After the shock of last year’s budget, you could hardly blame people for wanting a quiet one this year. With only days to go to the biggest shake-up in pensions history and the introduction of pension freedom, now was not the time to complicate matters further by bringing in new measures.
But George Osborne, did exactly that. He used his budget speech on 18 March to launch a consultation into the second-hand annuity market, and, to the great dismay of many, announced a cut in the lifetime allowance to £1m starting next year.
In a world where defined benefit transfers is becoming a topic of hot debate and splitting opinion, both these measures will only serve to muddy the waters further on whether transferring is a good idea or not.
Introducing a second-hand annuity market seems a positive step and a natural extension of the pension freedoms announced last year. But it’s not without risk. People need to be sure they are making the right decision and are getting value for money by cashing in their annuity. They need to consider how their later years of retirement will be funded.
While the government are full steam ahead with pension changes, the Treasury seems to have got this need to go cautiously; perhaps too much so. The consultation includes a proposal that the existing annuity provider will have to give its consent for the annuity assignment to happen. In a world where no one wants to be held to blame, it’s easy to see how such a belt’n’braces approach could play out so no provider would give its consent and the market would never get off the ground.
The second-hand annuity market only applies to defined contribution pensions. Those receiving defined benefit annuities have no flexibility to cash these in. So if defined benefit members want to exchange them for cash they will have to transfer before retirement.
The other key change of the budget was cutting the lifetime allowance to £1m from 2016. This is a great shame. From next year any funds above £1m when benefits are taken will be taxed at 55%, unless protected. The lifetime allowance charge is an insidious tax. People save in good faith and are being encouraged to do so, and yet if they make good investment choices they could ultimately pay a heavy price. This seems a blunt tool. When we already have a limit on contributions to pensions, it raises the question why we need this additional tax.
This latest cut in the lifetime allowance – coming hard on the heels of the cuts to £1.5m in 2011 and £1.25 in 2014 – has thrown a spotlight onto the stark difference in the way defined contribution and defined benefit pensions are treated. Using a factor of 20 to convert pension into fund means someone could have a defined benefit pension of £50,000 before they would breach the lifetime allowance. But in the defined contribution world £1m would only buy a pension of £25,500 (based on age 64, spouse’s pension of 50%, and RPI indexation); half the amount.
Those who transfer from defined benefit to defined contribution schemes could be hardest hit. They could go from being comfortably under the lifetime allowance radar to brushing right up against the £1m limit, restricting their ability to build up other pension benefits – and enjoy investment growth success – without being taxed. These people will have to tread carefully and make sure they consider this unpleasant side effect.
At a time when the concept of defined benefit transfers is soaring in popularity – to take advantage of the pension freedoms – both these budget measures add a layer of complexity to an already thorny decision.
Whether to transfer is not a question of critical yields alone. Why only look at what growth rate is needed to replicate a defined benefit income with a defined contribution annuity, when the pension freedoms are about to go viral, and you can do anything you want with your defined contribution pot? It doesn’t make sense. Instead the question of whether to transfer from a defined benefit scheme requires consideration of a whole range of much softer issues. One of those might be whether a person can exchange their pension fund for cash. But another now will be whether the client will be hit with a potential lifetime allowance charge.
Pensions have just got even more complicated. And working out whether a defined benefit transfer is in the best interests of the client is one of the most complex areas. Advisers and their clients need help to unravel this tricky conundrum.
Please send any questions or responses to intelligentpensions@ipifa.com
