Lack of knowledge
A while ago, I used to arrange annuities for people as they hit retirement. Many of them were members of workplace pensions. Before the pension freedoms legislation was enacted in 2015, rules were far more restrictive and drawdown was only available to the relatively well off. Almost everyone bought an annuity: they had no real choice. But people’s lack of understanding could be surprising and dismaying. Often they had no idea that turning their savings into an income involved a transactional process. They thought it happened automatically when they announced they were about to retire.
I suspect part of the problem derives from the fact that ‘pension’ in the UK means two things: the vehicle you use to save for retirement and the income you receive in retirement. This is confusing.
The pension freedoms shook everything up, and enlightened employers have ensured that financial education in the workplace has come a long way since then. All the same, the results of an online poll conducted by Standard Life in February and March this year and quoted in Pensions Age magazine are not encouraging. Of 2,825 respondents:
51% of over-55s said that they ‘know little’ about the pension freedoms
A further 10% said that they had never even heard of the rules
Despite this widespread lack of knowledge, 55% plan to take tax-free lump sums from their pension before they retire
The stats above indicate how much scope there is for uninformed people to make unwise decisions.
One potentially damaging action that people who are still working and contributing to a workplace pension can take is to withdraw money from a policy using UFPLS, pronounced ufplus. UFPLS stands for uncrystallised fund pension lump sum, and means that an amount consisting of 25% tax-free cash and 75% taxable cash is withdrawn. The taxable component is added to, and taxed as, earned income in the tax year it is taken.
If you use UFPLS, the immediate consequence is that your annual allowance — the maximum amount that you can tax-efficiently pay into a pension every year — is reduced by up to a factor of ten. Most people’s pension annual allowance is the lower of 100% of salary or £40,000; after money has been withdrawn via UFPLS it is £4,000, and renamed the money purchase annual allowance (MPAA).
Just to be clear, these allowances are the maximum that can be contributed tax-efficiently into pensions. You can contribute as much as you like, but pensions’ tax-efficiency is what makes them such an attractive means of saving.
The MPAA stood at £10,000 in the 15/16 and 16/17 tax years, before being cut to £4,000. It is there to prevent recycling — withdrawing money from one pension and putting it into another to generate extra tax-free cash.
Employees have every right to use UFPLS at their own behest. They are, however, legally obliged to tell their employer within 91 days; and their employer may have to reduce their contributions.
Avoiding triggering the MPAA
There are three ways of accessing pension savings that avoid triggering the MPAA:
You take a tax-free cash lump sum of 25% and move the residual 75% into a flexi-access drawdown (FAD) account but don’t take any income.
You take 25% of the money as a tax-free cash lump sum and use the 75% taxable component to buy a lifetime annuity — a guaranteed income for the rest of your life.
You encash pensions valued at less than £10,000. The ‘small pots’ rule means that any number of small pensions like this can be cashed in without affecting your annual allowance.
The problem, of course, is that so many people don’t know these rules.
The pension freedoms and pension providers
We are all in favour of the pension freedoms — but they were announced in March 2015 and came into force a few weeks later, at the start of the 15/16 tax year, without prior consultation with the pensions industry. This meant that providers were at sixes and sevens for quite a while, trying to update their processes so accommodate people’s new legal rights.
It is our experience that, for several years, employees could trigger the MPAA unwittingly, largely because unprepared providers were reluctant to obstruct their legal rights and had had insufficient time to develop effective processes. Hence my Wile E Coyote image above. Inadvertent MPAA-triggerers were in effect running off a cliff edge and pedalling in mid-air until they realised there was nothing beneath them and fell to the ground below.
The good news here is that providers now have much more robust systems in place to prevent this. Employees can’t just ask for their money. They have to go through controlled, guided processes (if they’re not receiving financial advice) and sign to say they understand the implications of UFPLS.
First, we are very pleased that pension providers have put procedures in place to ensure that people are aware of the detrimental effects of UFPLS before they can go ahead.
Second, a pension is a tax-efficient investment vehicle designed to provide income during retirement. Taking money out early means that retirement income will be lower. Everyone has a right to choose, of course. Installing a new kitchen, taking a cruise, buying a new car in your mid-50s: these may seem very appealing, 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.
Third, financial education in the workplace is essential. In our onsite presentations, seminars and 1:1s, among many other topics, we explain the pension freedoms and help employees to plan their financial future by focusing on the income they would like in retirement.