Avoid these 10 potential pension slip ups
1. Cashing in pensions ‘just because you can’
Whoever said: ‘A bird in the hand is worth two in the bush’ obviously wasn’t familiar with current pension legislation and the benefits the pension ‘wrapper’ offers your hard-earned cash. In addition to facing a large tax bill when you make your withdrawal, you also lose valuable protection from inheritance and income tax further down the line.
This means it only makes sense to take money out of your pension if you have a genuine need for it, and if it isn’t available from other sources such as Isas (where withdrawals won’t be taxed).
However, according to research from Royal London, 23% of customers cashing in pensions have done so just to move the money into a savings account. Fiona Tait, pension specialist at Royal London, says only the first 25% of every withdrawal is paid tax-free.
“The other 75% is subject to income tax so if you take your money out of one investment just to move it into another, you need to be confident your gain will cover your tax bill,” she explains. “Even if you are worried about investing, you can still hold it in cash within your pension.”
If you feel you can make your money work harder, you can still access investment funds and shares within a self-invested personal pension (Sipp).
2. Ignoring guaranteed annuity rates
During the 1980s, personal pensions often offered guaranteed annuity rates (GARs), which were priced at a time when interest rates were so much higher than today. However, according to research from the Financial Conduct Authority (FCA), some 68% of guaranteed annuity rates are not being taken up, rising to 79% for pots worth less than £30,000.
Even on small pots that you might be otherwise tempted to cash in, GARs can be too good to ignore, as Claire Walsh, head of advice at Unbiased, explains: “I had a client with a pot worth £17,000. It had a guarantee of 11% on it, giving him £1,800 a year – it doubled his money in terms of what he would have been able to get with a standard annuity.”
The downside to GARs is that they are not usually very flexible –you may have to start taking the income on a specified date or not get a spouse’s benefit, but you need to be aware of the income that is on the table before dismissing
3. Not shopping around for an annuity
Despite industry-wide attempts to make retirees aware of their ‘open market option’, the number of retirees who are shopping around for guaranteed income is falling, not rising. According to the latest figures from the FCA, 64% of purchasers bought their annuity directly from their pension provider.
Andrew Tully, pensions technical director at Retirement Advantage, says: “People trust the pension company they have saved with to provide the best deal. However, even the financial regulator has recognised that most people can get a better deal by shopping around.”
Figures from Retirement Advantage show that a healthy individual buying the worst deal could miss out on as much as £7,780 in lost income over a typical 20-year retirement (based on the average £53,000 annuity). You can shop around for annuities on comparison websites and with annuity brokers. Alternatively, you can consult a financial adviser.
4. Not telling your annuity provider about health problems
Smoking, being overweight or having medical conditions often mean you pay more for products like life insurance, but when it comes to annuities they count in your favour. This is because you’re likely to have a lower life expectancy and, as such, specialist annuity providers are able to pay you a higher income.
Mr Tully says: “Some people don’t think they should tell their adviser or pension company about a health problem or a long-standing condition, for example high blood pressure. What might seem like a personal question about your health can have a significant and positive effect on the annuity income you could receive. Some companies even employ specialist advisers who are trained to ask the right questions in a caring and sensitive way to try to give you the best deal possible.”
The differences in rates may seem small at outset but, again, they rack up over the years. Retirement Advantage’s figures show that a less healthy retiree with a pot worth £53,000 could miss out on £15,040 over 20 years by not getting an enhanced annuity.
Specialist annuity providers estimate that between 60% to 70% of retirees would be eligible for an enhancement of some kind. However, most pension companies don’t offer enhanced annuities, so you are only likely to come across these specialist providers if you shop around.
5. Don’t assume you’ll get the full state pension
The new state pension (introduced this April) pays a headline rate of £155.65 a week, but while some 10 million savers will be better off with the new scheme (most notably the self-employed and women), double that number will be worse off. Indeed, government figures show that just 37% of the 400,000 people retiring in the coming tax year will be entitled to the full amount.
“People assume they will get it because they have paid into the system for 35 years,” says Alan Higham, founder of pension information site Pensionchamp.com, “and they are coming to me because they don’t understand why.”
The reason is that the new scheme isn’t simply a new, bigger state pension, rather it combines the old basic and additional state pension. This means those savers who contracted out of the additional state pension at any point in their working life – in return for lower national insurance contributions – won’t be entitled to this element in the new scheme.
However, just because you are not eligible for the headline rate, it doesn’t necessarily mean you will be worse off, as all those national insurance rebates should have been redirected into your private pension. In order to work out how much you will have to live on in retirement, it’s important you know what you’ll get from the state. Once you are 55, you can get an accurate state pension statement at Gov.uk/state-pension-statement.
What value can advice add to your decisions?
Cutting your tax bill
Sarah Jones is 56 and has no plans to retire, she earns £90,000 a year and has £400,000 in a pension. She’d like to give her daughter £50,000.
Without advice: Sarah will get £12,500 tax-free (25% of her withdrawal) but the remaining £37,500 will be taxed, giving her a tax bill of £19,240 and reducing the value of her £50,000 withdrawal to £30,760. Under new rules to prevent people from investing their savings to gain a tax advantage, the amount she can pay into her pension will fall from £40,000 a year to just £10,000.
With advice: Sarah splits her pension into two £200,000 pots. She leaves one alone and takes 25% tax free cash out of the other. The remaining £150,000 goes into drawdown but is left untouched. Sarah pays no tax and can continue to save up to £40,000 into her pension each year.
Source: NFU Mutual
6. Don’t underestimate your life expectancy
With an annuity, your income will be guaranteed for life – so even if you live until you’re 110, you can be sure that you will always be able to pay the bills. But if you decide to take advantage of the pension freedoms and manage your savings more flexibly, you will need to give serious consideration to your anticipated life expectancy to ensure you don’t outlive your savings. Unfortunately, this is not something we are very good at.
Alistair McQueen, savings and retirement manager at Aviva, says: “People tend to be influenced by their parents and how long they lived but that makes no sense as life expectancy is continually improving.”
He adds: “Men typically think they will live until they are 80, while women expect to die at 84, but hard analysis shows that if they are healthy a man is likely to live until they are 88, while women can expect to hit 89.”
There are a variety of life expectancy calculators online to give you some guidance, but on top of the fact that they will not be able to accurately predict your years on Earth, they may also just be based on UK averages. “There is a plus or minus five-year difference in life expectancy depending on where you live in the UK,” Mr McQueen explains, “so someone on the west coast of Scotland is likely to live five years less than someone in south-east England.”
7. Track down old pensions
Today’s workers can expect to have an average of nine jobs over their working life, so it’s easy to see how you might forget about schemes you paid into early on in your career, or were only a member of for a short period of time. Some people are also unaware of their rights regarding former pension schemes too, with worrying research from LV= showing that one in 10 people think they will lose their pension when they leave their employer.
According to LV=, there is currently more than £3 billion in lost pensions. The good news is that if you think you’ve got a plan that’s gone AWOL, you can track it down using the government’s Pension Tracing Service (Gov.uk/find-lost-pension). It will not be able to tell you the value of your pension, but it will be able to give you the contact details of schemes you are a member of, allowing you to be reunited with your money.
8. Don’t assume your situation will stay the same
You may be entering your golden years, but that doesn’t mean you are at death’s door. As life expectancy continues to rise, there is every chance you will live for another 20, 30, maybe even 40 years, and a lot can happen in that time.
While divorce rates might be falling across the board, the number of ‘silver-splitters’ is on the rise, with the number of men over the age of 60 getting divorced rising by 73% between 1991 and 2011, according to the Office for National Statistics.
Miss Tait says: “When you are on your own, you may have less support and may find it more difficult to get by financially.”
Health problems may also disrupt your retirement plans – you may end up needing to retire early to care for a sick relative, or find your own health deteriorates and that you need to pay for care as you get older. On the other hand, it may just be that a child moves to Australia and you need to set aside more money for long-haul flights. Whatever your retirement holds in store, it pays to maintain some flexibility so that your financial plan can change as your circumstances do.
9. Ignore inflation at your peril
While you may have the money to pay your bills when you first retire, if you don’t factor the rising cost of living into your budget, you may struggle in the years to come.
“The CPI measure for inflation is forecast to average over 2% for the coming 10 years,” says Mr Higham, “but inflation often hits retirees the hardest and their inflation rate could be as much as 4% to 5% a year.”
This is because the basket of goods considered by the CPI may not accurately reflect the typical spending habits of older generations, who tend to spend a greater proportion of their income on food, transport and heating. One of the best ways to counter inflation is to keep some of your money invested; alternatively, an investment-linked annuity should be able to deliver a rising income.
10. Don’t overlook the benefits of guidance and advice
Royal London research shows that 40% of people who withdrew cash from their pensions did not take advice because “they had already made their mind up”.
“It is like people don’t want to be talked out of the decision they have made,” says Miss Tait.
Simon Kew, associate director at Deloitte, agrees and warns that following April’s pension reforms, a little knowledge can be a dangerous thing.
“Rather than listen to a friend in the pub, coffee shop or workplace, free initiatives such as Pension Wise are there to be consulted first and foremost. Then, if questions or doubts remain, seek independent financial advice.”
Whether you have made up your mind or not, check out the box above to find out how advice can add value to your plans.
What value can advice add to your decisions?
Inheritance tax planning
Widow Marion Taylor would like to take the money from her husband David’s £300,000 pension as a lump sum. He was 74 when he died.
Without advice: Marion could take the money tax-free to invest in a portfolio of cash and shares. But even though she doesn’t pay income tax on the money (because her husband died before 75), it now forms part of her estate and gives her children a potential inheritance tax (IHT) liability of £120,000.
With advice: Marion leaves money invested in a portfolio of cash and shares within the pension and has access to income and lump sums when required. Income and gains within the fund are largely tax free, and Marion can nominate to leave the money to her children on her death free of IHT, offering a potential saving of £120,000.
Source: NFU Mutual
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. From April 2016, to qualify for the full state pension, individuals will need 35 years’ of NI contributions.
Open market option
People who have a money purchase or defined contribution pension, at retirement must use their fund (minus an optional 25% as tax-free cash) to purchase an annuity. As the annuity market is very competitive and rates differ vastly between annuity providers on a daily basis, the open market option is your right to shop around and buy the annuity from the company offering the highest rates at that time.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
Generally thought of as being interchangeable with life assurance, but isn’t. Life insurance insures you for a specific period of time, at a premium fixed by your age, health and the amount the life is insured for. If you die while the policy is in force, the insurance company pays the claim. However, if you survive to the end of the term or cease paying the premiums, the policy is finished and has no remaining value whatsoever as it only has any value if you have a claim. For this reason, life insurance is much cheaper than life assurance (also called whole of life).
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.