The Queen’s Speech has confirmed the implementation of fresh legislation on ‘pension freedom’ announced in the Budget back in March.
Before the changes: The annuities era
Annuities have traditionally been the most popular method for an individual to draw down on their retirement benefits. Essentially, the retirement pot is used to purchase a guaranteed income stream for life which cannot be altered.
Annuities have come under a lot of scrutiny in recent years as a result of falling rates. A single life, five year guaranteed annuity for a male aged 65 in 2000 would secure a rate of 9.23 per cent, compared to just 5.18 per cent for the same annuity in 2013. This represents a reduction of more than 40 per cent in retirement income over a 13 year period.
This has had major implications on those retiring in recent years who have had to suffer large reductions in retirement income as a result of falling annuity rates.
Additionally, many people aren’t aware that annuities are not the only way to access pension benefits, with income drawdown being an alternative, particularly for those with larger retirement pots.
From April 2015 individuals will be able to access their pension pot more freely, although the option of purchasing an annuity will still be available for those who want a guaranteed income. 25 per cent of the pension pot will still be available as a tax free lump sum but the remaining pot can now be accessed without restrictions either as a lump sum or income, taxable at an individual’s highest marginal rate of income tax.
Historically this option has only been available to individuals with a guaranteed income stream of over £20,000, known as ‘flexible drawdown’. For those with incomes below this level the Government imposed restrictions on the maximum level of income that could be withdrawn from a pension pot.
There are some transitional changes which come into effect immediately. Between April 2014 and April 2015 the maximum income that can be withdrawn from a pension pot has increased from 120 per cent of the Government actuarial department’s limits to 150 per cent.
Also, the minimum income criteria to access ‘flexible drawdown’ has been reduced from £20,000 to £12,000, disappearing completely in April 2015.
From April 2015 individuals will be able to have unlimited access to their retirement pots from the age of 55 regardless of income. The pensions will retain their tax benefits, but the previous restrictions on the maximum level of income that can be taken from the pension pot have been withdrawn.
This is excellent news for those who are retiring post April 2015 who will be able to access their benefits more freely. One of the major psychological barriers people had to making pension contributions was the limited access to the pension pot once they retire. This enhanced flexibility is likely to significantly increase the use of pensions as a means towards saving for retirement.
Individuals will be able to take advantage of tax relief on pension contributions, tax free growth within the pension fund and a 25 per cent tax-free lump sum when they decide to withdraw their benefits. The remaining pot can then be taken either as taxable income or a taxable lump sum.
Additionally, those who obtain higher rate tax relief (40 per cent) on the initial pension contribution may only pay basic rate tax on the income they withdraw, creating an immediate 20 per cent tax benefit. The new legislation will provide flexibility to help individuals withdraw income from their pension pots in a tax efficient manner.
Although there are no immediate changes in pension taxation there has been talk about reducing the death tax charge of 55 per cent if the pension was commuted as a lump sum, the outcome of which is still uncertain.
Greater choice is the main change
The main difference between the old and new systems is the freedom of choice. The reforms follow criticism over the pensions market, which was deemed “disorderly” by the FCA after its review into annuities.
Individuals now have greater control over how to access their pension savings and with that comes greater responsibility.
The ultimate decision on how retirement benefits are taken will depend on the individual’s circumstances and wider financial position. This makes it essential to seek professional advice to ensure your pension savings are working best to achieve your objectives.