P ensions offer the best of worlds, and the worst of worlds. While they offer significant taxation benefits, they also need periodic tending along the way if they are to deliver their best. And there is more to pensions than meets the eye...
● Little known Pension Fact One:
Pensions can be outside of our Inheritance Tax (IHT) taxable estate while still delivering income and capital growth throughout our retirement.
● Little known Pension Fact Two:
While being outside our Inheritance Tax taxable estate, pensions can be immediately available to our survivng spouse or civil partner completely tax free. (They also have the option to continue with a similar plan in their own name should they choose to do so. Such an arrangement could also be outside of their Inheritance Tax taxable estate.)
● Little known Pension Fact Three:
While there may be very sound reasons to purchase an annuity, at the end of the day they can leave a big hole in an estate; whereas an income drawdown arrangement - if run properly - offers the possibility of preserving or even enhancing one's estate.
Passing wealth to one's surviving spouse, and ultimately the next generation, doesn't seem such a bad objective, especially if such objective can be achieved without damaging our own retirement income.
● Little known Pension Fact Four:
The decision to purchase an annuity is largely irreversible, but the decision to use income drawdown keeps the option to switch to an annuity (in full or in part) a possibility. In other words, should investment conditions (or personal circumstances) warrant it, a switch from income drawdown to an annuity is possible and is relatively straightforward to set up.
Pensions can deliver the best of both worlds.
Professional and independent advice is required if mis-steps are to be avoided and the best outcome achieved.
B roadly, there are two types of pension, with no mutual exclusivity between them. Depending on one's career path, pension provision may encompass both − sometimes with periods of concurrent accruals. In addition, the state pension is an important foundation upon which these 'private' pensions sit.
The two categories of 'private' pension are: Money Purchase and Defined Benefit.
Below is a list of pension types and where they fall within the pensions landscape.
— The Harvest Partnership — offers the advice our clients need to correctly identify their pension options and opportunities, and make quality decisions, from a fully informed position.
● Defined Benefit - also known as Final Salary:
This is the traditional occupational pension, where one's retirement income is defined (hence the name) by a number of factors: One's final salary (hence the other name), the number of years worked as a member of the Scheme*, and a fraction as defined in the Scheme Rules.*Some firms have historically delayed admitting employees to Scheme membership for five years. Thus, a series of short employments could seriously impact one's retirement benefits.
This fraction differs widely between schemes. For example, the most generous we've come across is a City firm's final salary scheme based on a fraction of 1/20th. On that basis an individual would achieve entitlement to a pension of 50% of their salary after just 10 years' service. We are not sure if this scheme is still operational or if, like many others, it has had to rein in its ambitions.
By contrast, schemes in the public sector are usually based on 1/80ths - on the basis that after 40 years one would qualify for a pension equivalent to half one's final salary.A worked example: Sally is about to retire from her role in the Civil Service. Her salary at retirement is £50,000 p.a. and she's worked there for 30 years. Her pension would be calculated as follows: (£50,000/80) x 30 = £18,750 p.a., where 1/80th is the fraction of salary given in pension for each year of service.
Many public sector schemes have now been reformulated in response to various factors such as the general increase in longevity, etc., but the above gives the general idea.
Most schemes in the private sector are based on a fraction of 1/60th. The difference between the respective fractions used by public and private sector schemes is probably explained by the cost of maintaining fully indexed retirement income from the former.
Whether public or private sector, final salary or defined benefit schemes offer resilience of income. In recent years the resilience of member benefits from private sector schemes has been enhanced with the advent of the Pension Protection Fund - a 'lifeboat' arrangement which protects 90% of members' benefits against scheme insolvency with the liability effectively being transferred to other schemes. Of course, transfering the liabilites of failed schemes to functioning schemes poses the possibilty of wider problems for the entire defined benefits scheme sector, especially in the wake of the Covid-19 crisis.
However, on the death of which although limited to guaranteeing 90% of a member's benefits, guarantees a fact of final salary and years of service is called a defined benefit scheme. They offer significant taxation benefits, but need periodic tending along the way if they are to deliver their best. And there is more to pensions than meets the eye...
● Money Purchase - Personal Pension Plans, Workplace Pensions and Additional Voluntary Contributions, etc.:
The term money purchase may sound confusing, but it simply refers to the fact that one's retirement benefits are purchased with money accumulated in a personal (to you) pension arrangement.
Originally, the way such schemes delivered retirement benefits was by the purchase of an annuity*. Such an action epitomises the swich from the 'accumulation phase' of one's working life, to the 'decumulation phase' of one's retirement.*Annuities are contracts purchased from an insurance company that [in this context] pays income for life. At the time of purchase, one has the opportunity to link the income to one's spouse or civil partner and/or to index the income to help combat the effect of inflation. This is called the 'inflation risk'. Such 'bells and whistles' are expensive in terms of immediate income, perhaps requiring 20 or more years even to reach break-even, compared to a level single-life contract. And at the end of the day, there could be nothing paid to the survivor's estate.
There must be better ways of doing things, and there are! However, such 'better ways' may replace the inflation risk with investment risk. Instead of an insurance company taking the risk in ensuring an annuity income is paid for life exactly to the terms of the contract, alternatives to annuities place that risk on the client!It is therefore important that alternatives to annuities are managed well and revisited periodically to test whether replacing a non-annuity arrangement with an annuity, in full or in part, is indicated.
The 'better' way for many people is a SIPP (Self-Invested Personal Pension).
● SIPP (Self-Invested Personal Pension)
A SIPP puts you in the driving seat. As the name suggests, a Self-Invested arrangement offers the choice of both investment arrangement and the mechanism for drawdown of income. It also offers the prospect of passing wealth to the next generation, conveniently including one's spouse or civil partner in the income path, whilst all the time keeping the capital outside of one's Inheritance Tax taxable estate. That's a heady cocktail of benefits.
|And it's for that very reason, professional and scrupulously independent financial advice is essential when making such significant decisions. Because the total number of funds available to a SIPP can run into the hundreds - across diverse asset classes - the experience of a good Independent Financial Adviser can literally pay dividends.
● Cases where a SIPP or sipp Drawdown arrangement may be appropriate.
Deployment of a Self Invested Personal Pension for retirement income is typically arrived at in THREE distinct steps:
● Step 1: Open the SIPP.
A SIPP is simply a pension arrangement with great flexibility of investment choice, more than would be available from within the fund selection of a traditional life office. It is this breadth and depth of available asset choices, including those offered by the SIPP provider as well as third party offerings, that is one of the primary attractions to the use of a SIPP. The SIPP is typically set up by amalgamating (transferring the value of) existing pension arrangements into the new plan. This is sometimes referred to as 'pension consolidation'. Along with the cash comes certification of the PCLS (see below) entitlement. Step 1 defines the latter part of the 'accumulation phase' of an individual's working life.
● Step 2: 'Crystallise' the SIPP.
Crystallisation is simply releasing the Pension Commencement Lump Sum (PCLS) - usually referred to as the 'tax free cash' and taking income from the residual fund. NB It is important that any entitlement to tax free cash is taken before any income is received as otherwise it will be treated as income and taxed. The act of crystallising the arrangement epitomises the beginning of the 'decumulation phase' of one's financial dealings, during which time pension — along with other investment income — is received.
● Step 3: Review the SIPP.This is a 'revolving door' process, carried out periodically by your IFA to reassess the viability and continuing suitability of the SIPP when compared to the alternative of purchasing an annuity. The indications to taking an annuity might be: Age, interest rates and prevailing Inheritance Tax rules.
Step 3 may be the trigger for the 'annuitisation phase'. Interestingly, should annuitisation be indicated it is possible to achieve this progressively, across more than one annuity arrangement. It is not necessary to burn all of one's bridges at once.
In the author's humble opinion, it is the inherent flexibility found within the SIPP framework that often swings the decision away from annuitisation of pension arrangements at the time of retirement. Put another way, annuitisation can be postponed, perhaps indefinitely, keeping one's options open.
● Cases where an annuity may be the better option.
A SIPP may not be right for everyone. If a person is generally risk-averse, a pension annuity, which can be linked to one's spouse or civil partner, may be the best option. Annuities are not perfect (nothing is), but they get the job done. An annuity is reliable.
NB (1) If choosing the annuity route, once the arrangement has settled, options such as including one's spouse or civil partner, degree of indexation, etc., are irreversible; they cannot normally be revisited. In other words, the arrangement becomes a hostage to fortune.
NB (2) Pension annuities ease Inheritance Tax concerns because, at the end of the day, there could be nothing left. As in NIL!
NB (3) It is usual for annuities to be issued with a 'Five Year Guarantee.' If the annuitant dies within the period, the estate would receive the balance of five years income, possibly commuted to a small lump sum. It can be seen from this that while annuities are often seen as the 'safe' retirement income option, they can also be extremely risky for the surviving family. Furthermore, opting for the maximum level income at the outset could leave the family high and dry in the short-term, or the annuitant with a vastly diminished income over time because of inflation.
NB (4) More than one pension annuity may be purchased with a view to tailoring their overall income and benefit profile. This activity may be achieved over a period of years (even decades), as the situation dictates.
● Structuring income the right way.
At — The Harvest Partnership — we structure SIPP arrangements such that as far as possible, income received is the dividend earned by the underlying assets; not just the return of one's own money. This single vitally important attribute has contributed to the good outcomes seen by our clients over more than two decades.
In fact, as far as possible we structure investment income from all products - both pension and non-pension - in the same traditional manner. This strategy has stood the test of time, not only in the dealings of — The Harvest Partnership — with our clients, but is the hallmark of quality retirement investment advice the world over.
The benefit UK-based clients have is that the British stock market has an above average yield, when compared to equity markets in other territories. Thus, there is every encouragement to doing it the 'right' way.
Good client outcomes are largely due to this very traditional investment strategy which provides significant protection* aginst capital erosion during the inevitable hiccups that occur in the global economy.
*Investment values will always fluctuate and are not guaranteed. This is why structuring client income correctly is so important.
● SSAS - (Small Self-Administered Scheme)
A SSAS is a money purchase pension scheme, offering some very interesting attributes.
➤ A SSAS is a good choice for company owners and/or directors, with scope to include employees and family members to a maximum of 11 in all. Like a SIPP, a SSAS can invest in commerical property but with an important difference: A SSAS can borrow up to 50% of its net value, which can include the value of commercial property being purchased by the plan. It is possible to obtain a mortgage in the name of the SSAS with the advantage that capital and interest payments are made very tax-efficiently by the sponsoring employer via the Scheme: (The Scheme pays the lender. The sponsoring employer pays rent to the Scheme and in so doing reimburses the Scheme the capital and interest payments.)
➤ A SSAS can lend to the sponsoring employer (the same 50% rule applies) at extremely low interest rates. Such loans must be repaid within five years.
➤ A SSAS can also invest up to 10% of its value in shares of the sponsoring employer.
➤ This overall flexibility makes the SSAS a compelling option for business owners.
A SSAS is a powerful tool, especially suited to business. To set a SSAS up, specialist advice is highly desirable. The officers of the sponsoring employer can be trustees of the Scheme. It is advisable to use the services of a professional so-called 'pensioneer trustee' to guide the trustees and oversee the laying of accounts for the Scheme to HMRC. Many life offices offer this service for nominal fees.
● State Pension:
The state pension forms the bedrock of retirement income for many people. If we are to maximise our state pension benefit, it is important to ensure our National Insurance contribution record is complete before we reach state pension age. We do this by maintaining appropriate National Insurance contributions or if paid via dividends, ensuring we are paid a salary up to the so-called NICable level which qualifies for National Insurance purposes but which does not require National Insurance contributions to be paid.
|Interestingly, the United Kingdom maintains reciprocal agreements with many countries which allow social security benefits accrued in the UK to be honoured in those counties and vice versa. This means that UK state pension entitlment may qualify for local social security pension (and possibly other benefits) in those territories.
|Such countries include: ● Ireland ● Canada ● Iceland ● Switzerland ● United States of America ● Israel ● South Korea ● Japan ● Turkey ● New Zealand ● Mauritius ● Republics of the former Yugoslavia ● Jamaica ● Philippines ● Jersey and Gueurnsey ● Isle of Man ● Jamaica ● Barbados ● Bermuda ● Chile ● Lichtenstein ● Norway, and others.
|As the treaty between the UK and an overseas territory may change, if planning to retire abroad it would be wise to buttress one's state pension provision with other means. Also, to check the current position both with the UK government and the foreign territory.
|NB The receipt of additional benefits in a foreign territory, such as healthcare, would almost certainly require citizenship or resident status and perhaps separate contributions towards those entitlements.
— The Harvest Partnership — has specialised in the delivery of good client outcomes* for over 25 years. Our specialist advice has enbabled our clients to correctly identify pension options and opportunities, and to put them into effect on the basis of quality decisions made from a fully informed position.
*Based on historic performance. Retail investments should be viewed over the medium to long-term. Past performance is no guarantee of future returns.