Pension reform is obviously something close to Chancellor George Osborne’s heart. Last year he announced that he was bringing forward the introduction of important changes to the State Pension so that they would come into operation one year earlier than had been expected. In this year’s budget the pension reform that Mr Osborne announced went somewhat further and is being described as the most radical change to the pension system for a generation. In trying to get our head around the proposed changes we have approached matters with something of a broad brush.
Pension law is extremely technical and there are always exceptions to every rule. As with everything on our website therefore this piece is not intended to replace specific legal and financial advice about an individual’s particular circumstances, but simply to give an overview of the proposed changes.
Pension Reform – the Basics.
There are some things about this pension reform that one needs to understand. First of all the reform does not relate to the State Pension scheme. Secondly there are two types of private pension arrangement. Defined Benefits Schemes are usually provided by an employer and are based on the idea that if you complete a particular period of employment (usually 40 years) you will receive a fixed percentage of your final salary by way of a pension. There are very few such schemes left in operation, but those that are seem to be unaffected by this pension reform.
The other type of private pension arrangement is known as a Defined Contribution Scheme. Under these arrangements contributions are paid into a pension savings scheme, usually based on a percentage of income. The contributions may come from the individual alone, or be topped up by an employer. These Schemes are becoming the norm nowadays and are increasing in number because of the government’s desire to promote pension saving. TheWorkplace Pension Scheme that is gradually being phased in for all employees is a Defined Contribution Scheme. It is this type of Scheme that is the subject of the pension reform that Mr Osborne announced.
The third thing that one needs to understand is for the moment at least the changes are simply proposals, subject to consultation. Once the initial euphoria that greeted the announcement of the pension reform wore off some considerable doubts began to be expressed. Whether this pension reform will therefore come into law in its proposed form remains to be seen.
Pension Reform – the Current Position
At present, upon retirement an individual who has made contributions to a Defined Contribution Scheme has a pot of money. Up to 25% of the pot can be taken in cash, but, generally speaking, the remainder must be used to buy an annuity, a contract with a Financial Services Company under the terms of which the Company agrees to pay the individual a fixed income for the rest of that person’s life, however long or short period that may be.
The amount of income that an annuity provides is highly dependent upon interest rates that are prevailing at the time of the purchase of the annuity. We have been going through a period of uniquely low interest rates for some time. Accordingly the income that annuities have been producing have been similarly extremely low. Once the annuity contract is purchased the amount of income that is paid is fixed, it doesn’t change even if interest rates significantly improve.
Pension Reform – the Problem
Despite the apparent explanation of low annuity rates by low interest rates there has been growing criticism of the Financial Services Companies. First of all many of the companies that provide annuities also operate the Pension Schemes. While individuals do not have to purchase their annuity from the same company with which they saved their pension fund, this has not always been made clear. Indeed there is anecdotal evidence that suggests that some Companies have misled individuals into believing that they must purchase their annuity with the same Company. Recent research has shown that very few individuals shop around for the best annuity rates and it is very clear that very substantial sums of money are being lost as a result of that failure.
The amount of your annuity can vary greatly
Pension Reform – the Proposal
Now, Mr Osborne is suggesting that he is going to scrap the annuity arrangement altogether. When you retire you will be entitled to take the whole of your pension pot and do with it as you will. It is a proposal that has both supporters and those who consider it to be the road to disaster.
Those in favour of the change point to the flexibility and freedom that the suggested arrangements will have for all concerned. It will be open to anyone retiring to take into account the relevant circumstances at the time and choose their investment vehicle accordingly. If all goes to plan this should produce significantly greater pensions, more wealthy pensioners and a reduced burden on the state. One point that has received little publicity is that any cash taken out of a pension scheme after the first 25% will be subject to tax at an individual’s marginal rate in the year of withdrawal. On the Treasury’s own figures this will result in a significant increase in the amount of tax that will be collected from pension funds. By 2018 the Treasury is suggesting that it will receive an additional £1.8 billion in tax from this source. It doesn’t take a genius to realise that the investment returns will have to cover this tax as well as produce extra income if the proposed pension reform is to be a success.
Pension Reform – the Criticism
Those who oppose the pension reform suggest that many individuals will simply be unable to properly invest their pension fund. Whether the money falls into the hands of the unscrupulous, or is simply poured down the drain, wasted on fast cars and expensive holidays, once it is gone there will be no opportunity to replace it.
Is this where pension pots are headed? (Courtesy Bethan Moody (c))
To counter this criticism Mr Osborne has proposed that the Government will spend up to £20 million a year providing for face-to-face advice for those who retire. The difficulty is that at present some 1000 people each day by an annuity. Quite where the qualified advisors to meet that sort of demand are going to be found by 2015 is something that the Government is yet to explain.
There is also a concern that there may be other unfortunate side-effects to the proposal. If those who have the funds from their pension pots available choose to invest in property will this further push up the price of houses, making them still more unaffordable for young people? At the same time those who wish to invest their funds in the traditional annuity contract may find that they are even less productive than at present. With fewer such contracts being taken out Financial Service Companies will no doubt lead to cover their costs by increasing their charges for each contract.
Pension Reform – the Immediate Effect
The proposed pension reform is already having its effect. Insurance Companies, particularly those who generate significant income from the annuities market, have seen their share price plummet. A significant number of those who might have been expected to have purchased an annuity in the last two days have postponed their decision. Some who were on the verge of completing purchases already arranged have withdrawn. It is quite understandable that those affected by this seismic change to pension arrangements should want to have the opportunity of considering their position. Whether that will be realistically possible in the course of the next few weeks, or even months however remains to be seen. Certainly if you are able to postpone any decision on the purchase of an annuity for the time being that may well be a sensible thing to do. In many cases however the recently retired will need income to come on stream quite quickly and may be faced with little alternative but to purchase an annuity under the existing regime.