The economic crisis has hit the retirement income planning of clients with money purchase pension savings.
Not only have they seen a fall in the actual value of their savings, but the effect of falling gilt yields has affected both the value of annuities they can purchase and the income available from capped income solutions. There are however effective solutions available to help with their future retirement planning as Adrian Walker explains.
What are the key retirement planning issues right now?
We have a long-term savings issue to deal with. The availability of the state pension is being pushed back and so the key message from government is that people need to take more responsibility for saving a decent retirement income.
Auto-enrolment will help by bringing more people into the market, though I know there are concerns about the level of potential opt-outs. This highlights the issue as to what kind of savings wrapper people should utilise and I think the use of ISAs, combined with auto-enrolment pension savings, will become increasingly important as time goes on. Many are not in a position to lock all their savings away until they are 65 and ISAs can prove to be a more accessible savings vehicle. It is also important we encourage more people to shop around at retirement and see what their options are.
We expect to see enhanced and impaired annuities play a bigger part in retirement planning as people become more aware of what’s available and are potentially delaying their retirement income planning until later in life.
As people look to phase into retirement, what opportunities does this present for advisers?
We have seen amendments made to the death benefit rules for those who have started taking a retirement income. Before April 2011, there was a 35% tax charge on funds if death came before age 75.
Now the rate has been set at 55% for both pre- and post-age 75 deaths. This means we need to think more about how retirement income can be taken in the most tax-efficient manner possible. If the person is still working, they will have income coming in – does this meet their needs? If not, what can be done to make up the shortfall? Some will use their tax-free cash to make up this gap. But if clients are phasing into retirement, it may not be tax-efficient to take all tax-free cash in one go. It may be more tax-efficient to take sufficient tax-free cash and income from the associated pension fund to meet a more targeted need (say, one year’s income).
In the event of early death before 75, this means less of the remaining pot will suffer a tax charge if paid out as a capital sum. In this case, short-term income needs are being met while the remainder of the fund is being kept in a tax efficient manner. In another example, the client may have taken their tax-free cash but no income from their income withdrawal fund – they may have income from a job or other savings. Clients under 75 can still contribute annually up to £3,600 or 100% of their relevant earnings for a tax year.
Taking income withdrawals to a level they are allowed to contribute per tax year and then making those contributions will make their long-term retirement income planning more effective. They will reduce the potential tax charge on the remaining capital if they die before age 75 and increase the tax efficiency of their future income available from their pension savings, all without creating any additional tax liability. The tax increase from 35% to 55% on lump sum death benefits from drawdown funds prior to 75 and any pension fund after 75 means clients need to review how they utilise their pension fund when providing an ongoing income for dependants. The dependant could receive the remainder of the pension drawdown fund as a capital payment that would be subject to a tax charge.
But what would happen if the remaining capital on death was instead transferred into a pension income vehicle for the dependant? The dependant would pay income tax on the withdrawals, which could well be at basic rate rather than receive a capital value reduced by 55%. This would then form part of their estate for IHT purposes.
What role do you think flexible drawdown has to play?
Flexible drawdown will become more prevalent in the future. Of course, the client needs to have secure pension income of £20,000 a year to be eligible to use flexible drawdown. Doing this means they won’t be subject to the vagaries of the annuity and capped drawdown market in terms of the income they take and can use flexible drawdown to top up income when needed. It may also be possible to use the normal expenditure rules to gift excess income to beneficiaries. The 55% tax charge on death applies to capital and investment growth, so if surplus income was gifted out then any future investment growth will immediately benefit the dependant. A good example of this in application is to use the income to pay third party contributions to beneficiaries’ pension funds. This will allow the beneficiary to benefit from tax relief on those contributions and increase the savings they will need to deliver a decent income in retirement.