assets, they can use their pension fund to meet their needs in a more effective and efficient way.”
Certainly, plenty of people are taking advantage of the opportunity to access their funds. According to figures released by HM Revenue and Customs in July, savers withdrew £2.3 billion from their pensions in the first three months of the 2018/19 tax year alone. That’s an increase of 50% on withdrawals made in the first three months of pension freedoms three years ago. Between April and June, about 264,000 people withdrew an average of £3,950 each from their pots.
And the freedoms make it easier for them to plan for the different phases of retirement. Jones explains: “People’s circumstances change when they retire and the amount they need changes. Most retire in good health and in the early years they will need more income, for example to travel, whereas in later years they will not. There is the flexibility to tailor the income to their needs.”
It’s perhaps no coincidence that the people with the largest pension pots, who are likely to be more financially-savvy, tend to take advice. According to the Work and Pensions Committee, 89% of people with pension savings of more than £500,000 sought advice, while that was true of just 20% of people with a pot worth less than £10,000.
The freedoms have, in many cases, replaced more traditional ways of funding retirement that were more rigid but did offer a guaranteed income for life. “In the past the majority bought an annuity, but annuity rates have been low for some time,” says Jones. “That means the annuity market has suffered and it is annuity versus drawdown. But another advantage of income drawdown (staying invested in retirement) is that they can be passed down through generations, whereas an annuity dies with the surviving spouse.”
Some people opt to combine annuities with drawdown and if and when annuity rates finally do begin to rise they will probably become popular once more. But of course, once locked into an annuity rate, that cannot change, you are locked in. “Some people choose to take an annuity for a secure amount of income and use drawdown for discretionary expenditure,” says Jones.
Passing it on
And it may be an uncomfortable topic, but the new freedoms also have advantages when you die. If you die before the age of 75, you can leave your entire pension pot free of tax, to be taken as a lump sum or an income. After the age of 75, the pot is taxed at the rate of the beneficiary’s income tax.
Of course, there are still some people in final salary, or defined benefit, pension schemes, which often can’t be left to children after they die. But many are transferring out of them in order to take advantage of the new rules (which don’t apply to final salary schemes).
According to figures released in May by the Financial Conduct Authority, pension cash worth £20.8 billion was transferred out of final salary schemes in 2017, up from £7.9 billion the previous year, again prompting murmurings of concern. According to Jones, this is a question of moving from a scheme in which you do not personally carry the investment risk to one in which you do – but with far more flexibility.
And while final salary scheme benefits can die with the pensioner, a drawdown pension does not. “People have these negative associations with pensions and they don’t understand that a pension is essentially a tax wrapper (a tax break that can be wrapped around an investment),” he says. “You should always take expert advice, but hopefully the new pension freedoms will give them many benefits. They will have freedom and flexibility to live the life they want.”
So, if you’ve taken advice and made sure you have enough to fund your future lifestyle, you can do whatever you want with any remaining money – even buy a Lamborghini. Perhaps it’s time to head for the supercar showroom.
6 ways to take your pension pot
In the wake of the new freedoms there are essentially six ways of using your pension pot from the age of 55. In short, it’s extremely flexible, which is important when you’re faced with the possibility of a very long retirement.
You can leave it untouched.
Take a guaranteed income by buying an annuity.
Get an adjustable income by drawing down some of the money from your pot.
Draw down cash in chunks when you need it.
Cash in the whole pot (though it’s crucial to get proper advice first).
Or you can decide on a mix of these things.
To find out more about how you could help your children financially, talk to your financial adviser.
Based on our understanding of HMRC rules as of December 2018. Tax rules subject to change.