Collective Pension Schemes

This is the first of two posts that are a diversion from the step by step examination of planning for retirement and instead focus on issues that have been in the financial press in the last two weeks.

The first of these issues is the announcement in the Queen's speech that legislation will be introduced in the UK to enable the setting up of collective pension schemes.

My take on these schemes are that they provide a half way house between defined benefit schemes and defined contribution schemes.

In a defined benefit scheme the sponsor of the scheme (generally an employer) guarantees a certain pension, e.g a pension equal to 1/60th of final salary for every year worked. All the risk is with the scheme sponsor.

In a defined contribution scheme the sponsor guarantees to make a certain level of contribution to the pension pot, i.e. 5% of an employees salary for every year that he is employed.Now there is no guarantee as to the final pension that will be available, which is dependent on interest rates, developments in longevity and stock market returns. Now all the risk is with the scheme member.

In a collective scheme there is an expressed aim for the level of pension benefit but it's an aspiration not a guarantee, for instance the scheme will pay  a pension equal to 1/50 of average salary but if circumstances change we may have to reduce that percentage or reduce future indexation of the pension. So the risk is, kind of, shared between sponsor and member.

I'm not going to say much about collective schemes as they are not directly relevant to the theme of this blog which is me planning for my retirement.  As I'm 48 and self employed it's very unlikely I will be a member of a collective scheme.  But for people who share my nerdy interest in this type of thing this a good English language summary of Dutch pension schemes.

Just to editorialize a bit: I think the introduction of collective schemes is an interesting, encouraging and curious development.  Making provision for retirement forces a society to choose between a utilitarian approach, i.e come up with the best approach for society as a whole even if a few individuals get squashed in the process, against an individualistic approach that gives each person the right to make the choices that best suit them.  Since, at least, 1988 and the introduction of personal pensions, the UK has gone down the individualistic route.  This has been apparent not only in legislation (the new rules on draw down are a good example of individualistic legislation) but also in the Equitable decision where the contractual rights of guaranteed annuitants were placed above the best overall outcome for the company's policyholders.  Another example of an increasing trend towards individualism in pension provision is the closing to new members of many occupational pension schemes.  As an old school collectivist I was rather shocked by this. It seemed that many employers took pension holidays in the good times but as soon as the true cost of pension provision became apparent they reneged on their "moral duty" to do something to keep pension schemes open, although they did (generally) meet their contractual commitments to existing members.  However, my belief in a "moral duty" does not seem to have been shared by British society as a whole. Defined benefit final salary schemes were closed with barely a whimper, we didn't see company directors squirming in front of House of Commons Select Committees.

It's nigh on impossible to say whether the UK's pension individualism has been a success or not, as you are balancing financial loss against an increase in the freedom of the individual. But there is a strong case (maybe irrefutable) that there has been a financial cost to individualism. The Office of National Statistics concluded  "The UK, with a gross replacement rate of 32 per cent for average earners, has one of the largest pension gaps in the OECD, at 25 percent."

But if the UK introduces Dutch style pension schemes these will be unabashedly collectivist.  It is mandatory to join a a collective scheme, all members of the scheme get the same benefits regardless of health and sex, and benefits can only be taken as an annuity.  It will be interesting to see whether the UK is prepared to accept that degree of compulsion.

   

Employers Pension Contributions and National Insurance Contributions

A short break from my description of my attempts to build up a retirement pot to cover why employers, as opposed to employees, pension contributions are a good thing.

What makes employers pension contributions so compelling is that they are exempt both from employers and employees national insurance ("NI") contributions.  The level of employers NI contributions varies depending on contracting out but can be 13.8%.  For employee's earning more than £7,956 per annum employees national insurance is payable at 12% but this drops to 2% on earnings above £41,865.

The national insurance benefits of employer pension contributions are particularly valuable for people with their own companies which includes me.

For instance I could pay myself a salary of £10,000, with the intention of using this to pay a personal pension contribution.  But I already take a salary from the company and this uses up the employers and employees "NI free" band.  So the £10,000 salary attracts a NI charge of £2,240. (13% employers NI less corporation tax relief at 20% on the employers contribution plus 12%  employees NI).  Or alternatively I could just pay the £10,000 as an employers contribution, and pay no NI, it seems a no brainer.

Another group that can use the national insurance advantages of employer contributions are employees in their 50s.  That is the employer can pay the employee via pension contributions as opposed to salary, generating a national insurance saving for employer and employee.  The employee will have their money tied up in a pension but can access that at 55.  There may be non taxation considerations here (say redundancy is based on salary not including pension contributions) but given the national insurance benefits it should be possible to sort something out that was of mutual benefit to employer and employee.

The main downside to this is I'm not sure for how long the NI benefits of employers contributions will persist.  The Institute for Fiscal Studies has already identified it as "hard to justify" and it doesn't really to seem to "fit" with the 2014 - 2015 pensions regime.  Someone who was over 55 could just receive their salary as employers pension contribution, avoiding NI in the process.

So it might be a good idea to look to increase employers pension contributions now, whilst the going is still good.

The Limits on Pensions Saving

In previous posts I have explained that I am in the accumulation stage on my retirement planning, looking to build up a retirement pot using the tax advantages of pensions saving.

But because pension saving is tax advantaged the government doesn't want me doing too much of it and there are limits both on the amount I can save in any year and the total lifetime pension pot I can build up.  This post looks to outline these limits.  Although I work as a tax adviser I specialize in company tax and not pensions, so you need to take this as what it is, some notes on a complicated topic and not a definitive guide.

Limits on annual contributions

Annual Allowance

Every year the government sets out an annual allowance, which is the maximum amount that can be paid into pension pots by an individual in a year without an annual allowance tax charge being triggered.  For income tax the year runs from 6th April to 5th April.  The annual allowance for 6 April 2014 to 5th April 2015 2015 is £40,000.  The annual allowance is tested for the individual and not for the pension pot, so if I had more than one pension pot I would need to amalgamate contributions to all the various pots to see if I broke the £40,000 limit.

There is, however, a ridiculous complication that is the Pensions input period.  This was a new one on me but my reading of it is that if you, or your employer, are making contributions to a  defined contribution scheme then the pensions input period will just be from 6th April of one year to 5th April of the following year but the situation is more complicated if you are in a defined benefit scheme.

In applying the £40,000 allowance all pension contributions by, and on behalf, of an individual are counted.  So that includes employer contributions and any contributions someone else makes on my behalf (fat chance).  As I only have defined contribution pension pots the calculation is relatively easy, tot up the contributions made in to my pension and if they are under £40,000 then I shouldn't have to worry Link to HMRC website.  However, if you are in a defined benefit scheme then the calculation of contributions can become very complicated.

But even if my contributions are over £40,000 there is still the possibility that the annual allowance charge will not apply, as I can carry forward unused portions of the annual allowance from the three previous years.  There is an HMRC example of how this calculation works and also a annual allowance checking tool.  

Personal Contributions Cannot Exceed Income

As well as the annual allowance limit, personal pension contributions do not obtain tax relief if they are greater than the higher of 

a) £3,600

b) The taxable income of the person making the contribution.

This is a link to the HMRC material on this.  But it's important to note that this limit does not apply to employer contributions.  This is one reason why I make pension contributions via employer contributions (I have my own company), there are other reasons for using employer rather than employee contributions and I will return to these.

The Lifetime Allowance

As well as the limit on contributions there is a limit on the total amount that can be accumulated in pension pots by any individual.  From 6th April 2014 the lifetime limit is £1,250,000 (previously it was £1,500,000.)  What this means is that at certain points (generally when I start to take benefits from my pension pot) the value of my pension will be tested against this limit and if I have a pension in excess of £1,250,000 then this excess will be taxed at 55%.  As with the annual allowance the test applies to the individual and not the pension pot, so I have to amalgamate all my pension pots (including any defined benefit pots)  Personally there is no possibility that I will accumulate more than £1,250,000 in my pensions so I haven't covered this in any detail.  But there is some coverage on HMRC's website. 

As with other areas the position is fairly simple if you have defined contribution pension schemes, the value of a pot for the purposes of the £1,250,000 lifetime allowance is just the cash value of the pension pots concerned.  But it's more complicated where the pension is in a defined benefit scheme.  It seems that in this case the pension is valued at the annual pension paid on retirement multiplied by 20 plus any lump sum on retirement.  So it's relatively easy for somebody with a good defined benefit pension scheme to hit the £1,250,000 limit.

Pensions saving and Tax

As I explained in my previous posts I am in the accumulation stage of my retirement planning, i.e. I'm trying to build up a fund for my future retirement whilst still spending money on the good things in life. This post is about why I decided saving via a pension is the best way of building up a pension pot.

Although my decision is really tax driven I first had to think about non  - tax considerations, in particular: 

• I'm prepared to save via pension contributions because I'm prepared to tie up the investment until retirement age.  As I'm 48 years old I can access my pension savings in seven years at age 55. (Although if you are currently 40 or under you won't be able to access pension savings until you are 57 or maybe later.)

• I'm not interested in buy to let, as a way of building up a retirement pot.  If buy to let had appealed then I would probably have to do this outside a pension as its difficult to use pension savings to invest in residential property.

• When I get to retirement I'm quite happy to draw down my pension as a steady (ish) stream of income, I don't want to draw it all down in one go and buy a Lamborghini.  Even in George Osborne's new pension world, there is still a tax cost to taking your retirement pot in one go.  So if you aim to invest your retirement pot in, say, a business then you might want to consider a vehicle other than pensions.   

Because I'm not fussed by these non  - tax considerations I'm free to judge using a pension as a savings vehicle on its tax treatment, and I think there are compelling tax reasons to save via a pension. The UK pension system is often described as an "EET" regime this is because:

When I save money in to a pension then the income I save it from is tax  Exempt   

As money builds up in the pension it is tax                                              Exempt

When I take money out of a pension it is                                                Taxed

Although EET is a good way of thinking about tax and pensions the system is actually more generous than that.

• Firstly not all of the pension is taxed on the way out, it is possible to take 25% of the final pension pot as a tax free lump sum.  This is good news, I get tax relief up front for my pension but I am only partially taxed on the way out.  

• Secondly it is possible that retirement income will be taxed at a lower rate than earned income.  (This isn't a factor for me as I earn via my business that pays tax at 20% but may be relevant if you are employed. Then you may be able to save in pension,  reducing  income currently taxed at 45% or 40% and pay tax at 20% when you draw the income down in retirement).

Just to prove to myself that this all works I did a little numerical example that compares ISA investing with pension investing.  Assuming that the individual doing the saving pays tax on income earned now at 40% but suffers tax on future pension income at 20% then saving in a pension rather than an ISA can increase the income in retirement by 25%. I have deliberately left national insurance out of the example, as that will be the topic of a later post.

(Hopefully) You can download the spreadsheet from the link below.

ISA vs Pension

In my situation the figures don't look quite so good  (I maybe get 10% more income from saving via a pension than in an ISA compared to the 25% + for a 40% tax payer) but it still seems clear that pension saving is the way to go.

There are however a couple of drawbacks from saving via a pension.

• Although money builds up in a pension tax free this tax exemption is not complete.  If you invest in equities then it is likely that the companies you invest in will have already paid tax on their profits.  At one stage pension schemes could claim a tax credit from the government when they received UK dividends to compensate them for the tax the company paid on profits, but Gordon Brown stopped all that.  Although this is a bad thing, ISAs are similarly unable to claim back  tax paid on company profits so it doesn't change the comparison.

• Although the tax rules for pension saving are generous there are restrictions on the amount that can be invested in a pension and the total amount of pension saving that can be accumulated.  My next post will be on these rules.

Pensions and Saving

This follows from my post on the stages of retirement, I identified the first stage as accumulation.  For me the accumulation stage starts when you are old enough to be prepared to commit to long term saving even if it means having money tied up in a pension but you are still  working full time.

My financial goal in the accumulation stage is to maximize the pot that I have available for retirement whilst minimizing the bad things in life.

The bad things are

• Work that isn't congenial

• Cutting back my spending on things that I enjoy

Obviously it's possible that I reach a point where I just have to choose between good things and bad things. I might  just have to take on a bit of work that I'd really rather not do, or cut spending on "luxuries" in order to increase my retirement provision.  But I don't think there's any point blogging about that, the trade off of competing wants is a personal choice, what works for me might not work for you.  But if I come across something that boosts my pension pot and doesn't give rise to a corresponding bad thing then that probably is worth telling you about. 

To start with a basic point: saving is better than earning.  Earning is always likely to involve working and there is always the potential for work not to be congenial.  In my opinion once I'm working more than a certain number of hours a week, work is always uncongenial.

Secondly, I'm going to spend money for as long as I live, but I'm not going to earn money for as long as I live. So finding £1 of savings will have more life time value than finding a way to earn £1 more.

Finally, if I earn money I'm going to pay tax on it, but if I save money that's tax free.

Just to give you an idea of the second and third effects: I have rigged up a spread sheet to forecast my income in retirement.  If I show my income increasing by £1,000 per year until active retirement it increases my net lifetime income minus lifetime spending figure by £14,000. Pretty good.  But if I can save £1,000 then that increases my lifetime income minus spending by £37,000.

So last year I had a look at my spending.  I don't want to say too much about this, There are tons of sites on the internet that tell you how to save money although quite a lot of them read like Viz top tips. But some things that I did find useful were:

• Recording what I spent.  Fairly obvious point but hard to save without it and much easier to do now that 85% of spending is on a card.  It also shows how small spends can mount up, for instance I was spending over £1,000 a year on take away coffee.

• Walking. Walking is the looking forward to retirement blog, top tip.  It saves money, its the most enjoyable way of getting around and it helps your health.  Win win win.

• Stop spending money on stupid things.  Its unlikely that you are this stupid but I found I was spending £20 a month on contact lenses when I had laser surgery on my eyes 4 years ago.   And there were a few other long standing orders that got given the heave ho without reducing my quality of life one iota.

• Look out for commodities.  I class a commodity as anything where exactly the same product is sold by different providers. Accordingly you can reduce spending without sacrificing anything.  A good one for me was broadband, I switched from Virgin to Sky but when I phoned up Virgin to disconnect they then, magically, beat Sky's offer.  Utilities is another good area.

• Something I did, that I wouldn't do again, was spending less money on my property.  It became apparent that I was going to have to reverse some of the cuts else I'd end up living in something that was falling down and unpleasant to boot.  I'd characterize my mistake as confusing investment with pointless spending.

And, on that bombshell I'll finish.

Next week I'll do a  post on some tax and pensions points. 

The Stages of Retirement

This is a more general post on what I see as the financial stages of retirement and what  I need to look out for during each stage.  However, I wanted to make one folksy point before I get into the financial side.

I've been an accountant for 27 years (I started very young) and after all that time accountancy colonizes parts of the brain.  So when I think of retirement I tend to think of it as a financial issue.  But  the big issues around retirement are:

• What do I want to do and;
• Will I be healthy for long enough to do all the things I want to do. 

Obviously financial considerations are important but they trail in a poor third behind "wants" and health.

I'm not going to talk much in this blog about life and health issues, as what constitutes the good life varies so much between individuals, and the internet isn't exactly short of information on a healthy lifestyle. But I thought it was such an important point, that I should make it at least once.

OK back to the money.  For me the stages of retirement are as follows:

1.  Accumulation: say 45 - 55. Prior to 45 its probably not worth thinking too much about retirement.  Putting some money in a pension might be a decent idea but at 30 you don't want to have too much money  that can't be accessed until you are 55.  I have always left extra cash in my company for investment or future dividends. But now I'm 48, if I save into a pension then I can access that money in 7 years, so the tax incentives of pension savings become attractive. The questions that I need to answer are how much can I save? (which I suspect is the real biggy of all pension planning) and how to best navigate the rules around pensions to make the best use of the tax relief available.

2.  Part retirement say 55 - 62 I'd still envisage working at this age but fitting in work around other things.  A reduced level of income means that some years I might be saving, other years I might draw on the savings I already have.  The question of how much can I save is still there but not as crucial. Now I'm engaged in a fiendishly complicated optimization problem where I want to access income, and save, in the way that maximizes the pot (i.e. minimizes the tax) I have available for stage 3.

3.  Active Retirement say 62 - as old as possible.  I've packed in work now so the how much can I save issue is largely redundant. Now I need to ensure that I have enough income to allow me to have the lifestyle I want. Minimizing tax is still important but hopefully a bit more straightforward.   I have two new problems to deal with though.  Longevity (i.e. the possibility that my retirement stays active longer than I stay solvent) and inflation (i.e. my income becomes eroded by rising prices).  It's also a time to start to think about what I want to happen to my money when I dead, you can't take it with you they say (although Tutankhamun surely proved them wrong).

4.   Death and decay.  I'm hoping not to die or decay but just in case.   The question arises of will I be one of the 1 in 4 people who needs to go into long term care? and what is the best way to provide for this? Also how to bequeath any surplus cash on death.  Trying to answer these questions in my 80s / 90s is going to be difficult, so depressing though it is, I'm probably going to need to have these end of life questions in mind throughout stages 1-3 and, hopefully, get them sorted out in stage 3.

My plan for the blog in the next few months is to work through some thoughts for stage 1 and 2 interspersed with  updates as the government fills in some of the detail on the many areas of proposed pensions reform. 

Government Pension Reforms and drawdown

For my second post I wanted to cover the government's proposed pension reforms announced in the 2014 budget.

These proposals will give people more freedom to access their defined contribution pension pot when they come to retirement.  The changes come in two stages; stage 1 applies to the financial year commencing 6th April 2014 (i.e. the current financial year) and the more radical stage 2 is scheduled to be implemented for the financial year commencing 6th April 2015.

Under the current system I have the following options.

1.  If I'm over 60 and I have a small amount of pension savings then I can draw down all of my pension with 25% being tax free and the remainder taxable at marginal rates.

2.  Or at any stage from 55 onwards I could buy an annuity, at the point of taking an annuity I have an option to also take a, tax free, lump sum of up to 25% of the value of the pension pot.

3.  Or at any stage from 55 I can can choose to draw down an income from my pension pot.  There is a limit to how much I can draw down each year, and, as with the annuity option, at the point of draw down I can take 25% of the value of the pension pot as a tax free lump sum.

4.  There is a fourth option that applies only if I have a guaranteed pension income of above a certain amount and additional amounts in a defined contribution pot.  In these circumstances I can draw down all of the additional pension pot with 25% being tax free and the remainder taxed at the marginal rate.

This framework will persist for the financial year 2014  - 2015 but all of the limits will become more permissive. I have set this out in a table at the foot of the post.  HMRC have recently issued guidance for people who took out pensions at the end of 2013 - 2014 and who would like to unravel the arrangements to benefit from the reforms.

For 2015  - 2016 and subsequent years these old "access" rules will be replaced by a new,more permissive system.  At any age from 55 onwards I will be able to drawn down as much of my pension pot as I like regardless of the size of the pot or the amount of my other guaranteed income.  I will be able to take 25% of the pot as a tax free sum at any age from 55 on, all other draw downs will be taxed at the marginal rate. I've already established that I need to watch out for tax in planning my retirement

One other point of interest in the consultation document is that it makes a commitment to reviewing inheritance tax rates on defined contribution pots.  These are currently at 55%. 

I'd like to make a couple of "editorial" points.  

• Firstly this is not the end of compulsory annuities. No matter what lazy journalists might say compulsory annuities ended years ago.  What it does do, is make what used to be known as capped draw down much more straightforward, I don't need to worry about not taking an income above a certain limit dictated by the government actuaries department and there used to be some weird rules about draw down reviews that I never understood and now will never have to.  But the heart of the defined contribution system remains pretty much untouched, in terms of the contribution limits for pensions, the way that pensions are taxed and the restriction on drawing down pension pots before the age of 55.

• Secondly all of the detail on the proposed reforms remains outstanding.  Normally if the government was planning to reform the taxation of pensions in a year's time it would already have been through a long consultation process involving government agencies and other "stakeholders."  But this has not happened for these proposals.  Actually I think this is fair enough, consultation has a place but works best when government has set out the policy basics, consultation at too early a stage can be used to prevent change.  However, these proposals are supposed to be brought into legislation in Finance Act 2015.  Normally I'd say this is just not going to happen, but given 2015 is an election year I don't think deferral will be an option.  So there's going to be a lot of detail coming up in the months ahead, that I'll try and stay on top of and include in the blog. 

In the mean time I'm planning that next weeks post will take the chance to pull back from some of the detail and try and think about my financial aims for retirement.

		2013 - 2014		2014 - 2015
Small value pot		18,000		30,000
Maximum % that can be drawn down		120%		150%
Guaranteed income level for full drawn of additional pot		20,000		12,000