Anyone for a Lambo?
I’ve made plenty of flippant remarks I’ve regretted, sometimes the moment the words were out of my mouth. I find myself hoping that people within earshot have poor memories. Mercifully, I’m not in the public eye and nobody is taking notes. But consider poor Steve Webb (now Sir Steve: he was knighted in 2017). As Pensions Minister in the coalition government from 2010 to 2015, he implemented sweeping, radical changes in the UK pensions system. Auto-enrolment was introduced in 2012; and in 2015 the pension freedoms legislation was enacted.
He had a huge impact and is widely respected in the industry — yet in the popular imagination he will always be the man who said glibly in a BBC interview in 2014 that people aged 55 could, if they wished, use their pension savings to buy a Lamborghini. Obviously, he was trying to emphasise how liberating the new regime would be; but creating a colossal tax liability by blowing money from a pension as soon as you can on a luxury car is simply crazy.
UFPLS, pronounced ufplus, stands for uncrystallised fund pension lump sum. This unwieldy chunk of jargon refers to one way that withdrawals from pensions can be made from age 55 onwards. Lump sums consisting of 25% tax-free cash and 75% taxable cash can be withdrawn. The taxable component is added to, and taxed as, earned income in the tax year it is taken.
If you use UFPLS, the other immediate consequence is that your annual allowance — the maximum amount that you can tax-efficiently pay into a pension every year — is reduced, usually by a factor of ten. Most people’s pension annual allowance is £40,000; after money has been withdrawn via UFPLS it is £4,000 (having been cut from £10,000 in 2017) and renamed the money purchase annual allowance (MPAA). This of course makes trying to restore money withdrawn by increasing your contributions in future more difficult. It also, in our view, runs counter to the spirit of the pension freedoms by restricting people’s ability to phase their retirement.
Using UFPLS can be entirely your own decision but you are legally obliged to tell your employer, who may have to reduce your contributions.
Tax-free cash and drawdown
The alternative to UFPLS is taking a tax-free sum instead. The 25%/75% ratio applies. In other words, if you take (say) a £5,000 tax-free sum, £20,000 of your pension is ‘crystallised’ and the residual £15,000 must be designated as drawdown money. What actually happens to the £15,000 depends on your workplace pension provider’s rules and resources and your instructions. It may stay in your pension, segregated from uncrystallised savings; it may move smoothly into a flexi-access drawdown (FAD) account held on the same platform; or it may have to go into an entirely separate FAD vehicle.
The main advantage of taking tax-free cash only is that, as long as the £15,000, in my example, remains untouched, or is used to buy an annuity (a guaranteed lifetime income), the MPAA won’t be triggered and you can contribute more than £4,000 to your pension every year.
The principal problem with it is: what happens, by default, to money put into drawdown? According to the Retirement Outcomes Report published by the Financial Conduct Authority (FCA) in July 2018, 33% of consumers in non-advised drawdown are holding their money as cash. This, to quote Steve Webb more sympathetically, is ‘reckless caution’. It is essential that money in drawdown — money you will be depending on in retirement — is invested, so that it can keep growing. Yes, it will be subject to market forces, and will fluctuate in value, but that’s the deal, that’s how flexibility works. Sensibly and suitably invested, in the long term its value should increase, whereas the value of cash is eroded by inflation and savings dwindle.
The Retirement Outcomes Report reveals that between 56% and 76% (the percentage varies according to pension value) of people who went into drawdown did so simply because they wanted to access some tax-free cash. The FCA is concerned that non-advised consumers who decide to access their pensions via drawdown don’t fully understand their decision. It is now consulting with pension providers, and will require them to introduce four ‘investment pathways’ that will enable consumers to invest according to their objectives. Pathways will need to be offered by July 2020 for the following objectives (the wording is mandatory):
- I have no plans to touch my money in the next five years
- I plan to use my money to set up a guaranteed income (annuity) within the next five years
- I plan to start taking my money as a long-term income in the next five years
- I plan to take out all my money within the next five years
One or two marshmallows?
The Marshmallow Experiment was a series of studies conducted in the 60s and 70s at Stanford University in California. Children of nursery school age were told that they could either eat a marshmallow put in front of them, or resist temptation and not eat it, and then be rewarded with two marshmallows fifteen minutes later. Some children caved; some held out.
A pension is a very tax-efficient investment vehicle designed to provide income during retirement. I’ve mentioned the short-term issues with the two ways money can be withdrawn prior to retirement above. The crucial long-term issue is that taking money out early means that retirement income will be lower.
Everyone has a right to choose. Installing a new kitchen, taking a cruise, buying a new car (probably more modest than a Lamborghini) in your mid-50s: these may seem very attractive, but their true cost doesn’t stop at their price.
We understand that middle-aged people nowadays may find themselves pitching in to support infirm parents or cash-strapped children reaching adulthood. These and other valid reasons for digging into your pension early certainly exist, such as settling burdensome debts or dealing with illness. If you really need the money, confining withdrawals to tax-free cash lump sums, if possible, is preferable. UFPLS should be regarded as a last resort.
In our onsite presentations, seminars and 1:1s we urge people to reflect on their financial future and the income they would like in retirement — and to think very hard before they lift that marshmallow to their mouth. Wait, if you possibly can. Two marshmallows are always better than one.