I thought it was the right time to discuss pension liberation, announced by George Osborne in last year’s Budget, and coming into force from 6 April this year. From there, my mind wandered to a couple of other linked issues concerning government policy on this issue and how far the lengths to set up tax avoidance schemes have gone. Bear with me!
For years, the default retirement position for any personal pension savings was the pension annuity. You invest a lump sum with a pension company and they promised either a level or increasing pension for the rest of your life, and with the insurance compensation scheme, the annuity was practically guaranteed by government.
In the 1990s, a £100,000 pension fund would buy a level pension of circa £11,400 per year for a 65-year-old life. In 2015, the same lump sum will buy you £4,950.
The new position for ‘personal pensions’ is that once you turn 55 (eventually to be 57), you can take 25% of your pensions savings (normally, but sometimes more or less) as tax-free cash (but now called the ‘pension commencement lump sum’ – note the words “tax-free” have disappeared) and the rest you can take as income and pay tax, depending on your marginal rate.
If you manage your pension properly, it should pay out an income for life and, on your death, it could provide either an income or lump sum to your spouse and, potentially, to your children.
My view is that, for many people, leaving a pension to their children will be a big draw, rather than the current position where the annuity usually dies with you and your spouse/partner. Children will be able to draw on your pension at their rates of tax in their lifetime. This is a significant change.
Others will surrender their pension and invest in property. Remember that, apart from the tax-free lump sum, the rest is taxed at 0%, 20%, 40% and 45%. You could spread your taxable income over many years, after taking the tax-free lump sum, to reduce/avoid tax by keeping as close as possible to your lowest possible marginal rate. Or, in other words, try not to take large lump sums that push you into a higher tax rate. You cannot gift your pension to a lower rate tax-paying spouse.
The bigger picture could be for those in public and private sector pension schemes that offer a ‘defined benefit’, inflation-linked, guaranteed pension. Imagine you were offered an inflation-linked pension of £12,000 per year at 60, or a transfer lump sum instead, of say, £450,000 (and that is the roughly the amount of pension savings you would need to buy a £12,000 inflation linked pension), from which you could take tax-free cash of £112,500, and rightly or wrongly, the temptation to buy that Porsche could be irresistible.
Furthermore, you could then arrange to gift some/all of your lump sum to the children on your death. In particular, if you were in ill health and knew your mortality was shortened, wouldn’t you be tempted to take the transfer sum for part of your spouse/children’s inheritance. (NB Just to be clear, not all public sector schemes will offer a transfer value.)
With a lump sum of £112,500, you could certainly put a deposit on a buy-to-let or two. You could then take the other £337,500 as income over many years, or leave it be.
The truth is out there...
Now this is where I get all ‘Mulder and Scully’. In the 1990s, high annuity rates also paid high income tax receipts to government. Furthermore, government legislated to make sure annuity providers backed up their annuities with government gilts. Governments then had a steady source of buyers of gilts and index-linked gilts to finance the fiscal deficit.
A government regulator, the Financial ServicesConduct Authority (as it was back then), was and is very clear on the importance of annuities and, indeed, indexed-linked annuities seemed to be the default compliance position. As a financial adviser, you needed (and still do) to be very careful before recommending anything but an annuity.
Suddenly, annuity rates fall, governments buy up gilts via quantitative easing and annuity rates tumble even further, and so do tax receipts. Governments need tax revenues more than ever and the golden goose is dying.
So, what can the Exchequer do? Well, they can let everybody take much of their pension nowearly in lump sums; more tax now, and then change the rules to make annuities look even less attractive. Lo and behold, more tax revenue!
Much, much later, when tax receipts drop from pensions income, because everybody bought a Porsche when they first retired, a new parliament will need to come up with another way to take revenue from pensioners. We shall see.
How to spot an elephant
So much of pension planning centres round tax planning that reminds me of Sam Gamgee, who was Frodo’s companion on their Middle Earth jaunt. Sam’s abiding desire was to see the famed Oliphant, which was, it turns out, a gigantic elephant. What can be more ridiculous than a creature with huge ears, a long trunk, a tiny tail and two huge tusks, as big as a house and all grey to boot? How can it be? But I guess if you saw an elephant in a room, it would stick out just a bit and the description wcould ring true.
And so, who would have thought that it was possible to gift earned income offshore to a charity, and actually then receive back capital and a huge chunk of tax. Or indeed, opt to be a film producer and as a “trading” film producer, offset losses against your tax bill. What about setting up a music production company that generates losses that you also offset against income. Who would have thought it possible?
You see, explaining a tax scheme can be difficult, but when you see one it’s pretty obvious. Tax avoidance schemes are not illegal, but some do seem a little too ridiculous.
When was it okay to donate to charity and get your money back with tax? How could investing always lead to a trading loss?
Lawrence Watts is a chartered financial planner with HBB. Contact 07982 235543, 01727 862477