In a few weeks, the UK’s pension system will undergo one of the most radical changes in its history. If you haven’t already retired, these changes will almost certainly affect you.
The British government has decided that people who reach retirement should be treated as adults and be allowed to make their own decisions about what to do with their pension savings. From 6 April, you will no longer be forced to buy an annuity – an irreversible contract which uses the lion’s share of your pension savings to get a guaranteed income for the rest of your life – as so many have been until now.
Instead, you will have far greater freedom to invest, save and even fritter away the funds that you have spent a large proportion of your working life amassing.
April’s reforms were initially announced less than a year ago in George Osborne’s March Budget. Although the changes have been largely welcomed, there has been some concern that the new rules are being rushed through.
Indeed, the Treasury and the City watchdog, the Financial Conduct Authority, appear still to be putting the finishing touches to the regulations needed to make the new regime a success.
Pension companies too are reportedly struggling to make necessary adjustments to their systems in time, and there are expected to be some teething problems in the first few months.
But while the changes will have the greatest initial impact on those who have just reached their pension schemes’ retirement age, or who are about to do so, these reforms will at some point affect the majority of today’s workers.
The pension system pre-April 2015
Until a couple of decades ago, most company pension schemes were final-salary arrangements: this meant that the amount of annual income in retirement was linked to your earnings when your reached retirement age.
This system meant that the employer was responsible for investing enough money to pay out what their staff were entitled to. If these investments fell short, the company would have to make up the difference out of its own pockets.
As more and more firms struggled to meet their final-salary obligations, they closed their schemes and turned to personal pensions, which are the most common type today.
With a personal pension, workers and employers typically pay a fixed amount of money into the fund every month. This is invested until retirement age: the size of the final fund depends on investment performance as well as how much money has been put in.
If this performance is poor or not enough has been saved, it is the worker who will lose out, not the company.
Annuity versus drawdown
April’s changes concern what you can do with this fund when you reach retirement age (55 is the earliest you can take a pension). Until now, there has been an obligation to make sure your pension is used to provide a steady income in retirement, which is generally done in one of two ways:
An annuity: this is an insurance product which swaps your pension fund, or a large chunk of it, for a guaranteed regular income for the rest of your life.
Drawdown: this involves leaving your pension invested in the stock market or other assets and taking (or drawing down) an income from it.
But government rules mean that drawdown has so far been limited to people who have large pension pots or significant other sources of retirement income.
As a result, most people who have retired in the past few years have used their pensions to buy an annuity.
Annuities, however, have been the subject of a lot of criticism: the financial crisis and falling interest rates, to which annuity rates are linked, mean that payouts have become much less generous.
And an annuity once purchased can’t be changed or cashed in – so if someone realises they have bought the wrong type of annuity, there is very little they can do about it.
There is also the issue of an annuity holder dying soon after retirement: in such cases the annuity will turn out to have been very poor value indeed.
Widespread dissatisfaction with the annuity option is one of the main reasons behind the forthcoming shake-up.
The pension system from 6 April 2015
So how will things be different in April? The biggest change is that no one will be obliged to buy an annuity.
The drawdown option will be available to everyone, regardless of how large their pension pots are or whether they have supplementary income streams.
And it will be significantly easier to simply take money out of a pension and use it to make other investments, such as buy-to-let property, or simply to spend it or give it to other family members.
This is because the tax rules on withdrawing cash from a pension are changing: now and in the future, anyone can take 25 per cent of their fund as a tax-free lump sum after they turn 55.
But until now, further withdrawals have faced a tax charge of 55 per cent.
After April this rate will fall in line with your income tax rate, which could be 0 per cent, 20 per cent, 40 per cent or 45 per cent depending on your other earnings in the relevant financial year.
As a result, cashing in a pension will become a much more attractive proposition.
The risks and rewards of the new pension rules
The government’s reforms give savers much greater responsibility for how their pensions are used. There is clearly scope for some people to throw caution to the wind and make dubious investments or go on spending sprees.
But pensions are designed to help savers fund the cost of their old age when they are no longer in work, and it is likely that drawdown and annuities will remain the most common ways of doing this.
Drawdown means that the pension remains invested, and it can therefore continue to grow even as income is taken from it. Drawdown customers are at risk, however, of running out of money if their investments do badly, if the income they take is too high or if they live too long.
Annuities on the other hand, do not offer the upside of investment growth but they do provide a guarantee that the money will never run out. Many investment professionals expect that in future, savers will use a combination of drawdown and annuities to provide their retirement income.