The UK Budget announcement on unlimited drawdown created great media excitement. For those of us who were around during the build-up to A-day in 2006, it is a familiar feeling. Radical pension reform generates lots of consumer interest, resulting in increased customer demand for guidance.
The proposal to remove restrictions on pension drawdown from April 2015 makes pension saving potentially more attractive for UK residents, as tax relief is available on contributions without the associated restricted access in retirement.
The ability to cash in accumulated pension funds in one go might seem an attractive proposition. However, if we assume the majority of individuals will wish to use their pension responsibly in retirement rather than blowing it on a Lamborghini, would removal of the funds be a good idea in practice?
A pension is a tax-efficient wrapper that provides important benefits that are lost when funds are removed.
First, any withdrawals in excess of the tax-free lump sum will be subject to income tax at the member’s marginal rate. So, while it might be tempting for an individual to strip all money from the fund, leaving the fund in the pension until it is needed would be more tax efficient in many circumstances.
Even if quick access is needed, in many cases it would be better from an income tax perspective if money could be drawn out in stages.
For example, Bill is due to retire at age 60 with a pension fund of £480,000 and has no other income. He wants immediate access to his tax-free lump sum and would like an income of £40,000 pa. He has previously been advised that, under current rules, his income is more likely to be between £18,000 and £27,000 pa.
Bill is excited to read about the proposals for unlimited access to pension funds, and he proposes to cash in the whole pension fund and put the money in a bank account from which he can make withdrawals.
Bill seeks guidance, and realises taking this course of action would result in a tax bill of £148,127 (based on 2014/15 rates and allowances). He sees sense and leaves the remaining funds in the pension and chooses a drawdown option.
Under the new proposals, his income will not be restricted post-April 2015, and he can draw £40,000 pa.
This example illustrates the importance of seeking guidance in the run-up to retirement, and how the initial excitement over unlimited access to pension funds is likely to die down when reality sets in.
Another important benefit of a pension wrapper is that lump-sum benefits paid on death before crystallisation are free of income tax and inheritancetax (IHT). These benefits are lost when the funds are withdrawn. If one has other sources of income, leaving the pension fund uncrystallised provides an invaluable IHT shelter.
Any lump-sum benefits paid on death are subject to the death benefit charge, currently 55%, should they be paid from drawdown funds or after age 75. From an estate planning perspective, retaining a drawdown fund is less attractive than holding funds personally where the maximum liability on death could be 40%, assuming it is subject to IHT.
The UK Government has stated it will consult on whether this rate is set too high, and there is an expectation that it will fall. It is unlikely it will fall below the current IHT rate of 40%.
Therefore, the use of a phased retirement strategy will increase in importance.
This has two benefits: first, the drawdown amount will include a tax-free lump sum, minimising overall income tax exposure, and, second, no IHT or lump-sum death benefit charge will apply to uncrystallised funds.
Under current rules, Bill would need to earmark substantial funds – starting at £130,000-£140,000 – in order to generate £40,000 pa, under a phased retirement plan that will be locked into a drawdown fund potentially subject to a lump-sum death benefit charge.
After April 2015, a straightforward encashment of £40,000 pa will be permitted, leaving more funds in the unvested pot. This potentially makes more of the remaining funds available free of tax to Bill’s heirs.
However, assuming the lump-sum death benefit charge will continue to apply after age 75, a decision may need to be made on whether to retain funds in the pension or not. This will depend on what rate is finally settled upon.
If a decision is made to remove funds from the pension, this could push income from other investments into higher rates of tax. It is therefore important during the accumulation phase to ensure non-pension savings are held in other tax-favoured wrappers, such as ISAs and offshore insurance bonds.
Spreading investments across various wrappers ensures that withdrawals can be flexed in the most tax-efficient way in retirement.
In addition to his pension fund, Bill has a 15-year-old offshore bond. Table 1 shows how Bill can meet his requirement for £80,000 pa gross by combining phased retirement and bond segment encashments. This enables him to keep his income tax effective rate at 10%.
Combining a pension and an offshore bond facilitates tax-efficient decumulation through a combination of phased retirement and segment surrender.
The availability of top slicing relief means substantial amounts can be drawn from the offshore bond while keeping income tax on gains within the basic rate band.
If Bill wishes to accelerate drawdown from the pension, for example, as he approaches age 75, bond surrenders could be switched off in favour of withdrawals within accumulated 5% allowances to minimise any exposure to higher-rate tax.
To improve the situation further, offshore bond wrappers can be placed in trust in order to mitigate IHT. A variety of trusts can be used to mitigate IHT, while giving the settlor access to his funds. One such solution could be a specially drafted trust that comprises two parts; a gifted part, which is a discretionary trust for a wide class of beneficiaries, and a retained part, comprising a series of future contingent interests that are linked to specific policy segments.
These are held on bare trust for the benefit of the settlor.
Staying with the example of Bill, if he knows he will need the capital back in a phased manner from, say, age 60, he could structure the policy as 100 individual policy segments, and the trust as a series of 10 ‘policy funds’, each containing 10 segments. Fund number one will vest if Bill survives until age 60, fund number two at age 61, and so on.
Providing the settlor survives for at least seven years after the transfer, the unvested funds are outside his estate for IHT purposes. This creates a structure that further complements a pension, as the remaining unvested funds on death resemble the IHT-free lump sum paid from a pension prior to retirement. Figure 1 illustrates this point.
Similarly to a pension, the funds are effectively ‘suspended’ in the structure until the settlor reaches each entitlement date. Upon reaching each date, the funds are ‘unlocked’ and can be utilised by the settlor. As the unlocked funds remain within the insurance wrapper, the settlor retains the flexibility to mitigate income tax exposure through planned exit strategies. See Figure 2.
It remains to be seen how the proposed changes to pension access after 2015 will influence drawdown strategies.
There is no doubt, however, that combining a pension and offshore bond wrapper will continue to provide a complementary structure with enhanced flexibility in retirement.