A MoneyWeek SpeciAl investment RepoRt. MoneyWeek. How to make Pensions Freedom Day work for You. ReseaRcH

A MoneyWeek SpeciAl inveStMent RepoRt MoneyWeek How to make Pensions Freedom Day work for You MoneyWeek ReseaRcH A MoneyWeek SpeciAl inveStMent R...
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A MoneyWeek SpeciAl inveStMent RepoRt

MoneyWeek How to make Pensions Freedom Day work for You

MoneyWeek

ReseaRcH

A MoneyWeek SpeciAl inveStMent RepoRt

Before investing you should consider carefully the risks involved, including those described below. If you have any doubt as to suitability or taxation implications, seek independent financial advice. General - Your capital is at risk when you invest. Never risk more than you can afford to lose. Bid/offer spreads, commissions, fees and other charges can reduce returns from investments. Taxation - Profits from investing, including both capital gains and dividends, are subject to capital gains tax and income tax respectively. Tax treatment depends on individual circumstances and may be subject to change in the future. MoneyWeek Limited Registered office 8th Floor, Friars Bridge Court, 41-45 Blackfriars Road, London SE1 8NZ. Registered in England Company No 1937374. VAT No GB629 7287 94. © 2015 MoneyWeek Ltd.

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Contents Introduction from John Stepek ....................................................................................................Page 4 The basics .......................................................................................................................................Page 5 The details ......................................................................................................................................Page 6 The pitfalls to avoid.....................................................................................................................Page 8

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a genuine pensions revolution For British investors, April 6 2015 marked the dawn of a golden age. That’s not because markets soared or because you were suddenly able to get a decent return on your savings again. It’s something much more significant. ‘Pensions Freedom Day’ marks a genuine revolution in Britain’s pension regime. We explain the changes in detail in this report, but it all adds up to you having a lot more freedom as to what to do with our pension pots when John Stepek you finally decide to take them. Money can’t buy happiness but financial freedom makes it much easier for you to pursue other more important goals in your life. At MoneyWeek, it’s OUR goal to help you use your pension freedoms to help secure your financial future. With that secure, you can go on to pursue whatever other dreams or ambitions you have in life. But to make the very most of these changes, and enjoy these newfound freedoms, you need to understand what’s going on. You also need to avoid potential pitfalls, such as the risk of draining your pot before you’ve had a chance to enjoy retirement, or being targeted by scam merchants. These changes should survive for (at least) the next five years – which suggests you can look forward to a greater degree of independence than perhaps any past generation of pensioners. So take full advantage! We’ll show you how. Good investing,

John Stepek Editor, MoneyWeek

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A MoneyWeek SpeciAl inveStMent RepoRt

The basics

In March 2014, Chancellor George Osborne stunned pretty much everyone by announcing some massive changes to the UK pensions regime. Voters (and the City) had grown used to Budgets being leaked heavily in advance, so that the potential for surprises on the day (at least, outside of the nasties hidden in the small print) was almost nil. Not this time. Osborne announced a series of changes that amounted to a wholesale revamp of the pensions industry.

1. Who do the changes affect? Osborne’s changes affect anyone who is saving into a ‘defined contribution’ (or money purchase) pension. That’s a pension into which you (and your employer perhaps) save for your retirement. There is no guarantee as to the amount of income you’ll receive when you retire – it all depends on the performance of the investments you put in your pension. This is very different to a ‘defined benefit’ (or final salary) pension, where you know what you’ll get once you retire – in effect, your employer (or potentially the taxpayer) carries the investment risk and you don’t have to worry. If you have a defined benefit pension and you think you want to take advantage of the new pensions freedoms, it may be possible to turn it into a defined contribution pension. But be very, very wary of doing so and take proper professional advice before you even consider it – defined benefit pensions are so advantageous compared to defined contribution that only a minority of those with special circumstances are likely to get a better deal by changing.

2. What’s changed? Several things have changed, but it boils down to giving you a lot more freedom with your pension pot. Traditionally, most people have used their pension pots to buy an annuity when they retired. An annuity guarantees to pay you a certain amount of income each year for the rest of your life. It sounds good, but the trouble is that today’s low interest-rate environment, combined with the general tendency of the financial industry to take advantage of consumers when it can get away with it, means that annuities have often – though not always – looked like poor value. It’s been possible to opt out in theory for a few years now, but in practice, few people have had sufficient independent income to avoid buying one. However, under the new rules, no one is under any obligation to buy an annuity at all. In fact since April 2015, you can take out all the cash from your pot in one go once you’ve turned 55. (For reasons we’ll get to later, this would be a stupid idea for most people, but it’s an option).

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Alternatively, you can withdraw an income from your pot, while leaving the rest invested to (hopefully) keep growing. Or you could take a series of lump sums – perhaps enough to last you for the year, without having to pay more than the minimum in tax on it. The choice is up to you. In this guide, we’ll explain all the different options, highlighting the pros and cons for each one.

3. What if you’ve already bought an annuity? If you’ve bought an annuity in the last two or three months, you may be able to cancel your purchase. It’s well worth contacting your annuity provider to see if you can do this. If you’re able to cancel your annuity, you can then sit down and work out what’s best for you. And if you’re unable to change your current annuity, remember that at least you have a secure pension income for the rest of your life – annuities aren’t all bad. If that’s no consolation, the government is consulting on establishing a second-hand annuities market, where you’ll be able to trade in your annuity for cash. There are several details to be ironed out – for example, how can you be sure of getting good value for your cashed-in annuity? The government initially aimed to have the market up and running by April 2016 but following the Summer Budget 2015, this has been delayed until 2017 at the earliest. While this is no doubt frustrating for those who want to move forward immediately, the government claims that the delays are required in order to provide policyholders with as much support as possible in making their decision.

The details

So what do you need to know about the changes to the pensions regime? We know that we won’t have to buy an annuity from the age of 55 now. What else is involved?

1. You still get 25% tax free One of the biggest attractions of pensions as a tax-efficient savings vehicle is that you’ve always been able to take 25% of your pension pot tax-free when you come to take it. That gives pensions a big tax advantage over Individual Savings Accounts (which are great, but don’t benefit from the 25% completely tax-free element). The good news is that – for now – the 25% tax-free bonus has stayed. But now it’s even better. You can still take out 25% tax free in one lump sum, with the rest of your pot taxed at your marginal income tax rate as and when you take it out. But you can also opt to take out smaller sums, and take 25% of each withdrawal free of tax (these withdrawals are known as uncrystallised fund pension lump sums). So it’s far more flexible.

2. How to avoid paying too much tax We know you’re not daft. Tempting as it may be, you’re not going to blow your entire pot on a Ferrari or a buy-to-let in Bournemouth. But – just in case – there’s one very good reason not to: You don’t want to pay too much tax.

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As we mentioned earlier, taking your whole pot out at once when you turn 55, is likely to be a bad idea. Let’s say you have £200,000 in your pot. You could take out £50,000 (25%) tax free. But if you took the rest all at once, you’d then have to pay tax on the other £150,000. Even assuming that you had no other income that year, you’d still pay tax of nearly £54,000, with a large part of your lump sum taxed at the higher rate of income tax. It’s simply unnecessary to pay that much tax. Say you took out £30,000 a year for five years instead (obviously this is just an illustration, not a recommendation!), you’d pay tax of around £3,880 a year, or £19,400 on the whole amount. So you save nearly £35,000, not through any complicated tax-planning manoeuvre, but simply by being sensible about your withdrawals.

3. The end of the death tax And speaking of tax, from Pensions Freedom Day, the ‘death tax’ on pension funds is being scrapped. Currently you can leave your pension pot to your children, but unless it’s entirely untouched and you are under the age of 75, it’s taxed at a 55% rate. This is no longer going to be the case. If you die under the age of 75, you can pass on your pot to your children entirely tax free (your spouse is already exempt), regardless of whether you’ve accessed it or not. If you are 75 or over, your children can still inherit – they’ll only have to pay tax at their marginal rate when they actually come to access the pension. In short, it’s now much easier to pass any leftover pension pot to your children – another benefit over the old regime that pushed most people to buy annuities.

4. You don’t get to ‘double-dip’ As it stands, you can put up to £40,000 gross into a pension each year (as long as you earn at least as much as you want to contribute). Contributions from basic-rate taxpayers are grossed up automatically (ie for every £80 they contribute, the tax office puts £20 in). If you are a 40% or 45% taxpayer, you have to claim the rest of your tax relief from the tax office – usually via your self-assessment form. However, once you have started withdrawing money from your pension – over and above the 25% lump sum – the annual allowance is reduced to £10,000. This is to make it harder for people to abuse the system by ‘recycling’ their tax-free lump sum in order to get tax relief on money that was never taxed in the first place.

5. What if I want to buy an annuity anyway? Some people will still want to buy an annuity. And it may be the option that suits some people best. If that’s the case, and you decide that you want the security of a lifetime income, it’s essential that you get the best possible deal. Make sure that you tell the provider of any health problems you have, or if you’re a smoker – put bluntly, you’ll get a better deal if your life expectancy is significantly lower than average. Also be sure to shop around and get quotes from a wide range of providers. Annuity Direct and Hargreaves Lansdown are two sites where you can compare quotes – you absolutely MUST do this if you want to make sure you get the best deal.

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The pitfalls

The new pensions regime means more freedom for everyone. But it also means taking on a lot more responsibility for managing your money in your old age. And as with any big change, there are some key risks to be aware of.

1. You might run out of money Annuities have their pitfalls, no doubt about it. But they have one advantage – and it’s a significant one. Your annuity will keep on paying out until – how to put this delicately you shuffle off this mortal coil. This is one reason that people were largely forced to buy them under the old system. It’s so that they didn’t run out of cash and become burdens on the state. So if you’re confident managing your own money, then Pensions Freedom Day is great news. You have far more scope to run your money in the way you think suits you best. But it in effect means that you have to set up your own annuity – a suitable income stream that will keep you going throughout your retirement. And unlike an annuity, this isn’t guaranteed. The fact is that it’s quite easy to underestimate your life expectancy. After all, on average, it keeps going up. By the time you retire, there’s a fair chance you could live into your 90s. Apparently even the Queen is having to employ ever-increasing numbers of people to sign off on her ‘Happy 100th Birthday’ cards to the growing army of centenarians! So you need to think about how much capital you can take out in any one year, while still hanging onto enough of a pot to fund the rest of your days of leisure. Clearly, the more money you withdraw, the quicker it’ll run out. But you might also make poor investment decisions – you might take too much risk. But it’s also possible that you won’t take enough, as we discuss in the next section.

2. The old ways of investing won’t do You’re also going to have to think differently about the sorts of investments you keep your pot in. In the days of the majority buying annuities, pension funds tended to use an approach known as ‘lifestyling’. When you were coming up for retirement age, these funds would gradually put a bigger chunk of your money into ‘safe’ (ie less volatile) assets such as bonds, and take some out of more volatile assets such as shares. This made sense. If you had to buy an annuity within a limited window of turning 65, say, then the last thing you wanted was for most of your pot to be sitting in shares, which could potentially crash by 50% in a really bad year. If you were buying an annuity with your pension pot in the depths of the financial crisis in 2008, for example – well, you really didn’t want to have much of your pot sitting in the stock market back then.

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However, now there’s no specific date on which your pension pot has to be ‘cashed in’ as it were. And that means the lifestyling approach no longer makes as much as sense as it did. Is there really any reason to slash your exposure to equities at the age of 60, say, if you are hoping that pot will continue to grow and be generating an income at the age of 75? Given that equities have had a historical tendency to rise in the long term (10 years or more) and given that there’s no need to withdraw your entire pot at any given time, then there is probably less need to make this shift from ‘risky’ to ‘safe’ assets – or at least, not as rapidly as the lifestyling model tended to.

3. Watch out for scam merchants It’s a sad fact that older people – judging by Financial Conduct Authority data (the FCA is Britain’s financial regulator) – seem to be unusually prone to being targeted by scam merchants. It’s very hard to give blanket guidance on what is a scam and what isn’t – the nature of the companies and the scams changes all the time. But there are some obvious red flags. If you are contacted out of the blue, be wary. If you are contacted by a firm whose name sounds a little bit like a well-known heavyweight financial company, but isn’t in fact related to that company, it’s almost certainly a scam. And be very wary of anyone offering to trade in illiquid or exotic or unregulated investments. But the golden rule is this – if it looks too good to be true, it is. If you are being offered much higher returns than you could get on a bank account or even in the stock market, and yet there’s little or no apparent risk, then walk away.

4. And of course, there’s the small matter of politics George Osborne’s changes to the pensions system are good as far as we’re concerned. But they also illustrate just how easy it is for politicians to meddle with your pension. Before this parliament, most people wouldn’t have imagined that a chancellor would be so radical as to virtually scrap annuities. And certainly the idea of being able to withdraw your entire pension (regardless of whether it’s sensible or not) at the age of 55, would have been dismissed out of hand. The problem is, there’s no way to guarantee that a future chancellor won’t be equally radical in the opposite direction – making pensions more heavily taxed, and much more restrictive. And you can’t even trust the current government entirely – in the March Budget, Osborne reduced the lifetime allowance too, from its current level of £1.25m to £1m from April 2016 (not half as generous as it might sound). Similarly, in the Summer Budget, the government announced a reduction in the annual allowance afforded to the highest earners.

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Currently, most people saving for a pension can save £40,000 a year and receive tax relief on it (so long as they don’t exceed the lifetime allowance of £1.25m). You can also use any unused portions of annual allowance from the previous three tax years. However, from April 2016, anyone whose total income, pension contributions and employer pension contributions exceeds £150,000 a year will received a reduced allowance. These changes shouldn’t affect those whose income (excluding pension contributions) is under £110,000, even if pension contributions take them over, but it does highlight how quickly changes can take place. You can certainly see a cash-strapped future government being tempted by all those big savings pots just sitting there – who’s to say that a one-off windfall tax might not appeal under certain circumstances? This may sound like the stuff of paranoid fantasies, but it’s worth taking seriously when you are planning for your future. For example, if you have 30 years to go before you plan to take your pension, that’s at least five more potential changes of government. Who knows what might be deemed acceptable by then? This is one reason why we’d still suggest investing at least some of your money via an Individual Savings Account (Isa). Their popularity and ease of access means that so far at least, they have proven a little less vulnerable to the whims of our politicians than pensions. MoneyWeek magazine is an unregulated product. Information in the magazine is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Appropriate independent advice should be obtained before making any such decision. MoneyWeek Ltd and its staff do not accept liability for any loss suffered by readers as a result of any investment decision.

© 2015 MoneyWeek Ltd. Registered Office: 8th Floor Friars Bridge Court, 41-45 Blackfriars Road, London SE1 8NZ. Registered in England. No. 04016750 VAT No. GB629 7287 94

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