The accumulation phase of retirement planning
There are two distinct and equally important phases of retirement planning, namely, the accumulation phase and the decumulation phase.
Pre-retirement, in the accumulation phase, clients are encouraged to maximise their contributions to pensions to benefit from the tax relief and to increase the size of their pot. Workplace pension schemes may benefit from employer matched contributions and salary exchange.
With the annual allowances limiting contributions, funds may be invested into other investments and savings vehicles, or “wrappers”, such as Individual Savings Accounts (ISAs), General Investment Accounts (GIAs) and investment bonds, and, for some, Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS). Clients sometimes make direct property investments for their ‘retirement’ portfolios (see separate note on ‘Buy to let: Points to Consider’). A multi-wrapper approach can provide greater tax efficiency because each vehicle is taxed differently (figure 1).
Figure 1. A Multi-Wrapper Approach
To grow funds and to maximise retirement income, we recommend starting early, maximising contributions to pensions, investing excess income into non-pension wrappers, and aligning portfolios with aims and appetite for risk.
The decumulation phase of retirement planning
In retirement, the decumulation phase involves drawing on assets to provide a sustainable income. Sequencing, the order in which investments are drawn, is important for asset longevity and tax planning. Preserving the pension by drawing on it later, or not at all, can be beneficial for estate planning.
Following the pension freedoms introduced by the coalition government in April 2015, from age 55 (rising to 57), individuals can draw as much or as little from their personal pensions as they like, subject to prevailing income tax rates in the year of encashment. Before this date, it was much more common to use pension savings to purchase an annuity, whereas now most clients will take income drawdown and keep their pension fully invested; this increases the investment timescale beyond retirement age, so that the portfolio should reflect the client’s attitude to investment risk.
Cash flow analysis, using a series of assumptions to project the future, can help to determine the level of income that might be generated by assets. These projections can be useful to provide a degree of comfort or indeed encouragement to save further or retire later.
What is a pension?
A pension is a tax-efficient vehicle for building funds for retirement and generating an income in retirement. Pension contributions can attract tax relief at an individual’s highest marginal rate, and, inside the pension, investments can grow free of income and capital gains taxes. The member can receive part of their benefits as a tax-free lump sum.
Tax relief on contributions
The amount of tax relief on contributions is limited by the lower of an individual’s pensionable earnings and their annual allowance. Someone with no pensionable earnings can still receive a small amount of tax relief. High earners may be subject to a tapered annual allowance. It is possible to carry forward unused annual allowances from the previous three tax years, starting with the earliest year.
What is a defined benefit pension?
A “defined benefit” (DB) pension promises to pay the employee a defined amount each year in retirement for their lifetime, normally based on their final salary or career average earnings, and length of service.
What is a defined contribution pension?
A “defined contribution” (DC) pension is where a defined amount is contributed to build the pot to provide retirement income, via withdrawals or by purchasing an annuity. The income from a DC scheme is dependent on several factors, including, the amount of contributions, the investment performance, and the choices in retirement, such as the quantum and timing of withdrawals.
Comparing pension schemes
Owing to the costs to employers and the associated administration, the number of active DB schemes is reducing, particularly in the private sector, and most pension accumulation is now via contributions to DC schemes and group personal, stakeholder and self-invested personal pensions (SIPPs). Group personal and stakeholder schemes tend to provide lower cost options but with more limited investment choices, whereas SIPPs can be more expensive but invariably provide greater choice of investments, and some schemes permit direct commercial property investments.
It is important to understand the terms and conditions of each scheme. Some schemes provide a protected pension age and others may provide protected tax-free cash (more than the standard 25%) or an enhanced annuity rate. These benefits could be lost on transfer.
Lifetime Allowance Update
In March 2023, alongside his Spring Budget, Jeremy Hunt announced plans to scrap the Lifetime Allowance (LTA). Its removal is aimed at encouraging workers considering retirement to remain in employment and retirees to re-enter the workforce.
LTA: The LTA acts to limit the value an individual can accrue in pension savings without further LTA tax charges. The LTA, first set at £1.5m in 2006, reached a high-water mark of £1.8m in 2012, and was £1,073,100 at the time of Mr Hunt’s inaugural Budget.
The LTA is set to be removed in two stages:
1) Removal of the LTA tax charge in the current 2023/24 tax year; the crystallisation mechanisms and reporting requirements have not changed per se but the LTA tax charge has been reduced to 0%, for all intents and purposes removing this charge.
2) Removal of the LTA altogether in the 2024/25 tax year.
Step one, the removal of the LTA charge, has been delivered by The Finance Act (2) 2023 which received Royal Assent on 11 July 2023.
Regarding step two, draft legislation has recently been published to remove the LTA and replace it with ‘lump sum’ and ‘lump sum and death benefit’ allowances.
Without an LTA, the role of the various LTA protection regimes becomes solely about increasing the amount of tax free lump sums available by increasing the amount of lump sum allowance and the lump sum and death benefit allowance.
There is substantial new legislation required to implement the removal of the LTA and the commencement of new proposed lump sum allowances. It should be noted that there must be a possibility that this next stage of legislation may never be enacted if a change of Government precedes such enactment or reverses any legislation which is enacted. Whilst the removal of the LTA will be a welcome simplification and many individuals with substantial pension savings stand to benefit from the more favourable tax treatment, the new lump sum and lump sum and death benefit allowances will introduce other financial planning considerations. As ever, we recommend seeking specialist advice for a tailored recommendation.
For more information on the Lifetime Allowance and possible future changes, please read the full briefing note here.
Pensions and estate planning
On death, Personal Pensions may be passed on free of inheritance tax (IHT), and, because of this, pensions are also important estate planning tools.
In summary, retirement planning is not limited to pensions, but encompasses non-pension assets and other sources of income. Pension rules are complex and need careful consideration. Please speak to one of our Chartered Financial Planners to develop a plan to suit your situation and aims.