With the new system, upon reaching retirement age, most people take part of their pension as a lump sum (up to 25% is tax free) and use the rest to purchase an annuity – an insurance product that provides an income for life.
Although there are other options available, including withdrawing an entire pension pot, various restrictions and taxes and the high degree of risk involved make these less attractive to many people, meaning that around 75% of pensioners see little option but to purchase an annuity.
However, a longer life expectancy combined with fluctuations in the stock market (where UK pension funds hold around a quarter of their investments) and low returns on bonds mean that annuity providers are now offering less than they were previously – annuity rates reached an all time low in January 2013 – and people are retiring with a much smaller income than they expected.This has caused a general lack of trust in the pension system and the government is concerned that people are being put off from saving for their retirement, which could in turn lead to a future pension crisis. To address this, they have introduced a number of pension reforms, including 'automatic enrolment', but the latest changes are expected to have the biggest impact.
What is the current situation?
The big change which took effect on 6th April is that anyone aged 55+ with a 'defined contribution' pension pot now have the freedom and flexibility to spend, save or invest their pension as and when they wish. The option to withdraw 25% of the pension pot tax-free will remain, as will the option to purchase an annuity, but people who want greater control over their finances can use the money in their pension pot as they see fit.
Example: Someone with a £400,000 pension pot would be able to take £100,000 (25%) as a tax-free lump sum, and would then have the following options with the remaining 75%:
Withdraw it immediately and pay income tax at the appropriate rate (based on total income – i.e. pension income plus any other income)
Buy a £300,000 annuity (which currently could provide an annual income of anything between around £7,000 and £21,000, depending on the age of the applicant and level of cover)
Buy an annuity with part of the cash, leave the rest invested or withdraw it and spend it 4. Keep the £300,000 invested with the pension fund and draw as much or as little income as they wish
Existing annuity holders
The Chancellor confirmed in the latest Budget that anyone holding an annuity will now be allowed to sell it to a third party, subject to the agreement of the annuity provider. Rather than having the money taxed as a lump sum, the proceeds of the sale of the annuity can be drawn down over a number of years and tax paid at the marginal rate in the same way as those taking their pension after April 6th. Whilst this is a positive move in theory, given the recent poor performance of annuities, it is debatable what sort of price annuity holders would obtain especially if the market were to be flooded with sales.
Lifetime allowance for pension contributions
Also announced in the latest Budget, the lifetime tax-free allowance for pension contributions will be reduced from £1.25m to £1m from 6 April 2016. The annual tax-free allowance (currently £40,000) will remain unchanged. From 6th April 2018, the lifetime allowance will be index-linked to CPI. The Government estimates that this will affect less than 4% of the population.
People will be able to pass their unused defined contribution pension savings to any nominated beneficiary when they die, instead of paying the 55% tax that currently applies. If they die before they're 75, the beneficiary will pay no tax on the funds; if they die after the age of 75, the beneficiary will pay their marginal rate of income tax, or 45% if the funds are taken as a lump sum payment. From April 2016, lump sum payments will also be taxed at the recipient's standard rate. Beneficiaries of individuals who die under the age of 75 with a joint life or guaranteed term annuity will be able to receive any future payments from such policies tax free. The tax rules will also be changed to allow joint life annuities to be passed on to any beneficiary. These changes mean that people will no longer have to worry about their pension savings being taxed at 55% on death.
N.B. These changes will only apply to people with 'defined contribution' pension schemes, not those with 'defined benefit' (also called 'final salary') pensions which provide a guaranteed income after retirement. Anyone with a final salary pension fund will only be able to take advantage of the change of rules by transferring to a defined contribution pension. This option will not be open to those in most public sector schemes.
(1) Figure includes the contributions of those aged under 55. Figure calculated using average defined contribution pension pot at end-2013 (£25,000) and the number of active members of defined contribution schemes (2.7m)
What are the implications for pensioners?
Making decisions about how best to invest any money withdrawn from a pension pot are tough enough for even the most seasoned investors, so there are concerns that some inexperienced investors may end up taking risks that they don't fully understand. There is also a potential tax pitfall: basic-rate tax payers need to be aware that any drawdown from their pension will be added to any other income they may receive and could result in them paying higher rate tax, as the Inland Revenue will assess tax liability on total income, not just pension income. Those reaching retirement age are advised to draw up a retirement plan considering when they wish to retire, how many years their money might have to last, what kind of lifestyle they want, the annual income they will need to fund that lifestyle – keeping a close eye on the impact that will have on their tax liability – and what their outgoings will be.
How will this affect the property market?
There are a number of reasons that property is likely to prove a popular investment choice for those who decide to take control of their pension pots and invest in something other than an annuity:
Residential property is generally seen as a less volatile and relatively safe long-term investment, when compared to other assets such as equities
Can provide a regular rental income
Strong capital appreciation over the medium-to-long term is anticipated
It is a tangible asset that people generally feel more comfortable with and understand better than other more complicated investment vehicles
Recent research (2) suggests that 11% of people approaching retirement plan to buy a second home to rent out, compared to the estimated 6% of pensioners who currently own a buy-to-let property.
If this turns out to be accurate, then a near doubling in the number of pensioners buying at least one investment property would push house prices up. If the properties purchased were then held as rental investments, this would help alleviate the current shortage of rented accommodation, which is especially prevalent in London, thereby stabilising the rental market somewhat. However, financing a property investment is likely to prove difficult for many 55+ year olds as lenders have been toughening their stance on borrowers who cannot repay their mortgage before retirement. Buying properties with cash is of course an option, but with the average pension pot in the UK standing at just £25,000, the number of people with enough contributions to cover the cash purchase of a property will be very small, especially in London where prices are much higher.
The more likely scenario is that those looking to invest in property would need to supplement their pension pots by selling their existing property and either downsizing or moving to a cheaper area. This said, many pensioners have already taken these options and dipped into their pensions to help their children and grandchildren onto the property ladder so a significant uplift in activity is unlikely. For those that can afford to buy an investment property, identifying the right property to ensure a longer term income stream and capital growth will be the challenge. Location and rentability are key issues and a realistic assessment of operating costs and voids will need to be made. Tax liability is a further important consideration and owners will need to be aware that their rental income when added to their pension or other income could take them into a higher tax band. The good news is that certain tax concessions are available: mortgage interest relief and CGT allowance (currently £11,000) for private (but not company) landlords. In conclusion, the pension changes could trigger a significant increase in residential property transactions but for most households, this is unlikely to involve the acquisition of an investment property. The increase in transactions is more likely to come from continued trend of pensioners selling larger properties and properties in prime areas and purchasing smaller properties and properties in cheaper areas in order to release additional equity to help fund their retirement years.
(2) A study from YouGov and investment adviser Old Mutual Wealth The contents of this document are intended for the purpose of general information and should not be relied upon as the basis for decision taking on the part of the reader. Although every effort has been made to ensure the accuracy of the information contained within this note at the time of writing, no liability is accepted by Chesterton Global for any loss or damage resulting from its use. Reproduction of this document in whole or in part is not permitted without the prior written approval of Chesterton Global. March 2015.