Pension awareness has to start with the government
Friday 15th September 2017
Written by Jonquil Lowe
Pension Awareness Day, 15 September, is becoming an important annual fixture. It aims to encourage us to save for retirement and help employers communicate pensions simply to their workers. According to Scottish Widows, only 56% of people are saving enough for their retirement and getting people to engage with pensions is tough despite ever more employees being automatically enrolled into a pension scheme at work. The core message of Pensions Awareness Day is straightforward: take your future into your own hands by setting aside money now to provide for yourself in later life. But for significant – and growing – groups of people using pensions is anything but simple.
Any suitable investments can be used for retirement planning, but saving through a pension scheme has advantages: the government usually tops up what you pay in, turning every £100 you save into £125 (and extra tax relief may reduce the cost of saving even further); your investments grow tax free; when you eventually draw money out, a quarter of it is tax-free; and, if you’re an employee, your employer must normally pay into your scheme for you.
For most people, this makes pension schemes a no-brainer, but if you’re a higher earner or you’ve cashed in some of your previous pension savings, saving is more complicated.
There is no limit on the amount you can pay into pension schemes. However, to contain the cost to the government of the various tax breaks, if your savings go above various limits, you have to pay a tax charge that in effect claws back the tax advantages. There are two limits to worry about: the Lifetime Allowance and the Annual Allowance.
The Lifetime Allowance is a cap on the total value of your pension benefits over your lifetime. Currently, the Lifetime Allowance is £1 million, though it used to be much higher. Each time benefits (for example, lump sums, income or death benefits) are paid out from any pension schemes you have, their value is checked against the Lifetime Allowance. If the running total of amounts paid out exceeds £1 million, then you must pay tax equal to 55% of lump sums over the limit and 25% of income (in addition to any tax due under the normal income tax rules). £1 million may sound like a huge pot of savings, but pensions are expensive. At today’s annuity rates, £1 million would buy a 68-year-old an inflation-proofed pension of around £36,000 a year. Some types of pension scheme (defined benefit schemes, like final-salary and career-average schemes) promise you a certain level of pension rather than a pot of savings and to value these against the Lifetime Allowance, you multiply the annual pension by a factor 20. This means that a pension of £50,000 a year would use up the whole Lifetime Allowance.
With the average (non-state) pension income of current pensioners standing at £12,400 and savers typically aspiring to a retirement income between £20,000 and £30,000, most people are well short of breaching the Lifetime Allowance. However, the second limit on saving, the Annual Allowance is fast becoming a trap that may catch less affluent savers as well as higher earners.
The Annual Allowance puts a cap on the amount by which your pension savings may increase each year. Go over this limit and you’ll have to pay extra tax. With most pension schemes, the increase equals the amount of contributions paid in by you and for you by anyone else, such as your employer, including any tax relief added by the government. If you have any defined benefit schemes, the increase in your savings is valued as the amount by which your promised pension rises multiplied by a factor of 16. For example, suppose you are expecting to get a pension that will be 50% of your pay and your pay goes up by £1,000 a year. That means the pension you are promised will rise by £500 (50% x £1,000) and, for Annual Allowance purposes, that is deemed to be worth £8,000 (£500 x 16).
The standard Annual Allowance is currently £40,000 a year - though, if you have not used up your full Allowance in any of the previous three years, you can carry the unused part forward, which could let you pay in quite a large one-off sum. So far so good – now come the tricky bits.
Your Annual Allowance is reduced if you are a higher earner – broadly, that means earning £150,000 a year though you could be caught at £110,000. Under almost impossibly complex rules that involve anticipating in advance what your earnings for the tax year might be, you could find your Allowance tapered away to as little as £10,000.
Separately, since April 2015, if you’ve reached at least age 55, you have a lot of new choices that let you use your pension savings (other than defined-benefit schemes) flexibly, including drawing out cash lump sums either at or before retirement. There are no restrictions on how you use your savings - for example, you might draw out cash to pay off your mortgage, give your kids a helping hand or just spend it. Depending on how you use this flexibility, part or all of any cash lump sum will be tax-free.
What a money-builder it would be if you could take out the tax-free cash and pay it back into your pension scheme with the government topping up your savings again as the money goes in – in theory, you could recycle your savings many times getting the tax breaks every time. But the government anticipated this and put in place rules to stop you recycling your savings in this way. The rules mean that if you use the new pension flexibilities, then the amount by which your pension savings (with the exception of defined-benefit schemes) can increase each year – called your Money Purchase Annual Allowance (MPAA) – was restricted to just £10,000 a year until 5 April 2017.
Legislation currently going through Parliament will restrict this limit even further to just £4,000 a year backdated to 6 April 2017. So, if you cashed in your pension savings in order to pay off your mortgage, say, expecting to rebuild your pension savings in time for retirement, you could find that you can no longer pay in as much as you need.
Pension Awareness Day has a laudably simple message: save more for retirement. While this message works well for many people, the reality is that the government has created a quagmire of rules that make saving through pension schemes full of traps for the unwary. If we are all to make well-informed decisions about planning for retirement, it needs to start with simpler government rules.
*Jonquil Lowe is a Senior Lecturer in Economics and Personal Finance at The Open University
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