In less than eight weeks’ time, new rules will come into effect to transform the way people take their pensions.
The reforms, first announced by Chancellor George Osborne in his Budget last March, effectively mean it will no longer be necessary to buy an annuity when you reach retirement, as has until now been the case for most retirees.
Instead, it will be easier to leave money invested in the stock market and other assets while taking a regular income from it, a process known as drawdown. It will also be simpler and cheaper to take money out of a pension as cash for use in other investments or, in theory, to spend as you wish.
At the moment, 25% of a pension can be taken as a tax-free lump sum but further withdrawals, while technically possible, come with a 55% tax charge. From April 6, this rate will be cut to the individual’s income tax rate – 0%, 20%, 40% or 45%, depending on what other income is earned in that particular financial year.
So why are we being given this freedom to choose what to do with our pensions? What was wrong with the old “annuities for all” approach?
Well there are two main reasons, although they are closely linked.
Firstly, rates on annuities have been falling steadily for years and were particularly hard hit by the fall-out from the financial crisis in 2008.
The second reason is that we are living longer than we used to. According to official figures, a typical 65-year-old can expect to live for around another two decades (increased longevity is another reason annuity rates are low).
So some thought needs to be given to how a pension can provide enough income to allow a comfortable retirement over such a long period.
What April’s reforms will let pensioners do is have more choice over how much risk they are willing to take with their pensions. For people with smaller pensions and no alternative sources of income – apart from the state pension – it may be that an annuity remains the best option, given the fact it guarantees payments for the rest of the customer’s life.
But for others, taking on some level of risk may be appropriate, as it gives the pension the chance to benefit from further growth in the value of investments.
For anyone reaching their pension’s retirement age from now on, this question of how much risk they should take on will be crucial.
As we discussed in a recent blog, there are a number of ways to control the level of risk your pension savings face. And while no one knows exactly how people will react to the new freedoms, many investment experts suggest that, rather than choosing between an annuity, drawdown or alternative forms of saving or investing, people may use a mix.
For example, some of your fund could be used to buy an annuity that could provide a small guaranteed level of income alongside the state pension. A further chunk could be left invested in higher-risk shares or other assets under a drawdown scheme, while the rest could be held in savings or other lower-risk holdings.
Last week’s blog pointed out that peer-to-peer lending is a halfway house between savings accounts and stock-market investment when it comes to risk. With the government effectively encouraging people to take more risk with their pensions after they retire, we expect P2P to play an increasingly significant role in pensioner’s portfolios.