A review of the retirement market by the UK regulator has raised concerns a growing number of people could be making poor decisions regarding their personal pensions.
In 2015 a raft of changes were made to money purchase pension rules. Many people were no longer compelled to buy an annuity, a product offering a guaranteed income for life. Instead, those reaching retirement age could choose the more flexible, though potentially riskier, route of pension drawdown – keeping a pension fund invested with the option of taking withdrawals – or even withdrawing the entire pot.
In the interim report from a study of the impact of pension freedoms, the FCA’s Retirement Outcomes Review, summarises how retirees’ behaviour has changed. It also reveals that significant numbers of people may not be making informed decisions with their personal pension pots – possibly leading to higher charges, needlessly paying tax or other mistakes that result in missing out.
The study outlines that accessing pension pots before age 65 has become “the new norm”. Around 72% of pots that have been accessed were accessed by consumers under 65, and the majority of those who took this option demonstrated a preference for lump sums rather than a regular income.
The findings also show over half of pension pots accessed were fully withdrawn. Although 90% of these were below £30,000 in value, there could be a number of cases where there was significant tax payable. Normally, only 25% of a personal pension fund can be taken as a tax-free lump sum with the remainder subject to income tax. Depending on circumstances, those wishing to fully encash their pensions might find it more tax efficient to withdraw over a number of tax years.
Where flexi-access drawdown is available, there is also the option to just take the 25% tax-free lump sum and keep the rest invested. This keeps the rest of the money in a tax-efficient environment but with the flexibility to take withdrawals as and when required.
Worryingly, the Retirement Outcomes Review has found that over half of fully withdrawn pension pots were not spent but moved into other savings or investments. It’s unclear whether these were invested in tax-efficient accounts such as ISAs, but it suggests some people may not be considering the longer term consequences of their actions in terms of tax and generating the best long term returns. Please remember the tax treatment of pensions depends on individual circumstances and is subject to change in future.
Drawdown surges in popularity, but is it the right option?
The other striking finding of the review is the widespread shift from annuities to pension drawdown as the retirement product of choice. Before the pension freedoms over 90% of pots were used to buy annuities, but recently twice as many pension pots are now moving into drawdown than annuities.
Some of the shift can be attributed to the continued deterioration in annuity rates – possibly partly a result of fewer providers and competition in the annuity market – but it’s largely a result of the lifting of annuity purchase restrictions. Before the pension freedoms, consumers had to buy an annuity unless they were eligible for flexible drawdown by having guaranteed annual pension income of over a certain amount from other sources. Now the FCA is suggesting many people are moving into the drawdown offered by their existing pension provider instead.
Pension drawdown is a more complicated product than a conventional pension annuity. Although it offers the potential for better returns, it is typically more risky and comes with no guarantees in terms of generating an income for the rest of your life. Therefore the decision to use pension drawdown should not be taken lightly and proper consideration of the alternatives should be made including:
- Whether an annuity offering a guaranteed income for life is a more appropriate option.
- If any guarantees or special benefits are attached to the pension such as guaranteed annuity rates that are high by today’s standards. This is particularly relevant for older pensions originating from the 1980s or 1990s.
- If the asset mix in drawdown is appropriate if this option is chosen. A post-retirement portfolio may need to be different from a pre-retirement one in terms of the level of risk taken or the need to generate income to fund any withdrawals.
- Whether the current provider is the most appropriate one. Features and charges vary between drawdown providers.
The need for guidance and advice
Pension freedoms have increased the range of retirement options, which is to be welcomed. However, this has led to complexity, and the interim findings in this study underline that in many cases people should be taking more guidance or advice.
There is free impartial guidance about retirement options on the government’s dedicated Pension Wise website. If you are in any doubt about your retirement options we recommend that you seek regulated financial advice. The skill of an independent financial adviser in terms of determining an appropriate retirement strategy and the product or products to implement that strategy can be highly valuable.
The above article was first published by Charles Stanley on 21st July 2017