Pension changes - what do they mean?
FROM April 2015, the way millions of people will be able to access their pensions will change.
People with defined contribution pensions will be able to get at their money from the age of 55 without penalty - rather than having to wait until full retirement - and they'll have more choice about what to do with those savings.
It's thought that more than 300,000 people a year will be affected - but what exactly do the changes mean?
What's changed, and for whom?
As mentioned, the changes apply to those in defined contributions (DC) schemes. That covers the majority of pensions, both workplace and personal - but for people with defined benefits or career average pensions the rules are thought to be unlikely to change.
And while some of those who became entitled to their DC pensions within the past year were given leave to defer arranging what to do with them until the changes came into effect, anyone who's already bought an annuity is locked in.
As well as the default access age being brought down to 55, the biggest changes are the options available to those who choose to access their funds, and how any money they take is taxed.
What you can do with the money
Until now, people were allowed to take a lump sum of up to 25% of their pension's total value tax free, but the other 75% had to be invested in an annuity or a drawdown policy.
From April, the annuity / drawdown option is no longer mandatory.
Instead people can choose to withdraw the lot or take it in a series of lump sums over time, buy an annuity, leave the money invested, or any combination of these options. There's no limit to what proportion of the pension can be used for each option.
Annuities, part one
The changes being brought in are partly as a result of concern that annuities as they stand aren't the best value for money.
The idea is that we use what we've saved to buy a policy which pays out a certain amount every year until we die, based on calculations about our life expectancy, interest rates and other factors.
A fit, healthy, non-smoker could be expected to live for much longer than someone of the same age who smokes, is unfit and has a poor family history or existing medical conditions. So the healthy person will be offered less per year than the smoker, as the money has to last longer.
From April, annuities providers will be able to vary how much they pay policy holders each year. That means people could arrange to be paid less in the early years when their health is good, and more later to help cover the cost of care, or to reduce the amount they receive when they qualify for the state pension.
Someone buying an annuity will also be entitled to take a further lump sum from that, as long as it's agreed when they sign up.
Finally, relatives or other beneficiaries will be now be guaranteed payment upon death. Previously, guaranteed annuities paid out for up to 10 years - but now all annuity funds must be returned to the family, and if the amount remaining is under £30,000 it can be taken as a lump sum.
As mentioned above, previously people could take 25% of their pension pot as a lump sum completely tax free - so someone with a £100,000 fund could get £25,000 without paying any tax on it.
Now, however, people will be able to take as much or as little as they want from their pension savings as a lump sum, but only the first 25% of each payment will be guaranteed tax free.
After that, the individual's personal tax allowance is applied, then the rest of the money is taxed at the marginal rate.
Say someone wants to withdraw £25,000, and they have no other income.
They'll get 25% - that's £6,250 - tax free. Then the personal allowance of £10,000 a year kicks in, meaning they'll get £16,250 tax free. The final £8,750 will be taxed at the basic rate of 20% - a tax bill of £1,750.
But a 55-year-old who earns £25,000 a year and wants to withdraw £25,000 as a lump sum will be in a very different situation:
The first £6,250 is again completely tax free, but the tax allowance is swallowed by their other earnings. So they'll be taxed on £18,750 of their lump sum - and because their total income for the year will be £50,000, some of it will be taxed at 40%.
Drawdown policies tend not to have received as much coverage, as they've typically been the preserve of people who have in the region of £200,000 to £300,000 saved.
Under drawdown the pension fund remains invested in the stock market - and therefore capable of decreasing in value as well as growing - with the holder withdrawing money from it, within certain limits.
There are two types of drawdown policy, capped and flexible. Capped policies won't be offered to new pensioners from April, with all new policies being based around flexible drawdown rules.
Those who already have capped drawdown policies will see what they're entitled to every year increase from 120% of what they'd receive if they'd use the fund to buy an annuity, to 150%.
Flexible drawdown previously required a guaranteed pension income of £12,000 from other sources - annuities and the like - before the holder could take any money from their investment. Under the changes, there's no longer a minimum "other sources" requirement.
As above, the first 25% of the money is tax-free, but the rest will be treated as income and taxed accordingly.
In recognition of the fact that many people have managed to amass several pension pots as a result of changing jobs, the rules regarding collecting multiple pensions have changed too.
Previously even small pensions funds had to be converted into annuities. However, the total amount of pension wealth that can be taken as a lump sum is now £30,000 - based on taking lump sums of up to £10,000 from up to three separate pension pots.
With people moving between jobs and pension funds during their careers, those with several small pensions could now get something significant out of them sooner, rather than being drip-fed over many years.
What you should think about
Annuities, part two
Annuities are therefore still one of the better options for people who suspect they've got more than a few years left in them, and considering the flat-rate state pension provides just over £7,000 a year, that guaranteed extra income is going to be vital for many.
But the changes outlined above might not be enough to fix the problems with them.
There's confusion and frustration about how payments are calculated and how fees are levied, and with the increased choice available from April, it's thought fewer people are going to buy them - which means those who do are likely to see reduced choice and higher costs.
What if you need care?
Age UK says around three quarters of us will need some form of care as we get older. While around half of us will have costs of about £20,000, but around 10% of us will spend more than £100,000 on care.
At present pension funds are counted as savings when people are means-tested for care. From 2016 however, any money locked in a pension scheme will be excluded. Combined with a £72,000 cap on personal expenditure for care over a lifetime, this should mean more people will be likely to qualify for help with care costs.
However, any money withdrawn from a pension, whether as a lump sum or annual income, will be counted when it comes to means testing - so taking a large chunk could affect how much financial help people are entitled to, if any.
It's clear to see that with the increased choice comes far more responsibility, and far greater chance for many to get their financial planning horribly wrong.
So a free and impartial advice service, Pension Wise, will be available to everyone with a defined contributions pension, offering unlimited guidance on:
- How people can use their pension pots
- The different types of pension they're likely to have
- Tax issues
There's more on what the service will offer here.