7th April 2015
With the Freedom and choice in pensions reforms that have come into effect this week, you now have complete control over your money. But retirement planning remains daunting for many.
Mindful Money talked to financial planners Nigel Yeo and Alex Hatfield, Partners at The Private Office, to identify some the key issues you need to think about including the tax implications, including not running out of money, income drawdown and paying for advice.
We list them below.
1. It’s not just about getting your hands on the cash. What you are going to live on in your retirement?
The reforms change a huge amount, but one fundamental question remains the same. What are you going to live on in your retirement? A lot of people have looked at the headlines and are aware of the opportunities, but we would urge them to consider the basics – what are you trying to achieve, what do you want, what do you need and what are the risks? You have much more freedom to work out a strategy, but if what you do goes wrong, you may only have the State Pension you to live on. That isn’t a very big number to cover your living expenses.
2. Be fully aware of the income tax implications.
The media is still full of articles discussing the pension freedoms and very many of these focus on the fact you can now access all your pension cash, but what they don’t often explain is that after you take the tax-free cash, which was already available, you may have to pay income tax at 20%, 40%, or even 45% on what you withdraw. Before taking out the pension cash, you really have to understand all of the tax implications to make the right decision.
3. Your pension provider doesn’t have to offer the full ‘freedoms’. You may need to move your money to take full advantage of the reforms.
Lots of people have different schemes of different types. Some have some years of defined benefit or final salary pension, and one or more defined contribution pensions. It can be ferociously complicated and there is a huge need for financial advice but advice isn’t going to come cheap in this sector. It is complex but complexity equals time and expertise, which equates to cost.
It is one thing being able to access Freedom and Choice, in terms of the regulations but it is another having a pension provider that is geared up for them. You may have to move provider, which is a lot of paper work. It is also about choosing a provider on cost, experience and service, and that is tricky without advice.
We have heard of one provider charging for providing a note giving information about the reforms. Other providers haven’t dealt with the public before, unless it is with an adviser. If you go too fast you might go on emergency tax rates. You get it back in the end, but you would want to avoid this if you can, therefore…
4. Don’t rush into the decision.
The focus for many people is whether they can get this lump sum out. That is a powerful attraction, but we urge our clients to wait and see. We want to build up a picture of what people want in retirement with a series of conversations. This means considering the whole picture from the different ways you can take money out, to whom you nominate to receive any death benefits and much more. It can take a lot of work. It is important to focus on the broader picture rather than just the attraction of the cash. In our experience, if you rush a financial decision, you are much more likely to get it wrong. It is worth taking your time to get the right decision.
5. Things might change with a Labour-led government, but, even if they do, you still have some time.
We do have to accept that a change of government could change the legislation. But Labour is discussing a review one year into the reforms. Where policy would be more likely to change is with tax reliefs for higher earners, but that is an issue for people still building up a pension pot not those taking a retirement income.
And even if you do believe a Labour Government will change things, you don’t have to take all your money out as soon as you can in April. You at least have until the election and a first budget (though that could come quite early) before anything will change. You probably have more time than that.
6. Given the new rules around inheriting pensions, it could make sense to keep your pension money and spend your other investments. And beware a tax double whammy!
This probably applies to people fortunate enough to have a range of investments or other sources of income. But there is a strong argument now for keeping your money within a pension, because of the inheritance position on death. If you take the money out, it may become part of your estate for inheritance. If you don’t spend it and leave it in cash, you have moved an asset from an environment where it could be inheritance tax-free into one where you might have to pay 40%. Why would you do that unless you have a purpose for it?
It is a different calculation if you are thinking ‘I have got to get rid of this mortgage’ or you want to move house or give money to the kids. But if you are doing it for a tactical taxation reason, you might be paying a lot of income tax to get the cash, and, as we say, moving it from somewhere it is free from inheritance tax to one that is chargeable. So you may get a double tax whammy, the wrong way.
As always, it depends on individual circumstances, but the best advice might be to spend your other assets and touch your pension fund last.
It used to be you would take your pension and leave your investments but now it has swung the other way. Now people are taking income from their investments and leaving their pensions. There have headlines about the pension now being the Maserati fund. But people that can afford the Maserati, may buy it out of their bank account and leave the pension fund alone.
7. You have to consider how long will live for. The industry jargon for this is longevity risk.
You need advice to manage the longevity risk, the risk of living a long time. 1 in 5 males aged 65 will live until they are 95. We do worry about whether people can manage that risk themselves if they are staying invested rather than taking an annuity. If there is a downturn in markets, taking high levels of withdrawals, can seriously damage someone’s pension fund and they could run out of money much faster than they imagine. You could be faced with living on the State Pension once again.
8. Really consider what sort of advice you are getting and how you are paying for it.
We are a little worried that some people are going to be ‘oversold’ to. We think this is definitely a classic area for advice where it is best to pay a fixed fee, not a contingent fee where the adviser’s income may depend on getting the client to do something and on a percentage fee from assets under management. The advice is often going to be ‘don’t do it’. But with a contingent fee, the adviser is going to want to get someone from A to B. Without being too dramatic, it does have the potential to be a mis-selling horror: ‘my adviser switched me out of a scheme and created a big number, that was then transferred, they took a percentage and got paid lots of money’.
With a fixed fee, it means advisers are working on a case to tell clients what their options are. As we said earlier, it may not be straight forward. You may have old final salary and money purchase schemes, the trustees of your workplace scheme may not have told you what you need to know. You may have what looks like a small defined benefit monthly pension, but a big transfer value. But transferring may bring big lifetime allowance issues. An adviser on a contingent fee might be tempted to recommend a move.
People may have to move provider or platform to access the reforms, but we have to lay all that out, a summary of where they are and suggestions for four or five routes. You can’t do that on a contingent fee basis. How does that sit if the conclusion is that the money should be invested in cash? What happens as funds deplete and an adviser’s income falls? Will they lose interest or cut back the service?
9. Think about establishing a minimum underpin for your income. That might even be an annuity.
Creating a minimum underpin is actually probably a pretty good place to start. If you have £5,000 a month as a desired expenditure, but your minimum is £2,000, you might want to know that £2,000 is always going to come in no matter what happens to stock markets, charges and fees and all that stuff. For that piece of mind, would it be worth annuitising with some of the money?
10. It is very difficult to make up market losses in drawdown if you are taking a lot of income.
Since 2008 we have had such fantastic market conditions, which is showing drawdown in a very good light. It is often the correct strategy for an investor, but a poorly executed drawdown plan has the potential to destroy wealth.
In an extreme case, we saw an investor back in 2007 who wouldn’t diversify the risk in their SIPP and had £500,000 in two investments. Those were Royal Bank of Scotland and Lloyds. They were in drawdown. £500,000 became £20,000. If you had offered them an 8% annuity rate, with the benefit of hindsight they would have bitten your arm off. You do not to see those horror stories mentioned much. People tend to project forward from the current situation.
When you are building a pot, there is a difference between a six month statement, where you might be down 20%, but it is a matter of going back to work, remembering you are not retiring for 10 years, and expecting markets to recover. But if you are retired and your investment statement is down 20%, we may have to say, we need to drop your income, cancel that holiday, don’t give money to the kids, or you are going to run out of money in the next ten years. It becomes a very personal thing. You also have to think about that along with how long you think you are going to live. The discussion is very different from when you are building a pot, to when you are spending it. It could literally ruin your life.
11. You need to keep revisiting all your plans
Drawdown historically, was mathematical. It was about ‘what return do I need to be better than an annuity?’ There were limits – based around the GAD rate and a minimum income on what you could take out. But now you can take anything so there is a lifestyle consideration and a mathematical calculation. Your pension is one piece of a bigger pie. When do you take profits? When do you take money and put it into cash and save it for a rainy day? When do you put the foot down on the accelerator and take a bit more risk? Can you make compromises about your expenditure? These things need to be constantly discussed. You might have 35 years of withdrawals. Do you have an appetite to take ongoing advice? There is no point having the world’s best investment strategy at retirement, if you don’t do anything with it for ten years it will be wrong. Unless you are taking it all out to buy something, you need to keep looking at it.
12. Buy-to-let boom – or maybe not?
If you warm to the buy-to-let concept, it may be something you want to do. For our clients, it is a case of love it or hate it. But will even those clients who like buy-to-let convert their pension? If you are going to lose x% on income tax, you are going to have to make a heck of a return from buy-to-let to make it worth your while. You might do it with your tax-free cash but you could do that already. We are not seeing any demand for people wanting to raid their pension fund and stick it into alternative investments.
13. What if I only have a small pot?
It is really difficult for those with smaller pots. For an adviser, one could almost argue in some cases it is close to the same amount of work for a £10,000 pot or a £1million pot. A fixed fee for advice on a small fund may not make sense. There is Pension Wise and some other services will offer online or telephone advice. Pension Wise is free, but we suggest calling soon if you want an appointment. They can discuss a lot of things generally, but cannot recommend specific courses of action. In the case of these other services, we would say make sure you understand what you are getting for your money and what you are being charged.
14. If you are paying for advice…
A client needs to be clear on what they are getting. Are you getting a review of the scheme every year? Are you getting a review of your income levels and of the underlying performance? Are you getting proactive contact from your advisers? There is a lot of scope for a misalignment of expectation between client and adviser. You need to get on with someone, find the right firm, decide whether you want an independent adviser who searches the whole market or a restricted adviser. Also you have to remember more engagement is more expense. We expect people to shop around, but we suggest thinking about avoiding contingent charges.
We also suggest if you think you need an adviser you start looking now. It may take some time for you to find someone you are comfortable with.
15. We doubt there is a simple fund solution
We still think it is a highly personalised decision about your investments. There will be market for solutions with a headline rate of income at say 5, 6, 7%. To deliver this, it could become convoluted at best and at worst, it won’t work. Generally the pension and fund industry, the moment they try and build to meet a market demand, it tends not to go well If you don’t rebalance your portfolio wealth skews to what has done best, but if you don’t reshape that, then the thing that goes up the fastest call fall the fastest. If you can, it is best to get an investment solution tailored to you.
If you are interesting in talking to The Private Office, please email email@example.com