Deadline looming for tax free cash
Introduction From the 6th April 2010 the age from which an individual can access their investments within a private pension fund will increase from 50 to 55. Should those currently between the age of 50 and 55 act quickly and draw on their pension before this deadline passes? The media and most advisers, mindful of average pension wealth, say ‘no’ but for many wealthy individuals the answer is ‘yes’.
Lifetime Allowance The Lifetime Allowance (LTA) will increase from £1.75m to £1.8m at the turn of the tax year. It will then be fixed at £1.8m until at least 2016 (unless reviewed by an incoming government).
As planned, individuals aged 50 that have opted for primary protection will have the allowable growth within their pension funds effectively capped for a period of 5 years.
By vesting the pension in full, the pension will not be subject to the LTA at a later date. The pension fund is not therefore restricted to any particular growth rate.
If further income is not required immediately, the income can be set at zero. And because the crystallisation of the pension triggered an ‘entitlement’ to pension benefits, the option for an income stream to commence before age 55 is retained.
What to do with the PCLS On pension crystallisation, an individual can take a portion of their pension as a pension commencement lump sum (PCLS) or, as more commonly known, ’ tax free cash’. If there is not an immediate need for the capital, it can be reinvested outside the pension environment. If held in a taxable form, growth will be subject to capital gains tax (currently set at 18%) after the personal annual allowance of £10,100 has been used. This is a lower ‘effective tax rate’ on growth than experienced in a pension, 75% of which will effectively be subject to income tax at 40% or 50% for higher earners when extracted.
This presumes that the individual buys assets that attract capital gains. If on the other hand, index linked gilts (ILGs) were purchased the arrangement becomes even more tax efficient. ILGs are subject to minimal taxation when held directly (outside a tax wrapper). Most of the inflation compensation element of the return is in the form of tax-free capital uplift rather than taxed coupon uplift. This contrasts with nominal interest rates, where most of the rate paid is compensation for inflation and is then taxed as income, and with equity returns, where the inflation compensation is partly via income and partly gain, with both subject to taxation.
Capital Extraction / Income Drawdown
Extracting the full ‘economic value’ in a personal pension fund is extremely difficult and in many cases impossible. Therefore, once a decision has been made to extract the tax free cash, a plan to extract the maximum amount of pension capital is likely to follow.
Throughout ‘decumulation’, the period of time during which individuals enjoy the accumulated capital, pensions are overly restrictive. Once the tax free lump sum has been drawn, the annual income that can be drawn from the pension is restricted to rigid government actuarial department (GAD) tables, influenced by the yield on 15 year Gilts, and taxed at marginal rates of income tax.
The after-tax benefits of savings in or out of a pension wrapper can be measured by comparing net present values (the total present value of a time series of cash flows minus the initial investment) of the two cash streams after their different tax treatment. We find many people who have previously focused on the tax advantages of accumulation are shocked to discover how small the net present value gain from their pension is. However, even this calculation ignores the uncertainty about the amount of capital that can be enjoyed either as lifetime spending or as a bequest. This is a serious oversight as there is in practice a large degree of inefficiency in the extraction of value from a pension account under current tax rules, aggravated by the penal taxation of residual funds after the deaths of both member and spouse. The rules are also designed to ensure that there is likely to be a residue if the second death occurs after age 75. The intention of these rules may have been to make the option of drawing down after age 75 unappealing.
The risk of not extracting all of the value from the pension fund can be avoided by buying, at some stage, an annuity. The potential loss of early death is offset by an equivalent gain from outliving one’s actuarial expectancy. However, this calculation is not a satisfactory explanation of the benefit of capital in or out of pensions where there are children and a significant value is placed on a bequest motive. Such an approach to the economic value of pensions is clearly dependent on individual levels of wealth relative to spending.
A critical source of loss of economic value in pensions is inflexibility. Pension rules generally do not allow an individual to access pension capital should it be needed. This is highly relevant when a large proportion of the assets assigned to retirement spending takes the form of pension capital, in which case it may be impossible to meet unexpected exceptional expenditures.
Pension Winners When considering the whole duration of a pension, from commencement of contributions to the pensioners demise, the tax benefits are very difficult to calculate. The only group that can be confident that they benefited from the pension tax structure, ahead of other alternatives, are individuals that made contributions to pensions as higher rate tax payers, and then drew down income as a basic rate (or lower) tax payer.
Pension Losers High earners who were able to make very large contributions to personal pension arrangements and based their actions on the tax benefits going in are those most likely, depending on later circumstances, to have destroyed value.
Their number will be significantly increased if, as many now fear, the pension commencement lump sum of, typically 25%, is axed by a future government desperate for tax revenues. We believe this fear is exaggerated because it would render savings in a pension fund economically irrational even for the majority of savers. But this concern has been described to us by one of our clients as a ‘monster under the bed’ which, once it had entered his mind, could not be ignored, and could only be assuaged by crystallising his pension to be certain of not losing out.
Potential for conflict? You may now be wondering, why you have not been advised to consume capital or crystallise pensions early by other advisers?
It could be that that they have placed too great a value on the benefit of income tax deferral and gross roll up (less the 10% tax credit), ignoring the real (after inflation) value that can actually be extracted from the pension fund.
It could be that they enjoy the dependency that is created by using the complicated legislation and tax structure of pensions?
Or it could be that the majority of advisers are remunerated by the value of assets within the pension fund. In practice these may play a part, but the most significant reason is that most advisers do not have the necessary investment expertise to manage what is, an extremely difficult investment challenge. On this basis they will be reluctant to advise, and will almost certainly refrain from drawing on your pension early, regardless of the level of assets an individual holds elsewhere. They may also advise clients to draw more conservatively from the pension than is sustainable so to avoid depletion of the fund.
Planning from a holistic perspective Putting aside the previous considerations, the decision to crystallise pension benefits should really be made within the context of establishing a sustainable level of lifetime spending that a total portfolio can support. Most pensioners are likely to value higher spending when fit and active, with income tapering down later in life. They are also likely to prefer passing surplus wealth to beneficiaries by the method of regular gifting from income. Not only is it efficient with regards to inheritance tax but the client also values the gifting with ‘warm hands’.
This type of spending plan is likely to be funded not just by pension funds but various financial assets both in and out of tax wrappers, as well (perhaps) as real property or contingent assets such as inheritance. Only by considering the balance sheet as a whole and the existing arrangements for holding assets can one make a fully-informed decision.
In a context of holistic resource planning , retirement spending funded by non-pension sources may run up against a cultural attitude that differentiates between income and capital, as in ‘not consuming the seed corn’. In a pension fund, of course, this distinction clearly does not need to mean anything significant. The ‘income’ drawn in retirement or taken as an annuity is actually a conversion of accumulated ‘capital’ to a stream of cash flows. The ‘capital’ accumulated is itself the product of savings out of earned ‘income’. It is just money.
The important output of planning is how money is consumed. Freeing up attitudes about where the money should come from will also allow greater tax efficiency, as the tax code penalises income relative to capital. Consuming capital is a way of reducing one’s overall effective tax rate but this is only likely to be acted upon if there is confidence in the solution managing the sustainable level of income.
The underlying economic principle of a holistic approach is total capital efficiency, where after-tax outcomes are measured against the particular way in which clients expect to derive benefits from their wealth. This is the essence of outcomes-based investment, organised to deliver both client- and goal-specific planned outcomes.