Pension freedoms – How to help your employees manage their retirement income
31 October 2019
In the first article in a series on financial wellbeing in the workplace, First Actuarial’s Catherine Lockyer looks at the tax implications of pension freedoms.
At First Actuarial, I lead a specialist team that works with employers to provide financial education in the workplace. Pension freedoms is something we often discuss with our clients’ employees, addressing its impact in a range of formats – from group workshops to drop-in surgeries and face-to-face sessions.
Giving people more choice in the way they spend their pensions is a positive development. But it is also a source of anxiety for many; the responsibility for making complex and life-sized decisions can be overwhelming.
This article, on personal tax issues, is the first in a series in which we will focus on specific areas of pension freedoms that have a bearing on financial wellbeing.
Pension freedoms explained
The Pension Freedoms Act 2015 has given people far more flexibility in the way they access their personal Defined Contribution pension funds. No longer forced to buy an annuity, they can effectively take money out as and when they like. This provides even more flexibility than many people realise.
People were previously at the mercy of whatever price annuity providers happened to charge them, for one thing. Less obviously, buying an annuity on a fixed date, as people had to do before 2015, locked them into the market conditions of that particular day. So after years or decades of saving into their pension pot, retiring at the wrong time could wipe out thousands of pounds, or more, at a stroke. This loss was set in stone – anyone locked into an annuity on poor terms faced lifelong losses.
As the Government foresaw, then, pension freedoms released savers from these restraints. However growing numbers of employers are now asking themselves – how can we equip our staff to make best use of these pension freedoms? After all, not everyone has the skills to generate a lifelong income from their pension pot.
Are your employees over-taxed with pension freedoms?
When the freedoms were introduced, commentators half-joked that people would blow their entire pension at their nearest Ferrari showroom. That has not been borne out by reality. It is certainly true that people should spread their pension pots though. Not just because it’s pretty foolish to spend your entire savings in one fell swoop, but because it’s tax-inefficient to do so.
The longer the period over which a pension pot is accessed, the more tax-efficient the process. It’s all about the Personal Tax Allowance! Let’s look at a simple example.
Jane has a pension pot of £100,000. After taking a tax free cash sum of £25,000 (the maximum she can take tax free is 25% of her total pot) she has £75,000 to access gradually. The UK personal tax allowance currently stands at £12,500.
Scenario 1: Jane decides to make three withdrawals of £25,000, in three consecutive tax years. She also has a State Pension of £8,500 payable each year, which is subject to income tax. So her total income in these three years will be £33,500.
Ignoring investment returns and changes to the personal allowance (remember this is a simple example!) HMRC will deduct £12,500 from her total income (from the pension pot and State Pension) leaving £21,000 to be taxed each year.
So, in total, over the three years £63,000 of the £100,000 will be taxed. If Jane is a basic rate tax payer then this gives an overall tax charge on her pension pot of 12.6%.
Scenario 2: Jane decides to make 10 withdrawals from her pension pot after tax free cash, of £7,500 in 10 consecutive tax years.
Adding this to her State Pension means that her income will be £16,000 in each of these 10 years, of which just £3,500 will be taxed. Over 10 years this amounts to £35,000 and there will be an overall tax charge on her pension pot of just 7%.
As these scenarios show, your employees can be smart in spreading their pension pot withdrawals, effectively paying less by spreading the money over a period of time.
Easing the pain of pension freedoms
Before 2015, people retired and bought an annuity. It may have been expensive, but the onus was entirely on the provider to generate a lifelong income for the pensioner. Pension freedoms flip that burden over. People now have to bear all the risk that their money won’t run out.
But a pension pot doesn’t work in the same way as the magic porridge pot of the fairy tale world. Pension pots can, and do, run out if they’re not managed well. Pension freedoms force people to take the risk that their money will last as long as it’s needed – that there will always be porridge in the pot.
Pension freedoms are worth celebrating. But the burden they place on the individual is undeniable. Managing a pot of money over an entire lifetime takes specialist skills and knowledge. Not everyone has the financial nous to work it all out for themselves.
One thing employers can do is to support their employees with financial wellbeing guidance. This is valuable at any age, but really comes into its own at certain points in your employees’ lives – such as when they start planning for their retirement. You can find out more on our financial wellbeing website.
In my next article, we will broaden out this whole area and discuss why it’s important that you urge your employees to give serious thought to their entire retirement, and not just the early years.