The big surprise of this year's Budget is the proposal to fundamentally rejig how defined contribution investment pots can be used to provide a retirement income.
The current problem with DC
The DC pensions industry, both trust-based and contract-based, has been taking something of a battering recently over how it provides (or more to the point does not provide) good value and retirement outcomes for savers. A key issue is how investment pots are turned into retirement income.
Presently, DC savers have three choices. Members with a high, alternative, retirement income (currently £20,000 per year) can use flexible drawdown to take money from their pension pot as they wish. Most people, however, do not qualify for flexible drawdown and have to use most of their pension pot to buy an annuity – 25% can be taken as a tax-free lump sum. An alternative to purchasing an annuity is capped drawdown where members can draw an income of up to 120% of the annuity they could purchase. Capped drawdown, however, lacks flexibility and can be difficult for savers to understand.
The Financial Conduct Authority found recently that the annuity market does not work well for savers. Although members can shop around for an annuity (the open market option), most buy an annuity from their pension provider. This often does not provide best value for money. Many people also do not receive financial advice to help them with their annuity purchase and may not choose the annuity which best suits their circumstances. For example, many people choose to buy annuities with no inflation protection, not realising how, over time, inflation will reduce the purchasing power of their pension.
The Government's solution
The Government's solution to this problem is to empower members with more flexibility as to how they use their pension pot. Its key proposals are:
- From 27 March 2014, flexible drawdown will be available for members with an alternative retirement income of £12,000 per year (down from £20,000). Capped drawdown limits will increase to 150% of the annuity which a member could purchase. From April 2015, all savers will have unrestricted access to their pension pots in contract-based schemes from the age of 55. 25% of the pot can be taken as a tax-free lump sum with any other withdrawals taxed at marginal income tax rates.
- From April 2015, as well as the current 25% tax-free lump sum that members can take from their savings pot, members will be able to take some or all of the remaining value as one or more lump sums, taxed at their marginal rate of income tax. Lump sums exceeding a quarter of the value of a person's pension pot are currently taxed at 55%.
- From April 2015, all members will have to be provided with free, impartial, face to face guidance on their pensions choices when they decide to retire. This will allow them to make the best retirement choice for their circumstances and remove the risk of ignorance leading to reduced retirement incomes.
- For those members who want to buy a guaranteed income in retirement, there will be a new form of pensioner bond. These will become available from January 2015 and up to £10,000 per year can be bought by people over 65. They will pay a fixed rate of interest, with early estimates suggesting a rate before tax of 2.8% for a one-year bond, and 4.0% for a three-year bond. The exact rates of return will be decided in the autumn.
- From 2028, the minimum age at which pension savings can be accessed will increase to age 57. This will maintain a ten-year gap with state pension age which will then rise to age 67.
The Government is also going to review how pension funds are treated on death with an indication that tax rates will be reduced. We support such a review as the present system can act to deter saving through a pension.
There are some other changes around trivial commutation which fit into the same overall framework:
- Members with limited retirement savings across several schemes will be able to commute total savings of up to £30,000 into a lump sum, up from the current £18,000. 25% can be taken tax free with the rest subject to income tax at marginal rates. The FCA's recent thematic review clearly shows how significant this will be as the average member pot in the review was well below this level
- Members with a small pot of retirement savings in a single scheme will be able to convert this into a lump sum where they have up to £10,000 of savings, up from £2,000. This can be done for up to three schemes, an addition of one scheme to the present limit - so £30,000 in total. 25% can be taken tax free with the rest subject to income tax at marginal rates.
More broadly, ISAs are also being simplified and expanded. Rather than there being separate cash ISAs and share ISAs, there will be a single ISA. The maximum annual amount that can be paid into this unified ISA will be £15,000, replacing the current £5,760 limit for cash ISAs and £11,520 limit for share ISAs.
Finally, HMRC will be given additional powers to deal with pensions liberation through the mechanics of its registration process. These include HMRC being able to consider whether an administrator is a fit and proper person to administer a registered pension scheme, and also a broadening of the grounds for deregistering suspect schemes.
How will things work in practice?
Given the breadth of the proposed changes, the Government has launched a consultation on practical implementation issues and on consequential changes for DB schemes and the overall pension system. Particular issues on which the Government is seeking input include:
- Should the new flexibility be optional or compulsory for trust-based schemes and how can the new system be designed to enable innovative pension products?
- Should there be a ban on DB to DC transfers? This will apply to the public sector schemes (but possibly not funded public sector schemes) and the Government has proposed that a complete, or a more limited, ban should extend to private sector schemes.
- Should the normal minimum age (currently age 55 except where a member is in ill-health) for using a pension pot be linked to state pension age? For example, this age could be linked to an age ten or five years younger than state pension age.
- How would the independent advice requirement be met? Would this be by information from the provider, or a separate organisation, and should this vary between trust-based and contract-based schemes? The Government has also asked for views on whether there should be on-going financial advice during retirement.
- What impact the changes will have on the investment and financial markets overall?
What do we think of the proposals?
The proposals represent a radical change to the current pension system and a U-turn on the policy decided in April 2011 by the Treasury not to allow early access to pension savings. Many issues will need to be worked through in finalising the new system and we hope that every effort will be made to make the new system as simple and clear as possible - not something on which Governments have a good track record. The speed with which the Government will need to put these measures in place may also count against a well co-ordinated implementation. We have doubts, for example, as to how realistic it is to get a retirement guidance system in place within the space of 12 months, especially as the details of the system remain to be worked out.
From a pension saver's perspective, we welcome the Government's decision to give members more flexibility in how they use their pension savings. The current system on how pension savings can be used is inflexible, difficult for members to understand and for many provides poor value for money. The changes will also better accommodate the more phased approach to retirement being adopted by more and more people.
We have reservations that the proposals go too far, especially in allowing total pension savings to be withdrawn at any time and that this could result in some savers using their pension pots in a way which fails to provide a sufficient retirement income throughout their life. Keeping some limits based on the value of other sources of wealth and income would seem a sensible precaution. The Government, however, has considered and discounted this risk and believes that people should be trusted to decide how best to use their pension pots. It considers that the new state pension system will significantly reduce the risk of profligate pensioners becoming a burden on the public purse. Other elements of the proposals, such as the wider provision of financial advice and possible increase in the earliest age for using pension pots, will further mitigate against this risk.
Savers will no doubt be happy about the increased flexibility, especially on lump sums. We expect howls of protest, however, should there be significant increases to the minimum age at which a pension pot can be used (for example, by setting it at an age which is only five years below state pension age). We believe that such a change should be avoided as it may act as a disincentive for people to save through a pension.
Impact on providers
Immediately following the Chancellor's announcements, there was a sharp drop in the share price of some insurers and particularly specialist annuity providers. Some commentators have speculated that the changes represent the death knell for annuities. We believe this is an overreaction and there is likely to remain a demand for alternatives to drawdown, particularly investment-linked and fixed-term products. Innovative providers will see the changes as an opportunity.
The Government has announced that it will be providing £20 million of funding for the right to guidance scheme that will assist members in making the right financial decisions at retirement. One of the main questions is how the additional costs of this will be funded. The proposals involve members receiving impartial and face to face advice and possibly from a third party rather than the providers themselves. Face to face advice is much more expensive to deliver than either telephone advice, or providing information on paper. The consultation is silent on this point, appearing more concerned with how and what advice will be delivered, rather than how this will be funded. Passing on the cost to members will be complicated if a charge cap is imposed.
The consequences of the changes for trust-based schemes will depend on whether they are forced to offer drawdown. The Government is considering whether the proposed new flexibilities should be mandatory or whether they will remain subject to contrary scheme rules. We believe that in principle it is best to avoid differences between trust-based and contract-based schemes but that the new system should operate so as not to impose significant additional costs on employers providing trust-based schemes.
For DB schemes, we believe that the Government is right to consider restrictions on DB to DC transfers as the new flexibility could cause a run on DB schemes with adverse consequences for employers and remaining scheme members. We do not favour a complete ban, however, and think a system where trustees or employers have a discretion as to whether or not to allow transfers, or where there are exceptions for certain members such as those in ill-health, would be more appropriate. It will be interesting to see if the possibility of a DB to DC transfer ban will spur employers to implement enhanced transfer value exercises over the next year. The Government already has the power to ban this type of exercise and even if employers are following the incentives code of practice, the Government could temporarily apply the brakes while it formulates its policy on a transfer ban.
The increased trivial commutation limits are likely to be welcomed by trust-based schemes. They will allow them to provide more cost-effective benefits to members with small savings pots. A lump sum will be a great deal easier to administer than the purchase of a very small annuity which, in most cases, even if a provider can be found, will offer poor value for money. The enhanced limits will also ease the burden of paying small pensions for DB schemes.
You can find full details of the HM Treasury Budget 2014 proposals here.