Gaming the pension rules
Pension rules were devised with the paternalistic objectives of encouraging savings and then ensuring stable and sustainable incomes throughout retirement. The wealthy can exploit these rules differently from people largely or entirely dependent on pension schemes to deliver their retirement ‘income’. Within the constraints of the rules, they have choices about how much to save in pensions and how much to draw from pensions that are driven entirely by externalities like tax efficiency or by a combination of personal objectives and tax. If they made themselves heavily dependent on payments from pension plans to fund their retirement spending, it was because they were either advised by someone who did not know how to game the rules successfully (accountants often got this wrong) or were not advised at all. We approach the latest round of pension changes, still in draft form in the 2011 Finance Bill, in this spirit.
The idea that financial decisions subject to rules might be made easier by applying strategies honed in competitive games ought not to be unfamiliar to wealthy investors. Even if it is unfamiliar it ought not to be counter-intuitive.
Winning in this context is about maximising the after-tax cash flows from personal pension funds but doing so as part of a holistic plan that maximises personal welfare, or benefit, from all forms of wealth and in terms of all different personal goals, of which securing lifetime spending is just one, albeit perhaps the highest, priority. This is how we develop wealth strategies collaboratively with our clients.
The Coalition Government’s contribution to the pensions regime that was last overhauled in 2006 is a series of changes to the rules, some of which reduce flexibility and some increase it. It is flexibility that determines the scope to game the rules.
We highlight below the changes and the possible implications for winning strategies. If you think this applies to you, it is likely you will need to take professional advice.
The typical scale of the difference between optimal and suboptimal decisions in this area makes paying for good advice entirely logical.
You should not assume that because you have an adviser in place or that you took advice at A Day that you do not need to check whether your strategy is now or ever was optimal.
You should not assume that this is just about searching for information and tips on the internet and managing your own retirement plan. Optimal decision making in conditions of uncertainty about capital markets and inflation, when subject to complex tax and other rules as well as uncertainty about future changes in those rules, is a massive challenge for professional advisers let alone self-directed investors.
At NMB, retirement planning is an important part of ensuring ‘capital efficiency’ across the whole of a family balance sheet. In wealthy households, where there are resources available to meet multiple goals that deliver very different forms of benefit or favour different beneficiaries, capital efficiency as a conceptual approach to managing finances integrates each of
maximisation of goal-based welfare
effective risk management
minimisation of tax
avoidance of unnecessary costs.
Given its obvious importance in your life, you should ask yourself why financial management ought not to be one of your largest budget items and why you would not give it the attention it deserves.
changes in the next finance bill
5th April 2011 is the last chance for individuals not caught by ‘regular contribution’ rules to make large contributions in their final year before ‘retiring’ (ie crystallising benefits) and gain tax relief at their marginal rate on up to £255,000 of UK relevant earnings.
From 6th April, those caught by the regular contribution rules will be able to make up the difference between Labour’s cap on tax relief of £20,000 pa and the new cap of £50,000, reaching back up to three years.
Should you make further contributions? You will want to consider the following.
Anyone making contributions should avoid the mistake of assuming that the after-tax cash flow values are higher in a pension wrapper than out. Recommendations usually focus on the tax relief going in and tax free ‘rollup’ and ignore the tax treatment of the money coming out, which effectively includes a charge on the apparently tax-free rollup. Increased marginal tax rates, if these survive through much of a retirement phase, affect this comparison significantly. At higher marginal rates in retirement than when saving, the net present values of a stream of lifetime cash flows generated from a pension fund is likely to be less than the value of a flow generated outside pensions. Ironically, the comparative values also depend critically on assumptions about death and IHT treatment. Finally, they are also sensitive to what investments you would hold.
Contributions also need to tie in with the Lifetime Allowance and any protection you have or could have in place.
Think about whether your retirement spending will be too heavily dependent on externally-imposed drawdown rules. There has to be a balance between capital in and out of pension pots because the drawdown rules conflict with the typical spending profiles in affluent households that are front-loaded and with typical plans to fund later stages with property sales. Pensions may not provide the spending power when you need it.
If the Finance Bill passes, the drawdown regime will be the same before and after age 75 and will be referred to as Capped Drawdown. This was presented as an end to compulsory annuities at age 75 but in fact wealthy people could have avoided the penal drawdown rules after 75 by moving to a plan written under ‘scheme rules’. So there is no real gain in flexibility.
Contrast this with the fact that everyone planning to take benefits before age 75 by drawdown is affected by a reduction in the maximum draw. If the Finance Bill passes, between 0% and 100% (currently 120%) of the Government Actuary Department (GAD) rate (derived from a gilt yield and age) can be taken as drawdown instead of buying an annuity. This is a significant loss of flexibility and increases the risk of excessive past contributions causing timing problems for spending.
Flexibility is also lost because the resulting drawdown rate is based on a capital value at intervals of three years, down from five years, if the Bill passes. A fall in markets can therefore trigger a fall in maximum draw, if the fall in triennial valuation exceeds the upward drift of the GAD rate with age. Longer periods offer greater flexibility to manage the profile of the draw.
There is still a slim chance an individual already in drawdown can request a new valuation basis before 5th April but HMRC only allow this on the anniversary of a previous valuation.
These rules are also impacted by transfers from one provider to another.
These constitute prima facie reasons for bringing forward the crystallisation of benefits and start of draw before 5th April 2011 – but subject to the personal relevance of the next two sections.
Death benefits and IHT
Up until such time as the tax free cash is drawn from the pension, the whole fund can be passed, on death, to your chosen beneficiary(s) as a lump sum without any income or inheritance tax (IHT) consequences. Once the fund has been crystallised, or you reach age 75, this option is lost. Though not a change, it is inconsistent with the principle espoused by the Treasury that tax relief already given should be recovered either by income tax on benefits taken as income or as a Tax Recovery Charge set at 55%. Death before 75 remains an exception to this rule, unless Parliament questions it.
Should you therefore opt for phased crystallisation? Under existing rules for drawdown, tax free cash can be spread across a number of years by crystallising part of the plan each year (the plan normally being divided into ‘segments’). The drawdown options are then applied to each ‘opened’ segment. Because each crystallisation produces both a tax free sum and a stream of payments, manufacturing an even stream across time means all the plan segments will be opened in the first decade of draw rather than spread across the plan. Phasing crystallisation therefore competes significantly with the tax-efficient disposition of death benefits on unopened segments.
How you make this trade off depends critically on the strength of any bequest motive competing with lifetime spending or gifting. The mathematical impact of the probability of death before 75, combined with a bequest motive, also influences whether to take advantage of the main change in drawdown affecting the wealthy: flexible drawdown.
The Finance Bill proposes to give complete flexibility on drawdown provided an individual can satisfy a Minimum Income Requirement (MIR) of £20,000 pa in the form of pension annuities or defined benefit scheme benefits (including State pension). It prevents a member who expunges their fund from falling back on State benefits. This test only has to be met once.
The decision approach will vary if an individual can satisfy the MIR from final salary scheme benefits and the State pension. Otherwise, the price of meeting the MIR is an annuity purchase from the personal pension pot which potentially conflicts with the objective of the increased flexibility.
Compared with phased Capped Drawdown, the option provides more scope to control a changing rate of draw, such as to minimise personal income tax, potentially leaving more of the fund open to the impact of death before 75. Individuals may have opportunities to exploit brief windows of low personal taxation due to their personal circumstances – although this aspect of the draft legislation may attract attention in debate.
The Finance Bill also alters the Lifetime Allowance of pension benefits (by capital value equivalent) from £1.8m to £1.5m. Any breach will be tested cumulatively with each crystallisation event, including occupational scheme benefits. Any excess will be subject to a tax charge of 25% (as currently).
The Lifetime Allowance will be tested again at age 75 (as currently) to ensure that people who defer drawing and have then exceeded the allowance pay the 25% charge, as a disincentive to using deferral as a strategy for mitigating IHT. Flexible drawdown could help in managing the combined chance of death before 75 and a 25% charge at 75.
To protect people who had already planned on a limit of £1.8m (and did not have any form of protection under the original ‘A Day’ regime) from inadvertent breach, as a result of the impact of unknowable investment growth on contributions already made, it will be possible to apply for Fixed Protection to ensure that their personal limit is £1.8m not £1.5m.
As a condition of Fixed Protection, a member would have to make no further contributions so anyone planning this might want to consider making a final contribution before 5th April 2012.
Deferred and active members of a defined benefit scheme are also affected (differently) by rules on the accrual of benefits and therefore risk a breach of their Fixed Protection.
Though not a change, the management of the risk of breach is highly sensitive to assumptions about nominal investment returns and future government policy about moving the Lifetime Allowance up if inflation turns out to be driving returns above protected levels. Planning is therefore a hostage to political fortune as well as to the uncertainty of real, post-inflation investment returns.
Managing the second risk assumes skills in modelling real investment returns probabilistically. It is not enough to rely, as most advisers do, on deterministic nominal return projections. In most cases, the same projection rates are used as the FSA prescribes for pension providers yet financial planners are under no obligation to use these non-probabilistic (and over-simplistic) assumptions. Good risk management is obviously about stress testing, not relying on assumptions that have only a 50% or so chance of being reached.
Continuous reprojection of probable outcomes, in real terms that correspond to spending, is a key part of the financial management you should be paying for in retirement. If your financial adviser or investment manager cannot do this, you should talk to us.