Pensions are the Cinderella of personal finance because they only deliver when you’re old, and the people who can do most about their personal finances are those who are still working. People’s situations vary much more when they have a lifetime of working life behind them. Most people who leave university and have a job have a shedload of student debt, and hopefully a shedload of human capital. Those coming up for retirement have had a working lifetime of variation between having some of that money stick to the sides or all being used for living plus incurring debt, they may or may not have a partner, they may or may not have had kids, they may have been buffeted by the vicissitudes of Divorce, Disease or Death (of close family), the divergence in circumstances just goes on an on. So pensions are terribly hard to generalise about, and much of what you would do has been made even more complicated with Osborne’s pension freedoms.
I know a few employees of The Firm read this, and it’ll loosely apply to others coming up to early retirement (55 plus) with a defined benefit pension – most public sector workers, and a fair few private sector workers if they were in scientific/technical roles and haven’t changed jobs for 15 years or more…
Note that pensions are complex, hard to generalise and vary from scheme to scheme. Employees of The Firm – take up the Wealth at Work seminars that are offered for free – and everyone, DYOR and consider taking independent financial advice before making irrevocable pension decisions.
A DB pension is valuable because it is defined. It lacks flexibility because it is defined
A typical DB pension is quite accurately defined, but the other side of that coin is that it lacks flexibility. One of the great things that seems to be have happened over the last five years or so is that more people are thinking about when and how they want to retire. I have to confess that I never did think about this – I joined The Firm’s pension scheme over 25 years ago and from that point I thought I would retire at 60, which happened to be the NRA of that scheme. Job done, end of thought. It was a total intentional living fail. That was excusable in the late twenty-something Ermine because like all young people I was never going to get middle-aged never mind old 😉
But the years did pass, and this fail got less excusable. I failed to address one of the most important things a wage-slave can think about – which is in the great balancing act between time and money that we have in the flight of the sparrow through the mead-hall that we call Life[ref]Venerable Bede , Ecclesiastical History of the English People[/ref], is the balance right for me? It is the age-old balance between the important and the urgent, where all too often the urgent gets all the attention and the important gets lost.
DB pensions were children of times when spending a large part of your working life at a single company was normal. Those times were more stable, and some might argue staid, and one of ways this is expressed is that retirement is not very flexible in a DB pension without taking massive knock-on costs. You can usually draw your pension early in a DB pension, but there is a reduction to account for the fact that it will be paid for longer. In itself that is fair enough, but the reduction usually disfavours the early retiree disproportionately more than other members. Obviously if you are going to retire before NRA you ideally need some money to pay yourself up to NRA.
Until about this time last year a SIPP was useless for that because they were meant to be a pension for life
because you either had to buy an annuity of go into drawdown at a modest rate that was designed to last a lifetime (typically 20 to 30 years), unless you had over £20k of guaranteed pension income p.a. in which case you were sorted. What you really wanted was a pension you could flatten over a short time, capital and all – the few years your early retirement until NRA. It doesn’t matter that you flatten your capital before you die if another pension comes along and picks up the heavy lifting. In my case that period is 55 to 60, on other cases it may be 55 to 65. In future it will be for 10 years (5x to 6x where currently x will go to 7 in a few years)
So in the past ISA savings were the priority for DB early retirees
There is no capital base behind a DB pension, but the estimated capital amount is valued by HMRC by taking the pension payable at NRA and multiplying by about 16. You can take up to 25% of the pension as a pension commencement lump sum, but this is hard to qualify with a DB pension – the amount of pension you lose to fund that PCLS is often disproportionally high.
However, The Firm’s scheme allowed me to build up a defined contribution component called an AVC – I targeted this to be a third of the estimated DB capital amount, so the entire AVC could be taken as the 25% PCLS. There’s nothing stopping DB pension holders taking out a SIPP, but then you can only take out 25% of the SIPP as a PCLS which isn’t as good as the AVC deal.
The reason for using pension savings was purely to get the tax benefit – the savings from not paying 42% tax/NI or even 32% tax/NI are too large to ignore. If I give up £58 and end up with £100 that is a return of 42/58 or 72% ROI. You just can’t ignore that if you are within a few years of getting it. But I couldn’t use it to retire early without losing part of the main pension due to drawing it early[ref]This is no longer strictly true though it was when I formulated the plan. I could and may move part? of it to my SIPP to make it up to the £70k described later. Before last year I would have had to have taken it as an annuity.[/ref]
But to pay my way until NRA I also saved into ISAs. Freedom from The Man was important enough to me to do without all the consumerism fun for three years. The great plus of ISA income is that it is not set against your personal allowance.
A short SIPP is now a great alternative as long as you don’t pay tax on it
The personal allowance is about £10,600. Many fifty-something people I know have BTL income with the deep religious significance of property in the British psyche, which is apparently taxable income. The Ermine gave up the property religion many years ago, so I have the full £10,600 available to me, because all my income is investment income. Although some of it is unwrapped that is still tax-free for these reasons. As it is I am still running down cash because I saved a shitload of cash before retiring so that gets reinvested.
Five years is a short time, there’s no need to wrangle with equities. So if you are retiring soon at 55 or later, load up a SIPP for as much as you can draw out tax-free before your DB pension NRA. If that’s 10 years you might consider holding some equities for the later years
How much can you draw out tax-free from a SIPP?
Take the number of years you will draw from it, until NRA. At that point your SIPP will be empty – the aim is to flatten it[ref]the exception to this is if your DB pension is below the personal allowance – in which case you may as well aim to top it up tax-free in the SIPP[/ref]
In my case that’s easy – five years, because the vast majority of my DB pension was based on a NRA of 60, and the earliest I can draw on the SIPP is 55. Each year I can draw tax-free £10600, so if I could put 5*£10600 = £53000 into the SIPP I wouldn’t pay any tax on taking it out.
But there’s more. You can take 25% of the money out right at the start of drawing it down as a PCLS. So the money I draw year on year is three parts out of four, so I can add on a third more, about £17600, making a total of £70600. The first tax year I draw £17600 + £10600 = £28200 and the subsequent four years I draw £10600. All tax-free. I have therefore turned a profit of £70600/5=£14120 because the taxman will add in that much, meaning I only have to save £56480.
The computation is simple – take the personal allowance × the number of years you want to draw the SIPP for until NRA and multiply by 4÷3 to allow for the 25% extra PCLS. That is the upper limiting case of how much you can save in a SIPP and get a guaranteed no-strings attached 20% return on your cash, less fees and inflation. It will cost you 80% of the total amount if you are a basic-rate taxpayer, less if you are a higher rate taxpayer or 45% rate.
Beware the annual limit
of about £40,000 or your entire salary whichever is lower. If I were working – I would be wise to save this over two years, £28240 one year (ie becomes £35300 in the SIPP) and the same the next. DB pension holders also need to knock off this the effect of any pay rise that raises their DB pension – this HMRC guidance note is your friend. It is easy for moderately Big Cheeses towards the end of their careers to fall foul of this. Imagine Mrs Roquefort on £50,000 with a pension payable at NRA of £25,000 and she’s in the last couple of years before NRA. If she gets a 10% pay rise on a she’s up for a £2.5k*20 = £50k lift so she’s SOL.
But I don’t have that much cash!
Bearing in mind that you will get the 25% PCLS and £10600 back as soon as you turn 55, you might consider borrowing it 😉 Even if you have to use the entire PCLS to pay the loan back you are still up on the deal by 20% less loan interest less fees. You should never borrow to invest, but this is not investment return – it is a return of the money you earned that was taken from you in tax.
Both borrowing money and having enough annual limit are easier when you are still working, so you probably want to play this game in the last couple of years of working.
Beware the Pension Recycling Rules
Note – this is my opinion, it is not advice. DYOR etc…
Another point in favour of spreading yourself out over a few years is this HMRC guide. Basically HMRC consider you are taking the piss when all of these apply
- the individual receives a pension commencement lump sum,
- because of the lump sum, the amount of contributions paid into a registered pension scheme in respect of the individual is significantly greater than it otherwise would be. Further guidance about what is a significant increase in contributions is at RPSM04104940.
- the additional contributions are made by the individual or by someone else, such as an employer,
- the recycling was pre-planned. Further guidance about determining whether the recycling was pre-planned is at RPSM04104930.
- the amount of the pension commencement lump sum, taken together with any other such lump sums taken in the previous 12 month period, exceeds 1% of the standard lifetime allowance , and
- the cumulative amount of the additional contributions exceeds 30% of the pension commencement lump sum. Further guidance about the cumulative basis of the recycling rule is at RPSM04104950.
Condition 5 is a PCLS of £12,500 or more (before Miliband gets in there). In future from Osborne’s changes you will be able to forgo taking a lump-sum PCLS and spread it out as you take the pension (ie take out 25% of your yearly SIPP income tax-free – this would equate to an annual tax-free SIPP amount of £14133 if that were your only taxable income) which would avoid that restriction because two amounts in the two-year scanning window is £8266 which is below condition 5.
It’s also worth noting pension recycling rules are all about the pension commencement lump sum. If you restrict your PCLS to £12,000 which invalidates test 5 and you keep your annual withdrawals below your personal allowance you still get a 20% boost to your money even if you premeditate, borrow the money and ramp up your contributions at the last minute 😉 There also is no law saying you must take the full 25% PCLS
Even ermines of independent means can do something here
I use this with Hargreaves Lansdown. Because Osborne made his changes after I had stopped work, I save purely in cash but because I am economically inactive I am limited to £3600 a year, I don’t think I can use my investment income as the level of income, it seems only selling time for money sort of income counts. Hargreaves Lansdown are piss-taking bastards on their fees for funds and equities, but as it happens for SIPP cash savers they don’t charge a holding fee (presumably they get interest on your cash). There’s a £354 account closing fee if the account is open for less than a year or £30 if it’s been open longer.
Because of the lousy imitations on what can be saved I’m not going to be in danger of pension recycling.
What are the risks?
There may be a change of Government in May. Miliband has already staked a claim on pension tax relief, and possibly dropping the annual allowance to £30,000. Although stories about abolishing the 25% PCLS do the rounds regularly before Budgets it hasn’t happened yet, and it forms a part of so many people’s pension planning it would be a little bit surprising if a politician wanted to pick a big fight like that. But it is a risk.
The Lifetime allowance continues to come down, Miliband is proposing £1m, and it is possible that this would spike the guns of people with a FSP of more than £50,000 at NRA (I have scaled HMRC’s £62500 down by 1.25 because the current lifetime allowance is £1.25 million). But to be honest if you’re earning a six-figure sum and coming up to retirement then damn well pay for pensions financial advice here because you will probably find it worth the fees 😉
I wouldn’t count on being able to use this ruse in five years time. But usually once you have started a pension even if Governments do piddle about with the rules they allow you to grandfather your existing rights, usually in return for not being able to contribute any more to a pension.
Sundry Government and HMRC meddling – this is always the problem with pensions. I’d be surprised if the Osborne pension freedoms are largely scaled back. The most obvious target in my view is higher rate pension relief. There are already calls from Miliband to ice that for 45% taxpayers and from Lib Dem Pensions Minister Steve Webb and Michael Hoban (a senior Tory) to flat-rate tax relief at 33% for all.
Mark Hoban, former financial secretary to the Treasury, said the present system, which allows savers to claim tax relief on pensions contributions at marginal rates as high as 45 per cent, was “skewed to the interests of higher earners”.
But in the end if you are a higher rate taxpayer then you may want to consider paying clever people with detailed knowledge to advise you 😉 Others will only gain from that change.