Spring has sprung and this April has brought us not only sunshine, but something even brighter - big changes in pensions!
Fundamental reforms, introduced in the 2014 Budget, come into effect this month. But if you don't have a clue what these changes are, you're not alone. To understand the implications, we need to take a step back and clarify some pension jargon. There are two main structures of pension provision:
The first is known as ‘defined contribution’, or ‘money purchase’ where you, the employer, or both, pay in a set amount each month. The fund grows and you end up with a pot of money at retirement. But the size of this pot isn’t fixed - it depends on how much is put in when, investment returns, charges etc. And the pension income you end up receiving is unknown until you start drawing from this pension pot.
The second structure is a ‘defined benefit scheme’, known as a ‘final salary pension’, which pays out a guaranteed level of pension income based on your income when you retire and the number of years you’ve been working.
Most people today are in a ‘defined contribution’ scheme, and the current reforms are mostly in relation to this. So what’s changed? In the past, from the age of 55 you could draw down 25% of your pension pot as cash, tax free, but the rest eventually had to be used to buy an annuity - a guaranteed income for the rest of your life that an insurance company pays out. So you could draw on your pension but only in a pre-determined way according to set parameters.
With the change in legislation there are no set parameters: you can draw as much as you like, when you like. There is no longer a requirement to buy an annuity, and so the only implication is tax. The 25% tax free lump sum stays but the rest is taxed as income as and when you draw it. Plus any bit of the unused pension pot can pass onto your beneficiaries in the event of death (tax-free for the under 75s, and taxed as income for the beneficiary for the over 75s).
Headlines in the press greeted this announcement with dire warnings of pensioners blowing pensions on Lamborghinis and leaving themselves destitute in their old age. I would give people more credit - if you’ve spent your life saving into this pot, you’re not likely to splash the lot and blow your pension.
People in a ‘defined benefit scheme’ will now also be able to transfer their pension to a ‘defined contribution scheme’ to take advantage of the same opportunity for flexibility, but this should only ever be done with extreme caution as you’d be giving up valuable benefits, which are otherwise guaranteed.
Overall I welcome the changes, but with some trepidation. It will mean more freedom and flexibility and many will use that well to enjoy their retirement. But I do have concerns that while the financially savvy will benefit, others could be very vulnerable. What may look like a lot of money as one ‘pot’ may not be if you then go on to live for 30 years or longer. Of course you can still buy an annuity, but they are currently at an all time low, and it’s a once in a lifetime decision that you’re then stuck with.
Having this level of choice about how to deal with your pension pot means having to continue making financial decisions, which means there will be a greater need for financial literacy into old age. To make money decisions you have to ‘stay in the game’, or get professional help, and making decisions on behalf of older people will become more complex. Money anxiety is something I deal with a lot in my work, and there is a risk of greater money anxiety as people get older. So while it will give more options, it also carries more risk.
For more information on this topic:
- I answered some readers queries on the pension changes in April’s Prima magazine
- The Money Advice Service pension calculator enables you to estimate the income you’ll get when you retire
- Pension wise is a free government service to help you understand and evaluate pension options. You can make an appointment to talk this through by phone
- Gov.uk explain the nine things you need to know about the new pension reforms