Pension Changes – A Few Questions

It’s long been known that the post-war promises made by European governments (to try to prevent social disorder from poverty) are simply unaffordable.

The recent Budget outlined in principle, an historic shift in how people can take their pension fund at retirement.

Before we look at the implications and (beyond the headlines) it’s interesting to review the recent history of pensions in retirement.

The major shift in policy occurred with the introduction of drawdown (taking income from pensions in retirement without the requirement to buy an annuity) which was in 1995.

The rules for drawdown and the allowable maximum income withdrawal have subsequently been altered numerously, but it was always clear that the overriding concern of authorities was to prevent chronic dissipation of funds by excessive levels of annual withdrawal.

It was assumed that apart from the potential financial hardship this would cause, the Government did not want the State to be liable for additional benefit payments if people exhausted their pension.

Since 2008/9 the maximum withdrawal has declined significantly, they are calculated using 15 year gilt yields and of course with QE and ultra-low interest rates these have been around 2%, down from the previous 4-5%.

Wealthier individuals, who are more likely to be in drawdown, have complained loudly that their income has been forced down often when their pension funds have increased materially in value.

The new rules (2014)

This heading is slightly disingenuous, nobody knows exactly what they are.

The headlines from the Budget centred on the change in regulations which would allow a fund to be drawn down in full with a single one off payment.

There were headlines in newspapers the following day about buying Ferraris and holiday homes in Florida.

Questions unanswered

  1. The budget raised the maximum limit for income drawdown by around 25% (from 120% to 150%) (partly to offset the reduced maximums caused by the lower gilt yields). Why do this when they also apparently announced the whole fund can be drawn down?
  2. The tax on pension funds on death is 55%, if the total fund is taken in one lump while alive it will be taxed as income which will be a lower rate (maximum 45%) this is illogical
  3. If the pension fund of an individual can be liquidated how does this effect benefit payments such as Age allowance and Nursing home fees?
  4. What are the rules on benefits if an individual spends the pension pot and then seeks state assistance, will they qualify or be refused?

What’s in it for the treasury?

Western Countries have large debts, the standard figures however do not include state pension obligations, add these in and liabilities go from onerous to off the chart.

It’s long been known that the post-war promises made by European governments (to try to prevent social disorder from poverty) are simply unaffordable. The provision of free health care and a guaranteed state pension consume an ever larger proportion of tax revenues and this can only go higher.

Books are written on the problem but in essence it’s simply to know that the average life expectancy of a male in born 1946 when state pension was introduced was ….. 64.1.

The average man would not have received one!

Today the average life expectancy of a male born in 2014 is 90.8 years, and increases year by year. A third are expected to live to 100.

So the NHS cares for people into their 90’s, in addition to them receiving state pension benefits; that’s the problem.

There is an expression in politics, “never touch the third rail”; this refers to the third electrified underground rail track, touch it and it kills you.

In UK politics to be seen to want to scale back state pensions or free health care provision is to touch the third rail, political suicide.

Raising tax revenue

The Thatcher Government (especially Nigel Lawson as Chancellor) was the first to really embrace the art of tax perception, that it had to appear to electors that taxes were being reduced and they were better off whilst they were actually in aggregate neutral or increasing.

The most obvious example of “tax spin” is the standard Budget headline of a reduction in Income tax, which everyone understands and likes, whilst simultaneously raising National Insurance rates which many people don’t understand.

The reality, they are both a tax on income, there is no difference.

The same is done with state pension indexation, it’s lower than inflation so in real terms pensions are being reduced but it’s not a cut and few people understand the difference between the average earnings and consumer prices index.

New pension rules

So if the new rules are enacted what will this mean for the Treasury?

  1. If an individual withdrawals a £300,000 in a lump sum, the tax take for HMRC will be around 40% (£120,000) in one go. If they draw down an income of 5% of the fund, the tax will likely be 5% £15,000 (£788 p.a.). This assumes the state pension is not being paid and there is no other taxable income
  2. If pension funds can be accessed in full then this will allow massive reductions in benefits as the means test will no longer be calculated on a set level of income, it will now include the whole pension fund as a lump sum (this is even if the fund has not been withdrawn; because it could be so it is an asset)
  3. The big Treasury saving that comes to mind immediately, is from no longer subsidising Nursing Home fees
  4. They must and will say that if the fund is squandered no additional state benefits will be available
  5. HMRC has spent billions on computerisation to allow cost effective individual means testing (child benefit was universal only because until recently it was more expensive to means test than pay to everyone) they will use it to track personal circumstances
  6. If they extend the right for public sector workers to withdraw cash sums this will significantly reduce future state liabilities and again generate instant windfall tax revenues
  7. Personal pensions are trusts and as such they bypass the deceased’s estate for Inheritance tax, the ability to take pension funds in full not only generates an initial large tax charge but funds drawn then become part of an individual’s estate so also liable to inheritance tax

Conclusion

Whilst libertarians and supporters of small government will applaud the initiative it is fraught with potential problems.

Many will succumb to the urge to plunder their pension and few will prosper from it.

It’s an appealing idea, it played well politically (an election looms) and it has the potential to raise huge tax revenues but the longer term cost to individuals who mismanage their situation will be significant.

The party may be great fun while it lasts but the hangover will be suffered forever after.

 

NOTE: This is written in a personal capacity and reflects the view of the author.  The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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