The freedom to make a mess
One year on from the government's overhaul of the pension industry, Binyamin Ali considers what the lasting legacy of the freedoms will be
'The tax rules around pensions are a manifestation of a patronising view that pensioners can't be trusted with their own pension pots. I reject that.' So quipped George Osborne as he delivered his budget on 19 March 2014, bringing into effect the changes now widely referred to as the 'pension freedoms'.
Keen to reorder the British understanding of what a pension is and what it actually means to save into one, he told the House of Commons: 'We will legislate to remove all remaining tax restrictions on how pensioners have access to their pension pots. Let me be clear. No one will have to buy an annuity.'
One year has now passed since the Pension Schemes Act 2015 came into effect on 6 April 2015 - a day that was branded as a 'Y2K moment' for the pensions industry by the chief executive of the Financial Conduct Authority, Martin Wheatley. Unlike Y2K however, this thing was real.
The Association of British Insurers has reported1 that nearly £6bn was withdrawn in the first 12 months of the freedoms. £3bn has been paid out in 213,000 cash lump sum payments, while £2.9bn was paid out in 835,900 income drawdown payments.
Who needs advice?
These figures alone, as enlightening as they are, do not offer a real window into what the legacy of the freedoms could turn out to be.
The latest statistics available from the Financial Conduct Authority2 on the number of savers who consulted Pension Wise (the governments free guidance service launched in tandem with the freedoms) or used a regulated adviser before making a withdrawal, makes for interesting reading.
Of those who withdrew £250,000 or more as a lump sum, the majority (67 per cent) did not use Pension Wise or a regulated adviser (see figure 1). Taking into account that only the first 25 per cent of an uncrystallised fund pension lump sum (UFPLS) can be withdrawn tax free, with the remaining 75 per cent taxed at the individual's marginal rate of income tax, the tax these savers have exposed themselves to is significant.
Matthew Brown, a private client partner at Thomas Miller Investment, describes the lack of advice being taken as 'frightening'.
'At those sorts of levels, you are automatically paying higher rates of tax than if you withdrew it over a number of years. I am surprised by that figure and it professionally worries.
'I'm not particularly surprised that they're not using Pension Wise because a lot of the information, educated people with large funds can probably do their own reading on the internet and find that information. But doing it without advice, when you're dealing with that quantity of money, that does surprise me because I would have thought the majority of people would have sought professional advice before doing something with a quarter of a million pounds.'
However, Geraint Jones, a tax partner at accountancy firm BKL Tax, is unfazed by the pension withdrawal trends witnessed in the first year of the freedoms. He believes the spirit of the changes should be upheld and people's right to do as they please be defended.
'Well that's part of living in a free society, isn't it? If they went and bought a rental property with it, that would probably be a reasonable investment and I'm not sure a financial adviser would have come up with anything significantly better. If they bought a Lamborghini with it, then it probably wasn't such a good investment.
'People know of the existence of financial advisers. We can't structure the whole of society to cater only for the most stupid people and everyone else has to suffer as a result.'
Firefighting stamp duty
One of the problems for the government has been that too many savers have been very clever and put their money into the asset that Jones suggests any financial adviser would be hard pressed to beat the returns on - property.
Following a surge in buy-to-let property purchases after the freedoms came into effect, Osborne introduced a three per cent stamp duty increase for second homes and buy-to-lets in the 2015 Autumn Statement, in an attempt to cool residential lettings investments.
Despite the government's intentions, Brown believes that savers who are interested in investing in property will continue to do so, as the strong returns will make it worthwhile in the long run.
'Personally, I don't think that's going to make any difference at all. I think it will be a good revenue raiser for the government', he predicts.
'In what is still, from what I can see, a generally rising and very buoyant house market, most people think they'll make that three per cent up over a short space of time on property increases anyway. I don't think it's going to put anybody off.'
Meanwhile, David Cox, the managing director of the Association of Residential Lettings Agents, believes that renters will, inadvertently, be hardest hit by the tax increase. '[This] is catastrophic news for the private rental sector, especially following the recent changes to mortgage interest tax relief and the annual wear and tear allowance,' he said.
'Increasing tax for landlords will increase rents and reduce property standards for tenants.'
There is no data available to substantiate or disprove Brown and Cox's predictions yet, but there has been a further unintended consequence of the freedoms on the property market. They silently undid what the Help to Buy equity loan, Help to Buy mortgage guarantee and the new Help to Buy ISA have all been set up to achieve: help first time buyers purchase a property.
I see the death, but where are the taxes?
As well as lifting the lid on pension pots, the Conservative-Liberal Democrat Coalition also abolished the 55 per cent tax on the inheritance of pensions. This was an extraordinary giveaway given the unprecedented opportunity it gave savers to circumvent inheritance tax through a state sanctioned avenue.
In the event that an individual dies before the age of 75, their nominated beneficiary will receive all payments from the pension completely tax free, whether taken as income or a lump sum, provided this happens within two years of death. Where an individual dies after the age of 75, drawdown income payments to the beneficiary are subject to income tax at the recipient's marginal rate.
As Robert J Young, a consulting actuary at Gordan Dadds explains, the flexibility afforded by the scrapping of the pensions 'death tax' can be stretched far beyond this basic inheritance panning, offering multigenerational tax advantages.
'If you die after age 75, then the funds are taxed but at the recipient's marginal rate of income tax. As a result, some funds could for example go to non-tax paying grandchildren with no tax payable until the amount exceeds the nil band rate.
'Death benefits do not need to be left to one person. You may nominate anyone you wish and they do not need to be dependent on you. There is no limit on the number of times that funds can be passed on, so any funds not withdrawn from a pension arrangement can continue to be passed on down the generations, with the rules depending upon the age at death of the successor and not the person from whom the funds originated.'
The Conservative party have been trying to find a way to increase the nil-rate band to £1m for some time now; it was a manifesto pledge of theirs in the run up to the 2010 general election.
In their failure to deliver this, we have seen the introduction of the highly convoluted main residence nil-rate band, in conjunction with the inheritance planning opportunities now afforded by pensions. As pensions have a lifetime limit of £1m, Osborne has been able to give high-net-worth individuals the option of using it as an inheritance tax mitigating tool only, essentially delivering on the Tory's 2010 manifesto pledge through the backdoor.
Secondary annuities market
For those who have already entered retirement and purchased an annuity, the liberated landscape has so far been something for them to peer longingly at and nothing more. In March 2015, however, the government announced plans to set up a 'secondary annuities market', where people who have already purchased an annuity can sell it on. This was initially scheduled to be established by April of this year, but has been pushed back to at least April 2017 due to market fears.
The Financial Conduct Authority has been placed in charge of working out the risks, requirements and parameters of this new market, and has published a proposed rules and guidance document3. Despite the government's expectation that 300,000 retirees will want to sell their annuities4, the plans may be derailed by further fears among advisers that they may be sued by clients who they advise to sell their guaranteed incomes, but then go on to regret their decision.
Barry O'Dwyer, managing director of insurer Standard Life, has highlighted that the family of someone who sells an annuity could also be exposed to lawsuits. He said while speaking to CitiWire5: 'If a company buys an annuity… and finds out [the seller who has died] held back information about their health [does the buyer] then pursue the widow or widower for the cash?'
The method with which the value of a second-hand annuity is determined is likely to be another very tricky sticking point. Indeed, the government expects that 300,000 retirees will want to sell their annuities, but surely this will only be the case if it is their best interests to do so?
'Somebody has to win and somebody has to lose. I don't think it will be particularly well used and I don't think it will be particularly well taken up; I don't think the value that people will get for their annuities will look particularly attractive,' forecasts Matthew Brown.
Furthermore, the medical evaluations taken of people who are heading into the years of their lives where they are more susceptible to illness, could lead some to adopt a very questionable approach to screening and risk assessment.
'You're going to end up with racial issues potentially arising towards people who are more predisposed towards certain illnesses than others,' Geraint Jones points put.
'It all seems rather strange, going into people's life history and seeing if their parents lived to a ripe old age and looking for someone with good genes. Also, how do you monitor that the seller hasn't disappeared off into the sunset once you've bought it from them? Who is going to be responsible for the reporting? You can't expect the purchaser to stay in weekly contact with the person who they've purchased it from.
'I don't know whether they [the annuities company] can actually monitor these people anyway. I don't think they're efficient enough to be monitoring the world's deaths to see which British citizen living in Columbia had been bitten by a snake and died, so that they could stop the annuity.'
The government is set to press ahead with the creation of the secondary annuities market, despite these myriad concerns. Whether or not it enjoys any degree of success will depend on how well these challenges are addressed.
What does the future hold?
There is no doubt that the Pension Schemes Act 2015 has been the catalyst for a paradigm shift in the pensions industry. A pension is no longer just a retirement funding tool. It is now a multigenerational succession planning mechanism, lifetime savings account, a modest tax sheltering structure and a retirement funding tool, all rolled into one.
Following an avalanche of 'initial pent up demand, the number of people accessing their pension pot as cash in one go has settled down,' says As Dr Yvonne Braun, the Association of British Insures' director of policy for long term savings and protection.
'People are taking a sensible approach and considering how they will pay for their whole retirement. Annuity sales are beginning to see a revival, with more annuities than drawdown products sold in the last quarter. This shows people still really value a lifelong guaranteed income,' she adds.
The effects of the new backdrop will have to be periodically reviewed and contained by government as savers flock to new investment opportunities in pursuit of strong returns on their investment. Meanwhile, the level of stress that will be placed on the state pension, should savers unwisely spend their money, will be a recurring theme for every new government of the future to tackle.
The changes that come into effect will invariably be influenced by the political ideology that the ruling party of the day subscribes to, but the inevitability of future change is unquestionable, laments Matthew Brown.
'Pensions are a political football and the reason for that is the treasury sees it as massive tax leakage.
'As a nation, we are under-saved and we have a massive savings gap so by its nature, it is a political issue so we shouldn't be surprised with this constant tinkering. I just hope that the politicians look to the long term and have that in mind when they're changing and tinkering with all of the rules.'
With regards to the question of whether the freedoms are a positive or negative development, Geraint Jones takes a very laissez-faire position on the matter.
'I think people should have the freedom to make a mess of their lives if they so wish. I'm intensely relaxed about the whole thing. I certainly wouldn't use my pension to buy a sports car but I'm essentially very cautious and prudent. But just because I am, that doesn't mean the next person is or ought to be.
'I've got friends who have a long history of cancer in the family and don't think for one second that they're going to live beyond 70. So why not let them enjoy their lives?'
If the lasting legacy of the freedoms is that people decide to save more through their pensions and from an earlier age, the nation's savings gap will certainly decrease and encourage greater personal financial responsibility. The great unknown in the matter is what our future political leaders will do. Will they play ball and help create a stable savings environment, or will they pursue popular and piecemeal policies with the goal of winning and holding onto political power? n
See the Association of British Insures' news release: https://bit.ly/1Qx7HEk
Financial Conduct Authority Retirement Income Market Data, July - September 2015: https://bit.ly/23YfLuJ
Secondary Annuity Market - proposed rules and guidance: https://bit.ly/1QAjMss
Creating a secondary annuity market: tax framework: https://bit.ly/1Uh2uHI
See CitiWire's article, Fears grow over second-hand annuity market, 22/04/16: https://bit.ly/236k95k
Binyamin Ali is the editor of Private Client Adviser