Last month I explained how the historic changes in pension rules from next year would make it easier to save up for a pension. This month I am looking at two more big changes on what the Government calls ‘A-Day’ – April 6th 2006. One is for people saving for a pension, the other for people living off their pension. In each case there will be much more choice about what you can do with your money.
Saving for a pension
At the moment, the money you save for a pension is normally with an
insurance company in one of its pension funds – which means it is invested in a
mix of shares, commercial property, bonds and perhaps some on deposit earning
interest. In practice you do not normally have much choice in the matter and
most people leave it to the experts. However, there is a growing trend for
people to use instead what is called a Self Invested Person Pension or SIPP
where you choose where your money is invested. At the moment a pension fund
cannot buy residential property or alternative investments such as works of art
or wine. So normally even a SIPP is invested mainly in shares and bonds. But
from April 6th these restrictions will disappear and if you have a
SIPP your money can be invested in anything you choose.
Immediately people think of investing in residential property – a second home in the Algarve or Cornwall or perhaps, more sensibly, a flat in a city where there is a well paid but transient population of potential tenants. But it is not that easy. You cannot just ‘put’ a property you own into your pension fund. The fund has to buy it. So you have to have enough in there already to do that. From April the fund will be able to borrow up to 50% on top of its value. So if you have a fund worth £100,000 you could use that to buy a property for £150,000, assuming of course that a lender would give the fund a mortgage for the rest. Overseas property would add complications – and expense. And it is not a good idea just to have one investment in your fund.
If the property is a genuine buy-to-let place that you intend to rent out all the year, then there are tax advantages. Any income from rent is tax-free and any gain when it is eventually sold (you will have to live on something when you retire) will not be liable to Capital Gains Tax. But if the property is one you want as a second home, there are disadvantages to balance against the tax gain. First, you will have to let it out as much as you can. Otherwise you may end up with a tax charge of 5% a year on the value of the property above £70,000. Second, if you spend time there you will have to pay the market rent to your pension fund for the weeks you stay. And you can forget those free weeks for relatives or friends. They will have to pay rent too.
Other things such as works of art, wine, classic cars, stamps, coins, clocks and so on can also in theory be bought by a pension fund. That means they are bought out of untaxed income and if they are sold there is no Capital Gains Tax to pay. But they do not generate income. So they are really only worth owning in the fund if you believe the capital gain is going to be bigger than the return you would get on shares or bonds. Nor can you use your fund as a way to indulge your collection tax-free. If you hang the pictures on the walls or drive round in those classic cars, that counts as ‘personal use’ of the assets and an annual 5% tax charge will be levied. You can avoid that by keeping the paintings in a bank vault. But that is expensive – and not much fun!
Living off your pension
One of the big complaints at the moment is that you have to use your pension
fund to buy an annuity. At the age of 75 that becomes compulsory and at younger
ages it is by far the best alternative unless you have a pension pot worth well
into six figures. From A-Day there will be a wider choice of what to do with
your money and the alternatives may appeal to many more people.
One little known feature of the new rules is that the Government has scrapped ‘retirement’. Neither the word nor the concept appears in the new laws. Instead, a moment arrives when you start taking money out of your pension fund. It goes by the catchy name of a Benefit Crystallisation Event – or BCE for short. And you can choose any time for that as long as you are aged at least 50 (or 55 from 6 April 2010). The big advantage of crystallising your benefits is that you can take your tax-free lump-sum. From April this is always 25 per cent of the value of your fund. You have put money in tax free, and now you can take a quarter of it out tax free. Under the present rules you have to use the rest of the fund to provide a pension. But from A-Day you can take a zero pension, leaving your fund to accumulate until you really want to use it to provide an income. You can even pay more in – and have a second BCE to draw 25% of anything you have paid in since the first one.
As long as you are under 75, you need not buy an annuity – an income for life from an insurance company. Instead you can choose to take what is called ‘unsecured income’. The money in the fund has to remain invested, but you can withdraw money from it to live on, up to a maximum amount, which is expected to be 120% of the income you could get from an annuity. Just to complicate things the definition is not related to real annuities but to tables produced by the Government Actuary. Those tables are ten years old and he will probably publish new ones before A-Day. But for now, reckon on 120% of what you could get from an annuity which provides nothing for your spouse and does not rise with inflation. At 65 that is around £690 a year for every £10,000 in your fund for a man and £650 for a woman and 120% of that would mean you could withdraw £828 a year (man) or £780 (woman). The rates are slightly better for larger funds – so a fund five times as big will produce slightly more than five times the income. If you want, you can take nothing and leave your pension fund to grow. The current rule that you have to draw a minimum income goes from A-Day and from then all current ‘drawdown’ schemes will become unsecured income schemes.
This unsecured income has to come to an end when you reach 75. Then you have two choices. You can, of course, convert your fund into an annuity and that will probably be the best choice – it will be a lot more per £10,000 at 75 than it would be at 65. Or you can take what is called an ‘Alternative Secured Pension’ or ASP (sorry about all the new jargon. Although the rules are simpler, the language certainly is not). You can withdraw money from your fund. But instead of letting you take out 120% of the figure from the Government Actuary tables, once you reach 75 you will only be able to draw 70%. That will be less than you could get with a standard annuity, though probably not much different from one that rises with inflation. The advantage is that the capital remains intact – remember with an annuity you give the capital to the insurance company and it guarantees you an income for life but when you die it keeps whatever is left from your money. With an ASP the balance of the money remains in your fund. However, when you die you cannot just leave the remains of the fund to your heirs. You have to transfer it to the pension fund of a spouse, a child under 21 or a dependant such as disabled family member you support. Alternatively, it can be transferred to the pension fund of another member in the same scheme. If none of that is possible, you can choose to leave it tax-free to charity. Wealthy families are expected to set up ‘family pension funds’ to allow money to be passed between generations. But for most people of ordinary means this rule is unlikely to be much use.
October 2005