Pension pressure

Easter Monday saw the most radical changes to private pensions for a generation. The political spin is it’s ‘freedom and choice in pensions’. Yet more choice means it’s far easier to get it wrong, so here’s what everyone needs to know in 5 minutes…

Pension freedom sounds like something from Braveheart – what’s actually happening? I suspect George Osborne does picture himself as a financial freedom fighter. Yet only time will tell whether these reforms will paint him as the man who liberated older savers, or who exposed them to huge risk.

This is all about how you use your pension savings. As always you can take a quarter of it as a tax-free lump sum. Yet for decades most people have effectively needed to use the remainder of the money to buy an annuity – a product that pays you an income each year until you die. Now anyone aged 55 and over can take the whole amount as a lump sum, paying no tax on the first 25% and the rest taxed as if it were a salary at their income tax rate.

Does it apply to all types of pension? No, we’re only really talking private pensions where you and/or your employer saved up a pot of cash for retirement. Technically these are known as ‘defined contribution’ or 'money purchase' pensions.

It doesn’t apply to the state pension, nor in the main part does it apply to pensions where what you’re paid is a proportion of your final salary – known technically as ‘defined benefit’ pensions.

There are ways to convert these final salary pensions into a pot of cash (be very careful of scammers), but don’t do it without genuine independent financial advice

Is it worth taking out my pot as soon as I can? Usually not. If you’re in your 50s or early 60s you’re probably still working towards retirement and should be focusing on putting yourself in a position to have enough income when you do retire – so you want your pension to keep growing.

Plus by accessing your funds earlier than needed you can reduce your ability to make future contributions.

Yet you’re saying if I want to, I can just take out all the cash? If you choose to yes, but remember only 25% of it is tax-free. The rest is taxed at your current income tax rate like salary, and if you take a huge whack, just like if you earn more, some of it will push you into the higher tax bracket. See the income tax calculator at www.mse.me/taxcalc to see the various levels.

If I don’t want to take it all out what can I do? There are many options, some of them can be combined, here’s the main ones.

Option 1: Leave it in your pension for when you need it. Then each time you withdraw, 25% of that amount is tax free. Eg, if you had £100,000 and took £20,000 out you’d get £5,000 of it tax-free, the rest would be taxed at your current rate.

Option 2: Take 25% tax free, then buy a flexible income drawdown product. This is a product you buy to keep the rest invested so it can still hopefully grow, but you can also use it to take income when needed. Here you get the first 25% you withdraw tax free and then the rest is taxed when you take it – possibly useful if you’re likely to be in a lower-tax bracket once you’re older.

Option 3: Take 25% tax free, then buy an annuity. This gives you a guaranteed income each year for the rest of your life. There are different charges on all of these, and it’s important to check them out and always compare different providers.

Eh, I thought annuities were as dead as a dodo’s granny? Actually annuities are a decent concept, you get the security of knowing exactly how much you can spend each year, and that it’ll last for the rest of your life.

The problem is the rates have been crap, and 60% of people just got them from their pension provider rather than checking for better deals, especially people with poor health who could’ve got much better rates. Yet done right, with some of your pension, it can be a useful option for security of income for life.

How do I know how much cash I should take out? That depends on when you’ll die. I’m not being a smart arse (well maybe a little), but truly that’s the only way to know.

Yet the Office of National Statistics mortality stats do show likely odds. The typical life span for a man who hits 65 in the UK is another 18 years, a woman 21. Add a little on that for safety and it means unless you’ve bad health you probably want to spend around 4-5% of what you’ve got a year.

What’s this ‘huge risk’ you talked about – let me guess you’ll warn me not to buy a Ferrari? I don’t think I need to. If you choose to do that you know you’re probably either rather rich already, know you’re being foolish, or that you ain’t got long left.

Actually, I’m far more concerned many will be nervous about releasing the cash in case they’re left with none in old age and will therefore sit on it, never spending it, depriving themselves of the benefit and living a worse life than necessary. We’re not an investing nation and are relatively risk averse, so I see this as being a real potential problem. There’s also the worry that there’s a lot of scammers about trying to tap people for cash too.

OK so it's complex, but hasn’t the Government set up a free advice service? No. It’s set up a free guidance service called www.pensionwise.gov.uk. This isn’t just a semantic difference – this system will tell you what you can do, not what you should do. It won’t include help on your benefits, nor on what product to get.

If you’ve a sizeable pension pot it’s worth spending the £300 to £1,000 it’ll cost to get an independent financial adviser who can tell you what to do (get quotes from a few first). You can find a local one through www.vouchedfor.co.uk or www.unbiased.co.uk.