The UK has seen a rapid rise in the number of people accessing their pension pots or enquiring about doing so, according to separate findings by Unbiased.co.uk and HMRC. A combination of pressures triggered by the COVID-19 crisis is driving more Brits to raid their pensions for one reason or another. And although many are wisely seeking advice on doing so, many more are clearly not – and may be risking their long-term security as a result.
Unbiased has seen a 91 per cent increase in the number of people seeking an independent financial adviser to give advice on pension drawdown. Meanwhile, HMRC figures show that in the first quarter of this year, the number of people using flexible pension withdrawals (i.e. drawdown) rose by 23 per cent compared to the first quarter of 2019. Withdrawals are now higher than they have ever been. Even though some of this is clearly due to a general rising trend, and partly pre-dates the crisis, the spike in demand for drawdown advice since the lockdown suggests it will accelerate from here.
Why are more people turning to their pensions in the crisis?
Anyone with a defined contribution pension can access it from the age of 55, though most prefer to wait longer. In addition to the usual reasons for wanting the money (e.g. retirement or semi-retirement), the coronavirus pandemic has resulted in two more.
Firstly, people furloughed from their work or made redundant may be in need of additional income, and could see their pension pot as a possible solution. Secondly, the stock market was badly hit at the start of the crisis, meaning that pension funds invested in equities will have lost a chunk of their value. Some holders of pension pots may have been alarmed by this dip, and hurried to move their money somewhere that they perceive to be ‘safer’.
There are indications that both of these things are happening. But there are likely to be unwanted and unforeseen consequences for those acting in haste without taking the necessary advice.
The risks of making early pension withdrawals
Workers aged 55 or over do have the option of accessing their pension pot to supplement their incomes. This can indeed be a lifeline if money is short, and isn’t necessarily a bad idea. Still, it is vital to understand the real risks and drawbacks involved.
The obvious point to make is that a pension accessed sooner will run out more quickly. If you planned to retire at 65 but start to take your pension at 55, the pot will have to last longer.
Even if it’s only a temporary measure (e.g. you draw pension money during the lockdown, and stop as soon as you’re back to work) there is still an unfortunate side-effect. Once you start to access your pot, you can no longer pay as much into your pension. Your annual allowance (the total you can pay into all pensions per year) drops from £40,000 to £4,000. It’s true that not many people pay in more than that in the first place, but for higher earners it can be restrictive.
Sadly, some people below the age of 55 may be tempted to try and access their pension pots, if they have few other sources of money. This is illegal (except when the person is suffering a life-shortening illness) so if it happens it is usually due to pension fraud. Accessing a pension in this way is never going to be a good option.
Another risk to be aware of is that of a very big tax bill (you can read more about this below).
The risks of moving your money out of your pension
Research by Moneyfacts.co.uk has suggested that some pension savers – worried by the stock market crash – may be moving their money into easy-access cash savings accounts. Moneyfacts has noted an increase in applications for such penalty-free accounts, happening in parallel with the rise in people accessing their pension pots.
Finance expert Rachel Springall said, ‘The rise in the number of individuals choosing to withdraw their pension cash hitting a new high is slightly concerning, especially as the value of withdrawals was the highest recorded for Q1 in any year since pension freedoms began. Retirees may well be doing so to boost their disposable income in light of the Coronavirus pandemic, however, any immediate respite could have a devastating impact on their pension provisions for the future that they may be unable to recoup.’
Though some might think it a prudent strategy to move pensions out of volatile funds and into a cash savings account, there are in fact huge disadvantages in doing so. The first downside is that withdrawing money after a crash ‘crystallises’ the loss, i.e. makes it real and irreversible, whereas leaving the funds invested would give them the opportunity to recover over time. Even the highest interest savings accounts cannot deliver the necessary level of growth.
The second disadvantage is that a pension is not like a savings account. Withdrawals from it count as income, so are taxed as income. This means you face yet another loss at the point of withdrawal, further cancelling out any benefit from lower volatility.
The third reason has been covered above – accessing your pension reduces the amount you can pay into it, so doing this before you’re ready is inadvisable.
The fourth, and perhaps biggest, obstacle is that your tax bill may be not just large, but excessively so, as explained below.
Lump sum losses: the tax hit of large pension withdrawals
Both courses of action outlined above run the risk of incurring a tax bill from HMRC that is actually more than you should really owe. Nevertheless this is tax you will have to pay, and reclaim any excess later. This can be an arduous process of form-filling and waiting, and at the best of times HMRC tends to move at a leisurely pace. Claims usually take at least six weeks, but in the current crisis, cash-strapped Brits may end up waiting many months to recover money that is rightfully theirs.
So how does this happen? It happens because HMRC assumes you will make regular pension withdrawals of a similar size throughout the year, and use this to calculate your tax band. So (incredible as it seems), if you make a single withdrawal of £30,000 from a pension pot in June, HMRC assumes you will do this regularly throughout the year, and so will put you in the higher-rate tax band paying 40 per cent tax (even though your actual income is nowhere near this band). You will therefore initially pay 40 per cent rather than 20 per cent tax on all your income, and must put in a request to recover the excess later.
Over £600m of tax has been overpaid and reclaimed by people making pension withdrawals since 2015. Steve Webb, a former pensions minister and now a partner at LCP, said, ‘[It is] unacceptable that HMRC routinely over-taxes thousands of people on one-off withdrawals from their pension pots, leaving them to fill in forms to claw back the excess tax that they have paid.’ He also pointed out that in the current crisis the system will prove even more unfair: ‘A lot of people who lose their jobs or suffer wage cuts will have reduced taxable income in 2020/21. As a result, they should be paying less tax on these withdrawals. But HMRC is going to carry on taking exactly the same amount of tax upfront as it has always done.’
It’s worth bearing in mind that 25 per cent of any pension pot can be taken as a tax-free lump sum, so people who are in genuine financial difficulties with no alternative courses of action may consider this a possible option. But those considering taking taxable lump sums should tread very carefully indeed, and never act without taking financial advice.
Those who are worried about the volatile stock market and the effect on their pension savings should likewise talk to a financial adviser. There are numerous options for reducing your pot’s exposure to risk, such as moving into less volatile assets, without cashing it in. The current times may be unusual, but independent financial advice remains as valuable as ever.
A version of this article was previously published by Unbiased 20th May 2020