The chancellor’s generosity couldn’t go on forever. Just days before his transformational reforms to pensions were enacted – the end of the compulsory purchase of annuities has at last given savers real power over their money when they reach 55 – George Osborne announced that the pensions lifetime allowance (LTA) would fall from £1.25m to £1m from April 2016.
This may still seem like an awful lot of money, and admittedly the allowance will be indexed to rise with consumer price index inflation from April 2018. But not only will those who exceed the LTA face punitive tax charges if they take money from their pension (at 55 per cent on any lump sum withdrawal), but a £1m pension pot – after taking 25 per cent tax free – would only be enough to buy a single life inflation-linked annuity of about £25,000 per year, says Stephanie Condra of AXA Investment Managers.
The lowering of the LTA was “one of the most negative aspects of the Budget,” says Jason Hollands of Tilney Bestinvest. “It looks like a shoddy attempt to neutralise a rather regressive Labour policy by adopting it.” Pensions expert Ros Altmann called the move “disappointing”, noting that it makes it “harder for people to plan their pension savings over the long term.” Indeed, it is a penalty for success – the investor bears all the risk of their investments performing poorly, but gains from strong performance are capped. The LTA has fallen dramatically since 2011-12, when it stood at £1.8m.
The Treasury expects the change will raise £1.9bn over the next five years. But you can survive the LTA, and prevent the government from taking more of your wealth than it needs to.
First, if you’re close to retirement and think you’re going to breach the new £1m limit, you aren’t completely powerless. As Alan Higham, retirement director at Fidelity Worldwide Investments, explains, “you can opt to protect yourself from the reduced LTA by freezing all pension contributions and keeping the current £1.25m limit.” The government is expected to detail how this will work soon, but as it’s such a complicated subject, Higham says that you should seek financial advice before acting.
For those not so close to retirement, it’s worth noting that the LTA is projected to rise to £1.25m again by 2029, if it is increased in line with inflation from 2018 as the chancellor has promised. So one big question is when to stop contributing.
As Hollands says, “this will present a challenge to middle class professionals who are mid-way through their careers.” Higham has calculated that someone aged 45 now, with a £700,000 pension pot, would breach the LTA with no further contributions at the age of 62 – assuming 4 per cent annual growth after costs. If they retired at 67, they would pay £43,000 in excess tax.
So it’s vital to keep a close eye on the projected value of your pension at retirement. It may also pay to take benefits early, says Higham. The rules determining when your pot size is calculated are complicated, and this is not an exhaustive list, but broadly it happens when you first access your funds and again at the age of 75. For defined contribution pensions, your pot size is simply the combined value of all your pension savings (for defined benefit, the rules are more complex). So if you expect to breach the limit at the age of 57, say, it might be worth taking sufficient money out at the earliest possible point – when you turn 55 – to avoid the excess tax.
Further, says Higham, if your employer is making contributions on your behalf, it may also be sensible to explore alternative forms of remuneration with them.
On the face of it, younger investors have little to worry about. Higham has crunched the numbers. A 25-yearold saving £1,000 a month in a pension, and increasing this amount each year in line with inflation, would not breach the LTA at the age of 70, assuming 4 per cent annual growth in their investments after charges and 2 per cent inflation. This is because the LTA is projected to rise to £2.34m while the individual will have accumulated £2.08m.
This, however, rests on certain assumptions – not least whether the government keeps to its promise to index the LTA. If the same person benefited from just 1 per cent extra growth per year, they would breach the LTA at the age of 67.
Pensions are still highly attractive, of course. Not only do you accrue tax relief at your marginal rate on contributions, but new tax rules mean that your pot can now function like a family pension. Osborne has scrapped the 55 per cent death tax which was previously levied on some inherited pension funds, and they can now more easily be passed on to children and grandchildren. Further, if you are a higher rate taxpayer and gain 40 per cent tax relief on the way in, but only take sufficient income to make you a basic rate taxpayer in retirement, you will be able to keep the difference.
Nevertheless, it’s worth considering alternatives to pensions to supplement your retirement savings. The Isa is the most obvious.
You can put up to £15,240 into an Isa this year – and while you don’t receive relief on the way in, once your money is inside the wrapper, it is entirely free from tax. As Maike Currie of Fidelity Personal Investing says, “there is no cap on how large your Isa investments can grow.” If you start an Isa at the age of 40, by the time you reach 68, you will have a £1m Isa pot if you contribute the full allowance each tax year, if the allowance rises in line with 2 per cent inflation, and if your investments grow by about 4 per cent annually after fees. Dividends from stocks and interest from bonds can be structured so as to provide a steady additional income stream in retirement, she says.
Currie adds that “soon-to-be-retirees may also consider other investment such as pensioner bonds or Venture Capital Trusts (VCTs)”. The former are subsidised by government and pay above-market returns, but are of limited availability and restricted to over 65s. They are also subject to tax. Octopus Investments managing director Paul Latham says that VCTs have “become an increasingly popular planning tool.” Figures from the Association of Investment Companies show that VCT inflows hit £429m in 2014-15, the most raised in a year since 2005-06.
VCTs were introduced in 1995, to encourage investors to put money into smaller companies whose shares are not listed on the main stock exchange. Octopus, the UK’s largest provider of VCTs, has products that focus on Aim-listed stocks, on early stage high growth businesses, and on small companies that require capital.
Given the nature of the firms VCTs invest in, Latham says “they should be considered a high risk investment – they are not suitable for everyone and I wouldn’t suggest VCTs should be used to replace pension planning completely.” Smaller firms have underperformed larger company indices over the past 12 months, weighed down by uncertainty in the UK and Eurozone.
However, the tax benefits are impressive. VCTs provide up to 30 per cent income tax relief on annual investments of up to £200,000, so long as the investment is held for at least five years and the investment remains “qualifying” under HMRC rules. Both dividends and withdrawal after five years are also free of tax. Furthermore, Latham argues that “over longer investment horizons, smaller companies offer potential for earnings growth that just isn’t found to the same extent in larger companies... it’s significantly easier for a small company to double a £1m profit, than it is for a larger company to double a £1bn profit.” Between 1955 and the start of 2015, £1 invested in the Numis Smaller Companies index would have delivered cumulative returns of £11,161, compared to the All Share index’s £821.
And if you do manage to survive the LTA and reach retirement with a wellfunded pension, Isas, and some investments held outside tax wrappers, what should you spend first? “Exhausting the latter, followed by the Isas, should probably take priority over touching the pension,” says Hollands. “Pensions are going to become very attractive from an inheritance tax perspective”.
IF A 25-YEAR OLD SAVES £1,000 A MONTH, INCREASES THEIR CONTRIBUTIONS EACH YEAR BY 2 PER CENT, AND ENJOYS 5 PER CENT GROWTH IN THEIR INVESTMENTS EACH YEAR, THEY WOULD BREACH THE LIFETIME ALLOWANCE AT THE AGE OF 67.
AGED 70, WHICH COULD WELL BE THE RETIREMENT AGE BY THEN, THEIR PENSION WOULD BE WORTH £2.68M, LEADING TO A £85,000 EXCESS TAX BILL OVER NORMAL INCOME TAX AT MARGINAL RATES.
AND THAT’S ASSUMING THE GOVERNMENT INDEXES THE LIFETIME ALLOWANCE FROM 2018 AS IT HAS PROMISED.