Fit for purpose?

Billy Mackay takes a look at recent pension developments and asks whether they will benefit clients and advisers

On 22 June, the Office for National Statistics released a number of interesting "Pension Trends" statistics. A few topical snippets jumped out:

• Participation in pension schemes in the private sector is falling. In 2010, 39% of male employees and 28% of female employees belonged to an employer-sponsored ­pension scheme in the private sector. This compared with 52% and 37% ­respectively in 1997
• While membership of employer-sponsored pension schemes fell in the private sector between 1997 and 2010, in the public sector it was unchanged for men (at 87%) and it rose for women (from 75% to 82%)
• The General Lifestyle ­Survey shows that 38% of full-time ­self-employed men in Great Britain ­belonged to a pension scheme in 2009, down from 64% in 1998-99.

 The release that accompanied the statistics made the obvious point that falling pension scheme ­membership implies less private pension saving, which will lead to reduced retirement income in future, unless you see other saving increases.

I have made the point many times in articles that I have always been of the opinion that getting the ­foundations right for pension ­investors requires:

• A clear incentive system that ­everyone understands
• Simple rules around what you can contribute
• Flexibility on what you can do with your money when it is in the pension arrangement, and
• Flexibility and fairness on how you get your money back out in retirement or on death.

Key drivers for change

It is early days, and I would be the first to admit that the ­system of tax relief is not perfect. ­However, in the first few months of the new ­regime from 6 April, we ­experienced a significant increase in new ­contributions to our SIPPs.

This must be viewed as a step in the right direction and I ­believe the ­drivers for this increase are straightforward. The first is ­replacing the complex anti-­forestalling rules with a simple, single annual allowance of £50,000.

The second driver is the increase in higher rate and additional rate (50%) taxpayers. The thresholds for higher rate tax and additional rate tax were not increased in 2011-12, meaning a much larger group of people are now subject to higher and ­additional rate tax. 

The government's own statistics indicate that the number of higher rate taxpayers will rise by 20% this year, with additional rate ­taxpayers increasing by 12%. This means there are a lot of people who could benefit from tax relief on pension contributions.

The final driver for increase is the re-introduction of carry ­forward, potentially allowing ­pension savers and their ­employers to pay contributions of up to £200,000 in any given tax year and receive tax relief. 

Contribution and tax ­planning opportunities have ­historically been embraced by advisers and driven up new pension ­contributions.

While it is not perfect, we now have an incentive system that ­investors ­understand. With this ­basic ­ingredient, there is every reason to believe that the pick-up in new contributions will continue.

While things are looking up on the contribution front, I still have the nagging doubt that the flexibility and fairness on how you get your money back out in retirement or on death will remain a stumbling block for some.

We now have a uniform tax charge of 55% applied to lump sum death benefits paid from ­pensions in drawdown, and to benefits that have not been put into drawdown where an individual is over the age of 75. 

We argued long and hard that the old ASP tax rules represented ­cliff-edge tax policy and were ­simply unfair. With no tax on death on pre-crystallised funds and a 55% charge on crystallised funds, a cliff-edge remains.

If fairness is a key driver for change, it would have been equitable for the government coffers and simple to introduce a charge to tax on all residual pension funds, ­irrespective of the age and vested status of the client, of 20%-25%.

Over time, we will find out if this will be a stumbling block for savers. My gut feeling continues to suggest that for some it will be.

Benefits boom

Despite this, the 2010-11 tax ­year-end was a record period for benefit claims. We also had the introduction of flexible drawdown, a new concept that has been at the centre of a great deal of discussion and debate.

Some providers have suggested that the complexity of the new ­proposals and challenges with system development have led to problems and delays. 

Are the rules that complicated? The Finance Bill has now ­received Royal Assent and there was tinkering around the edges with the rules, but nothing that would prevent a provider from offering flexible drawdown from 6 April. 

The majority of the rules remain the same. Individuals with a secure income that meets a Minimum Income Requirement (MIR) will be allowed to withdraw funds from their pension schemes in excess of the limits imposed by drawdown pension. 

It could be said that the ­introduction of flexible drawdown and the drafting of the regulations was all a little rushed. But putting this aside, the early evidence ­suggests there is clear demand from ­advisers and their clients.

Just after 6 April, we ­completed a piece of research with 250 ­advisers who used Sippcentre. The ­responses showed 98% believed they will use flexible drawdown as part of their clients' retirement and income planning.

 Importantly, more than 82% indicated that the main use would be phasing the fund to flexible drawdown as part of a structured plan to match income requirements and minimise the possible ­taxation implications. I don't believe that flexible drawdown will be a mainstream solution, but there is demand for it.

Some providers seem concerned about the obvious risk of many clients running down their pension funds. But looking at the survey responses, this seems unfounded. 

Over the years, I have worked for providers that apply charges on a percentage basis. I know from experience that the actuarial people responsible for pricing and ­profitability will have a negative view of a product that allows you to run down the fund. 

This will have affected the ­appetite of many providers to o­ffer this option. If there is demand in the market, the answer could be revisiting your pricing philosophy.    

Rather than seeing a significant acceleration in withdrawal for all using flexible drawdown, I believe it will instead develop into a useful option for savers to reduce the marginal rate of tax on income drawn from pensions.

At the same time, it will reduce the effect of the 55% tax charge on lump sum death benefits.

Case study

Looking at a case study, the ­background to the theory should become clear.

Mr Smith has a secure annuity income of exactly £20,000 and so satisfies the MIR, which qualifies him for flexible drawdown. His SIPP fund is worth £600,000, which he has yet to vest or crystallise.

Mr Smith could immediately take a lump sum of £150,000 and ­withdraw the whole fund. The ­obvious downside to this is that he will pay 50% tax on the ­majority of the income, and will place the funds into a non-tax relieved ­environment, as well as one where the funds are potentially subject to IHT on his death.

Alternatively, he could take a lump sum of £150,000 and ­withdraw an income of £22,475 a year from the SIPP, making full use of the 20% tax band. 

This is likely to be significantly more tax efficient than the first option as ongoing income is drawn at 20% and the bulk of the funds remain free from IHT. The problem with this option is that, on death, the residual fund paid as a lump sum death benefit will be subject to a tax charge of 55%.

He could consider using flexible drawdown before crystallising a small part of the core fund each year and immediately withdrawing the entire fund balance on the small amount that has been vested. 

For example, Mr Smith could crystallise £29,966 in 2011-12, receiving £7,491 as a tax-free lump sum and withdrawing the ­crystallised fund as a single taxable ­pension payment.

Taking the tax-free lump sum and taxable pension together, he will be paying only 15% tax on the combined income.

On top of this, because the fund that is left in the pension each year remains fully uncrystallised, any lump sum death benefits paid from the fund will not be subject to a tax charge. 

The day after the 2009 Budget, we took calls from many ­investors looking to cancel their pension ­applications.

As it turned out, the majority were not affected by the new rules, but a ­common theme was that many had ­become f­rustrated by the constant ­tinkering and lacked trust in future ­government policy. 

There is always a risk of ­unintended consequences when you look at change. Change is not always a bad thing but, as has ­happened in the past, it is when it leads to disenfranchised investors.

Billy Mackay is marketing director at AJ Bell