Pensions are rarely out of the headlines these days, but how much attention do you pay to yours? Do you know the real value of it? Recent research by YouGov found that four in five (79 per cent) Brits do not know what income their pensions will give them when they retire.
And the younger you are, the less attention you are likely to be paying to your pension. Only a quarter of under-45s with pensions know what their pension pots are currently worth, and just one in five (21 per cent) say they know what income they are expecting when they retire.
On the face of it, you might think it makes sense that we don’t tend to focus on our pensions until we are nearing retirement. But the problem is you could be missing a trick or two. By not keeping a close eye on your pension, you run the risk of leaving any top-ups until the last minute. Or, if you have managed to build up a large pension, you may find yourself paying tax you did not expect.
Hundreds of thousands of pension savers in the UK are running the risk of being hit by a hefty tax bill as a result of the latest cut in the Lifetime Allowance (LTA). This is the limit on the amount of money that can be built-up in a pension scheme before incurring a hefty 55 per cent tax charge.
So if you are among those who might be affected, now or in the future, failure to make some important decisions well before the end of this tax year could lead to an unexpected tax bill of up to £137,500.
Who is caught in the LTA net?
For most people, the amount of their pension savings will not reach the lifetime allowance. However, if you have contributed a significant amount towards your pension, or are fortunate enough to have a defined benefit scheme and a long service record, you could unknowingly risk exceeding the LTA.
From 2014/15 tax year, the LTA will be £1.25 million, which is lower than when it was introduced in 2006. And there is a realistic possibility that the allowance will be frozen for the foreseeable future – and might even be cut again.
Revenues and Customs (HMRC) estimates that 30,000 people will be immediately affected, with 360,000 expected to break this limit over the longer term. This takes the impact way beyond the one per cent of pension savers originally envisaged.
Should I be concerned?
A £1.25 million limit may not set alarms bells ringing. But it is easy to underestimate just how valuable a defined benefit pension is – or how it is tested against the LTA.
A defined benefit scheme, such as the Teachers’ Pension Scheme (TPS), pays an income at retirement which is linked to your salary and service.
For example, a headteacher earning £80,000 will pay 10.6 per cent of their salary towards their pension. Depending on when they joined the scheme they may receive 1/60th of their salary as pension for each year they are a member of the scheme.
Broadly their contribution of £8,480 will buy an extra 60th of the salary at retirement. So for £80,000 that would equate to an extra pension income of £1,333 per year. To put that in context, a male aged 65 in a personal pension would need a fund of around £38,000 to buy the same level of income (assuming a 3.5 per cent annuity rate).
And you might be surprised to learn that if you have already accrued a pension of £25,000 a year, this already eats up £500,000 of your allowance.
Even leaving the scheme early would see benefits revalued up to retirement. Allowing for inflation, at say 3.3 per cent over 10 years, this takes the pension up to £34,590 – using up almost £692,000 of the LTA.
This is because defined benefit pensions are valued at 20 times the annual pension when testing against the LTA. From next April the maximum defined pension that can be built up without suffering the tax charge is therefore £62,500. For those who joined the TPS before 2007, this figure is further reduced by any tax-free pension lump sum entitlement. And this before you factor in any separate additional voluntary contributions (AVCs), personal pensions, or pension schemes from a previous occupation.
Decision time
The government has tried to soften the blow if you have already exceeded the new allowance or expect your pension fund to break it by the time you reach retirement. Pension benefits can be protected from a possible 55 per cent tax charge if the fund breaks the reduced limit.
The new fixed protection 2014 fixes the LTA at £1.5 million beyond 2014. But there is a trade-off in that pension contributions must stop after April 5, 2014.
Individual protection is only available if pension savings exceed £1.25 million on April 5, 2014. This will give a personal LTA equal to the value of your pension fund on April 5, 2014 (up to a maximum of £1.5 million). But crucially, this one comes without the need to cease funding.
The clock is ticking if you are affected by the cut. You will need to take expert advice before April. Here are our top 10 questions to be asking your advisor
1. Do I need to apply for Fixed Protection?
This is the biggest strictly time-bound decision for you and your advisor. Applications need to be received by HMRC before April 6, 2014, and in most cases you will need to stop making any further pension contributions after this date to secure the £1.5 million allowance.
Benefit accrual for current defined benefits scheme members is limited to the consumer prices index (CPI) if fixed protection is not to be broken. With this figure now set at 2.7 per cent (September 2013) it means that even with a pay freeze you would need to have more than 38 years’ service for benefits to increase at less than this figure.
Your advisor will need up-to-date valuations on all your pension schemes to assess the likelihood of your pension pots exceeding £1.25 million when you reach your retirement date. So do not leave it too late as there could be delays in obtaining all the necessary details.
2. Should I apply for Individual Protection?
You need to have total pension funds of between £1.25 million and £1.5 million at April 5, 2014, to be able to apply for individual protection. This will give you an allowance equal to the value of your funds at this time.
Unlike fixed protection, you can still continue to pay into your pension. And more importantly, continue to receive valuable employer contributions. Any retirement savings over your individual protection, when you come to take your benefits, will be subject to the LTA tax charge (55 per cent if taken as a lump sum).
3. Can I apply for both?
It is possible to apply for both individual protection and fixed protection. This would give you a lifetime allowance of £1.5 million (fixed protection) and contributions in most cases will need to stop. If you choose to restart contributions in the future your fixed protection would be lost. But you would still benefit from your individual protection allowance rather than the standard £1.25 million LTA.
4. Can’t I just carry on as I am?
Sometimes it is good to do nothing. No protection might mean paying more tax. But it could still give the best result – particularly as it means continuing to build-up additional years of defined benefits.
5. Should I leave my final salary scheme?
In most cases, staying in the TPS after April will blow fixed protection. This raises the thorny question of potentially opting-out of final salary pension schemes to protect the higher allowance. There are important issues that will need to be discussed with your advisor to agree the best way forward.
It might be better, if you are more than say five years away from retirement, to keep accruing benefits – even if this means paying a bit more LTA tax.
The amount of benefit accrued each year can be extremely valuable, and your employer will pick up most of the cost.
If you are closer to retirement it might be best to opt-out. If you leave the scheme early your benefits will be increased each year in line with inflation. This could give a better result than staying in and taking the tax charge. And the contributions saved can be invested elsewhere. But remember by opting out you will be giving up potential ill-health and death benefits.
6. Should I stop paying AVCs?
Paying AVCs (Additional Voluntary Contributions) after April will automatically blow any fixed protection. If you expect to exceed the LTA you may decide to remain in the TPS and pay the LTA charge. While it may make sense to continue remaining in the TPS and making the mandatory contributions, paying AVCs may be less sensible.
If you breach your LTA you will only receive 45 per cent of the value above this limit as a result of the tax charge. It may be better to divert these additional contributions into non-pension savings which will not suffer such high tax charges.
7. Should I think about retiring early?
An alternative if you are thinking about retiring soon is to take benefits this tax year, even if this was not originally in your plans. Retiring this year will mean your pension fund will be tested against the current £1.5 million limit.
There may be a reduction applied to your pension for retiring before your normal retirement date.
8. Is it too late to top up?
The current tax year is the last opportunity to make a final top-up contribution if you are applying for fixed protection. Or, if you are close to retirement, you might want to top-up your pot to take it over the £1.25 million threshold. This would trigger eligibility for individual protection.
9. How do I keep track of all my pensions?
It will become increasingly important to review the value of your funds against the LTA after 2014. If you have more than one pension in addition to your teachers’ pension it may be easier if these are all held in one place. And this can bring other benefits too – economies of scale, wider investment choice and greater flexibility on how benefits can be taken.
Before consolidating all your pensions into a single pension scheme, any costs of transfer must be considered. In particular, watch out for guarantees under older plans that could be lost. But do not let the tail wag the dog.
Weigh-up the value of any guarantee against the benefits of having everything in one place. Your advisor can provide expert guidance in this matter as transferring pensions is not right for everyone
10. If I stop pension funding, what then?
Stopping pension contributions after April does not have to mean giving up on saving for retirement. You may still need to discuss with your advisor alternative ways to keep saving.
You could consider redirecting pension funding to your spouse, to make best use of both your allowances. Two pension incomes can be more tax-efficient than one. There are many possible alternative investments to continue your retirement savings. So make full use of other tax-privileged investments.
For example, official HMRC figures show that only seven per cent of individuals made the maximum contribution to their ISA in 2010/11. Holding a variety of different investments can also provide greater flexibility for you and your advisor to achieve a tax-efficient retirement income strategy.
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David Downie is technical manager at Standard Life.