Nightmare on tax-free cash street - volume 1
I now think that people like me in our industry have spent too much of our time concentrating on the way this new legislation will impact on the higher paid people in the UK workforce and not enough time on how the new tax rules will complicate the lives of Joe and Josephine Average. This BeeLine is the start of my redressing that balance. Thereíll be many more of them to come too, so Iíll apologise for that up-front.
Itís been important to start to focus on where this legislation meets people on edges, and particularly on the effect it will have in forcing most of the pension decision makers in UK plc to leave our pension system for good because of the imposition of retrospective tax charges on pension benefits already accrued. But the impression weíve given in pursuing this line is itís only high earners who will face problems after A-Day, and thatís simply not true. This new stuff will drive more and more people into needing sensible advice regarding their pension options and one area where this seems so apparent to me is in the way tax-free cash will work in the future.
Hands up those of you who think that the tax-free cash from money-purchase pension schemes after A-Day will be 25% of an individualís money-purchase fund? I canít count the show of hands from here, but Iíd guess itís most of you. Well, if it is youíre wrong. The truth is that the tax-free cash from money-purchase pension pots could be anything up to 45% of the fund, depending on the form in which people choose to take their retirement benefits. It could also be limited to 25% for the same reason, and I promise Iím not making any of this up.
Iíll stick in a statement here and then come back to it in a minute. After A-Day the tax-free cash that people with some forms of money-purchase pensions will be entitled to will depend on the level of annuity rates at the time they retire and the type of annuity they choose. Further, those who choose poor annuities may well end up with more tax-free cash than they would do if they were to choose more suitable annuities. If you read on Iíll try to explain how something so crazy has been put in place by this yearís Finance Act.
To start with, the tax-free cash we get on retirement wonít be called tax-free cash anymore after A-Day, itíll be called the Pension Commencement Lump Sum instead. Come to that, retirement wonít be called retirement after A-Day either, itíll be a crystallisation event. I mean, how modernís that? Anyway, for the purpose of this BeeLine Iím intending to stick to the pensions argot weíre all currently used to. Iíll modernise my speech when I have to some other time.
For this BeeLine Iím only talking about money-purchase pension schemes after A-Day, Iíll be writing about final-salary schemes and tax-free cash another time, and you really wonít believe how strange that one will be!
The money-purchase schemes Iím on about here are both trust based schemes like Contracted-out Money-Purchase Schemes (COMPS), Contracted-in Money-Purchase Schemes (CIMPS), Executive Pension Plans (EPPs) and Small Self-Administered Schemes (SSASs) and Section 32 Plans (S32s) as well as contract based schemes like Personal Pensions (PPs), Grouped Personal Pensions (GPPs), Stakeholder Pensions (SHPs) and Grouped Stakeholder Pensions (GSHPs), or to put it another way all money-purchase individual, group and grouped schemes. The Full Money-Purchase Monty in fact.
After A-Day people retiring from money-purchase arrangements will have the opportunity to take their pension benefits in the form of an open-market option (where they effectively shop around the annuity market with their pension pot to get the best deal available), or a Ďscheme pensioní which is provided by the scheme they are in. The first thing to understand is that where people go for the open-market option and shop around the new rules say that the tax-free cash is limited to 25%. So anyone shopping around for a good deal gets the 25% limit on cash that everyone thinks is the limit across the board after A-Day.
But, surprisingly, people who donít shop around and take a Ďscheme pensioní instead arenít limited to 25% tax-free cash by the new tax laws set out in this yearís Finance Act. For them the tax-free cash varies depending on the annuity rate applied and the type of annuity selected. I wonít go into how this works in this BeeLine - Iíll do that in another later on. What I want to do here is to get the information going around about the effects of the legislation as I understand it, the detail can follow. If I do it any other way the BeeLines would end up being too long and much harder to digest.
The broad rule of thumb is this: where people select single-life, level annuities as a Ďscheme pensioní they will become entitled to more tax-free cash than if they were to select a joint-life annuity with built-in increases. Also, the older they are when they retire, the more tax-free cash they potentially become entitled to. Strangely enough, the opposite appears to be the case for people in Final-Salary schemes where later retirement seems to produce a lower entitlement to tax-free cash. But Iím getting ahead of myself - thatís for a future BeeLine.
To put some of this in perspective we've produced a few sample figures to illustrate the point. The figures I've used are based on a £500,000 pot, which I know isn't an average pension pot, but lets not get hooked up on that. Anyway anyone who wants to can always divide the figures by 10. If you look at a 65 year-old guy who happens to have this £500,000 money purchase pot and work out the tax-free cash for just three options open to him; an open-market option, a single-life Ďscheme pensioní guaranteed for just 5 years and a joint-life Ďscheme pensioní escalating at 5% a year and continuing on death at the rate of two thirds to his wife who is 5 years younger than him. The tax-free cash sums available would be £125,000, £161,290 and £84,033 respectively. Obviously the annual pension amounts would vary greatly too, but Iím not intending to cover that here. This is just to make the point that Joe and Josephine Average will have some pretty difficult trade-offs to make when they retire from ordinary pension schemes after the 5 April 2006. Letís hope everyone involved in the advice chain has time to gear up to being able to advise them about the effect of these so-called simplifications!
24 November 2004
This document is based on Scottish Life's understanding of the Pensions Act 2004 & the Finance Act 2004.
Any research and analysis included has been provided by us for our own purposes and the results of it are being made available only incidentally.