UK pensioner’s love affair with the tax-free lump sum appears as strong today as it did thirty-one years ago.
Back then, despite very strong rumours to the contrary, the then Chancellor, Nigel Lawson, decided not to restrict individuals’ rights to it. Here, in 2016 however, in these post-pension freedom days, the question has to be asked: how appropriate is the affair?
For instance, as a starting point, the Financial Advice Market Review recommends the use of rules of thumb and nudges to improve consumer outcomes. Is the term ‘tax-free lump sum’ the biggest nudge available in savings but not necessarily in everyone’s best interests?
Let’s start at the beginning. Where does the tax-free lump sum evolve from?
In the 1970s the pension tax code for occupational pension schemes allowed, depending upon the period of completed service, a tax-free lump sum up to one and a half times final earnings to be taken at retirement. This was converted to a pension equivalent and offset against the maximum pension of two-thirds’ final earnings, again depending on service which allowed employers significant flexibility in the design of their schemes.
Of these, some schemes were modest and just provided a lump sum on retirement. You’ll appreciate therefore where the traditional view of the final day at work comes from, with the boss saying thank you to the employee, wishing them a long and healthy retirement, and handing over a carriage clock and the obligatory cheque.
The introduction of personal pensions, followed by the ‘A-Day’ pension reforms, moved us on however to a world where 25% of the value of the pension accrued could be taken in the form of a tax-free lump sum.
Now, the term tax-free lump sum, rather obviously, has two components – ‘tax-free’ and ‘lump sum’. The pension freedom changes, however, enable these elements to be split. Going back to the original occupational schemes all lump sums from all schemes of the same employer had to be taken at the same time otherwise rights to other lump sums were lost. This was not particularly flexible and is now not the case.
So, in today’s environment is there still an obligation to take a lump sum?
Instead, today an individual can take a lump sum at any time – although some of it may be taxed. Similarly, 25% of the pension savings can be drawn in regular instalments tax-free which really puts the individual’s personal circumstances at the heart of the decision.
So, in today’s environment is there still an obligation to take a lump sum? Well, there may be if the client needs to repay a mortgage, or pay off some other debt; perhaps there is a need for urgent house repairs or a celebration or other family need. However, if there is no reason to take a lump sum, why take it? What is the client actually going to do with that money?
For a start, many people simply do not have sufficient pension savings to provide a lifetime income that will meet their needs. And one way to stretch those savings is to take advantage of tax-free allowances.
Case study
Consider Ali and Michelle. Each has modest pension savings but no debts. They have state pensions of £8,260 and £7,060 per annum, respectively.
Ali can draw a further £2,400 before becoming liable for income tax.
To this, he can add a further £800 of his pension tax-free allowance making a total tax-free income of £11,460.
Michelle can draw £3,600 to which she can add £1,200 pension tax-free allowance giving a total income of £11,860. Combined their income could be £23,520 without paying any tax.
Should an emergency arise they still have the unused tax-free pension allowance to take the necessary lump sum. Assuming Michelle has the smaller pension fund, for example, £35,000, if a lump sum is not required, this approach will provide six to seven years’ income before Ali and Michelle need to consider using other wealth, for example, releasing equity from their property in order to finance the remainder of their wealth.
Changing mindsets
So how do we wean people off the desire to take the tax-free lump sum? Each year I receive a statement from my pension provider which shows the benefits I can expect from my pension. It shows two scenarios; taking the whole fund as income or taking 25% as a tax-free lump sum with the balance being taken as income.
I would suggest the first option should also say that often 25% of this income can be paid tax-free. The second option should be removed from illustrations and replaced by: ‘There are a number of lump sum and regular income options available that can be tailored to meet your personal circumstances.’
This would certainly help avoid nudging people in directions that may not be in their best interests.
Bob Champion is chairman at Later Life Academy
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