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Now that the dust has started to settle following the recent turmoil in the financial world, it is worth reminding ourselves of a more traditional challenge facing not only our clients, but the population as a whole, creating sufficient assets for a comfortable and financially secure retirement.
To quote from an article in the Times "We are not saving sufficiently for our retirement and our age expectancy is greater (we are living longer). The self employed cannot rely on an employer to make pension arrangements for them, in fact research shows that 53% of men and 67% of women who are self employed are not contributing to a pension".( www.timesonline.co.uk)
In recent years when discussing this issue with my clients I have often heard "my business & or my house is my pension", which perhaps was true for those lucky enough to retire prior to the recession and Banking crisis. But for those with plans to retire since then they have had to rethink their plans, due to difficulties in the property market or being faced with selling their business below the expected price, if at all. The message now more than ever is to have more than one string to your bow when planning for retirement to ensure that sufficient financial options are available to allow your clients to retire when they choose and at an acceptable standard of living. After all if you aren't talking to them about this who is?
With this in mind it is vital that Pensions are part of a strategy when planning for a comfortable retirement.
Why consider a pension plan over other types of investment?
The most compelling argument for using a pension is tax relief and the favourable tax treatment of the funds within a pension. Before we go on to look at the different types of qualifying pension plans it is sensible to remind ourselves of the tax treatment for pensions.
Tax relief is available on all contributions at the highest rate of tax that is payable, for example.
A basic rate tax payer making a gross payment of £3600 will receive tax relief of £720 a very good incentive that encourages contributions.
And for higher rate tax payers this is more valuable and the figure rises to £1,440.00.
Combine this with virtually tax free growth and the proposition becomes hard to ignore for the self employed especially the higher rate tax payer.
It is important to be aware that the rules for higher rate tax payers is changing following the pre budget report 2009, in particular for those with taxable income in excess of £130,000. Later on in this article I will go on to explore these changes in more detail.
Types of pension schemes available to the self employed
An adviser will consider the different plans available and make a suitable recommendation based on a client's individual circumstances. There are three variants of Pensions available to the self employed.
These are generally considered to be a cost effective option for clients who have unsophisticated planning requirements. These schemes are subject to DWP (Department of Work and Pensions) regulations and need to be considered first before more complex schemes are used. The key points are.
Low minimum paymentsÂ
Low Cost -Â Charges cannot be more than 1.5 % p.a of the fund valueÂ a yearÂ for the first ten years, fallingÂ to 1 % after the tenth year.
Typically these types of pension will appeal to those that have uncomplicated pension needs. However they do not provide access to a large range of funds, or the whole range of retirement options which we will consider later on in this article.
Similar to a stakeholder scheme but allows access to greater fund choice and can be more expensive as there is no regulation affecting charging structures. The number of funds available, charging structures and other options vary greatly therefore it can be daunting for the inexperienced to choose the most suitable and cost effective option.
Self Invested Pension Plan (SIPP)
As the title suggest a SIPP will enable the client to select their pension investments, although there are certain restrictions such as residential property. Investments can be combination of assets or just one.
Examples of types of investments can include:
direct commercial property (commonly a clients business premises)
real estate investment trusts
As greater investment choice is available the schemes are more expensive, they also offer greater flexibility when it comes to taking benefits, this will be covered later on this article.
The SIPP also has powers to borrow and can borrow up to half of the scheme assets. This is often used when the scheme purchases a commercial property.
A SIPP is appropriate for a client requiring greater sophistication of investment choice and when taking benefits.
It is perfectly possible for an individual to perhaps start with a Stakeholder pension at the beginning of their pension planning journey and move into more sophisticated contracts if their circumstances require it in the future, after all why pay for additional options until they are required.
Other types of investment should also be considered, an adviser will consider these types of investment vehicles alongside a pension fund, where appropriate, these typically could be
As mentioned in my introduction a combination of assets are likely to be used to build assets for a comfortable retirement and not just one.
Funding a pension is important, but just as important to your client is how the funds are invested once they have found a home in a pension scheme. Several factors will influence this and they can be broken down into three areas for your clients.
Risk, what level of risk are they prepared to take with their pension funds, are they very aggressive investors? Seeking high return for high risk. Or Low Risk, do they prefer smaller fluctuations in the value but prepared to accept lower returns, or somewhere in between?
A good adviser will take some time analysing this with a client, perhaps taking them through a questionnaire that allows them to gauge a clients comfort zone when it comes to risk and reward.
Time, how long before benefits might be taken i.e. if a client only has a few years to retirement compared to say 30 years it is likely that a high risk strategy would be inappropriate as a downturn in the markets just before benefits are taken could drastically reduce the fund value and subsequently the income and standard of living they may expect.
Charges, the more expensive the contract the more it will reduce the size of the pension fund. For example if your client is invested in a SIPP which typically has higher costs attached to it are they utilising the greater flexibility that is offered or would they be better off in a cheaper Stakeholder pension?
It is also worth remembering that when markets are rising then more expensive charges can be lost in the gains, but when markets fall the increased costs can be very noticeable.
Again a good adviser will take all of these points in consideration when recommending a suitable contract and investment strategy.
There is also the need to be mindful of HMRC rules on funding for the self employed these are summarised as follows.
To be eligible to make a pension contribution you must be a relevant UK individual and broadly speaking have UK taxable income.
Anyone that is eligible can pay up to £3,600 gross per tax year regardless of earnings and pension payments can be paid up to age 75.
Contributions in excess of £3,600 can be made as long as the individual has sufficient earnings, the limit is 100% of relevant UK earnings subject to an overall annual allowance of £245,000 in 2009/10 rising to £255,00 2010/11 any contributions in excess of this will attract a 40% charge.
There is also the Lifetime allowance a clients total pension funds cannot be greater than £1.75m 2009/10 increasing to £1.8m 2010/11. Any excess over this limit will be subject to a lifetime allowance charge of 55% on any lump sum drawn and 25% on income.
Important Changes facing higher rate tax payers
As I mentioned earlier in this article there have been changes to the tax treatment for some higher rate tax payers.
It is estimated that these changes will affect 450,000 individuals some of whom could well be your clients. (Standard Life http://www.techzone)
Over an 8 month period the rules changed and will effect your clients on incomes in excess of £130,000 (previously £150,000), having been reduced in the Pre Budget report 9 December 2009.
April 2009 saw the introduction of the special annual allowance with the aim of reducing tax advantages of pension contributions for higher rate tax payers. This is a temporary measure and will last until 5Th April 2011, when the government will implement its final rules.
So what does this mean for your clients with incomes in excess of £130K
"High income individuals have a special annual allowance of the highest of:
A basic allowance of £20,000; or
An enhanced allowance of up to £30,000. (This can apply where money purchase pension contributions have been paid by, or on behalf of, the individual less often than quarterly (such as single contributions). It is based on the lower of (a) the average of these infrequent contributions in the three tax years 2006/07, 2007/08 and 2008/09 and (b) £30,000); or
3. Their protected pension input amount. This is broadly based on their normal amount of regular pension provision before 9 December 2009 (or 22 April 2009 for those with relevant income of £150,000 or more in the tax years 2007/08, 2008/09, 2009/10), but can include other pension provision in some circumstances."(Standard Life http://www.techzone)
If pension contributions exceed these figures in this or the next tax year then there may be a special annual allowance tax charge. The rate of the special annual allowanceÂ tax charge for 2009/10 is 20%.
For the tax year 2010/11,Â the tax charge can be up to 30% in some circumstancesÂ to reflect the introduction of a 50% rate of income tax.
Crystallisation & Beyond
When the time comes for you client to consider taking their benefits they typically will need to be aged at least 55 (unless your client is in a particular occupation that allows earlier retirement) and 75 at the latest.
There are a number of ways benefits can be taken, all with different complexities and risks involved. It is vital that they take advice at this stage to guide them through what is likely to be one of the most important financial decisions of their lives.
Typically the first decision is whether your client wishes to take advantage of the PCLS (Pension Commencement Lump Sum). This can be up to 25% of the pension fund and is free of tax, as opposed to the income from the annuity which is taxable.
This sum can be invested or used to repay debt. Once this decision has been made they then need to consider how best to utilise the balance.
There are various options available some more sophisticated than others, which we will go on to look at now.
Perhaps the most common way and will always need to be considered before looking at more risky or complex options; a lifetime annuity converts the pension fund into an income for the rest of your clients' life. Lifetime annuities are provided by life insurance companies different options can be included, for example:
A spouses pension
An impaired life annuity, is aimed at individuals in poor health or smoke their life expectancy is shorter compared to a healthy person an annuity provider will typically pay a greater amount. Some companies specialize in providing impaired or smoker annuities only.
The older the client the higher the income purely because an older person has fewer years left to live than someone younger.
On average women live longer than men, so annuity figures will reflect this, a female will receive a lower income than a male with the same circumstances.
Lastly other decisions that are made such as whether the annuity should be an increasing or level and whether guaranteed periods are required. These will affect the amount paid out as these options are "bought" and typically mean that the client will start with a lower income than if no options were used.
Insurance companies do offer very different terms for annuities, therefore an Open Market Option (OMO) should always be considered as the difference between the worst and the best companies can be considerable. The only exception to this can be when typically older style policies carry guaranteed annuity rates which can be very attractive compared to today's rates.
Guaranteed income for life
No investment risk
Fixed for life and cannot be changed
If you die prematurely, your pension fund is lost (apart from any covered by a guarantee)
These are riskier alternatives and are intended to provide a greater income than a guaranteed annuity.
As the title suggests Investment-linked annuities put the pension fund into risk related investments, with a view to the client benefiting from better returns after retirement and therefore an increased income; however there is the risk that the value of the fund could fall in value and have a negative effect on the clients income.
These types of annuities will have higher charges attached to them which will impact on the level of income paid out
Potential for investment growth
Greater income flexibility
Annuity rates could increase or your health could deteriorate resulting in a better rate
Guarantees on the level of income and the size of your pension fund
Investment returns may be poor
More expensive than annuities
Annuity rates might fall and reduce future income
There are other options available and are likely to be more appropriate to those who have built up in excess of £100K
Given that there can be some drawbacks to buying a straightforward annuity such as low annuity rates or a client demands a more flexible approach to taking benefits then the following options should be considered.
The client is able to flexibly manage the level of income they take within minimum and maximum limits allowed by HMRC. It is possible to take no income and take the maximum PCLS until age 75. The HMRC limits will depend on age, sex and returns from Government Securities and are calculated using GAD (Government Actuary's Dept) tables. By not buying an annuity the balance can remain invested and continue to grow, subject to market conditions. This is known as full drawdown.
There are other variants on drawdown often referred to as Phased Drawdown and Dripfeed drawdown.
Phased allows you take income and PCLS in stages and can provide a more flexible death benefits
This option can be used to good effect when a client requires a regular amount of income and is made up of an amount of PCLS and income from the fund within the HMRC guidelines detailed above and can be between 0% and 120% of the relevant GAD limits. This can be used to minimize the tax a client pays and has useful death benefit implications.
All or part of the fund can be used to buy a fixed-term annuity which can last up to five years. Just as with conventional annuities various options can be chosen. At the same time, the balance of the fund remains invested. At the end of the term another short-term annuity can be arranged or they can combine income from a short-term annuity with income drawdown. It is important to be aware that the client must secure a pension income from the fund by their 75th birthday. Typically this will be a lifetime annuity.
Allows control of retirement income
An annuity can be taken at any point
Remains invested and can benefit from growth
Annuity rates could fall
Investment returns might be poor consequently reducing fund value
Alternatively secured pension
If by age 75 an annuity hasn't been purchased, another option is to use an alternatively secured pension. This works in a similar way to unsecured pensions but has different limits and rules. Inheritance tax and other significant tax charges may apply to any leftover funds on death.
Alternative to taking an annuity at age 75
Some flexibility over the income level you take
Can remain invested to benefit from potential growth
The amount you can take could reduce if your pension pot doesn't grow sufficiently
Drawdown limits are lower than for unsecured pension and based on an annuity for a 75-year-old
Death benefits are restrictive and your fund could be subject to taxation
Lastly there are other options if a client doesn't want to commit to a lifetime annuity but doesn't want the investment risks of income withdrawal. These relatively new products pay a regular income and offer guarantees of either:
Investment growth or the amount of pension fund they can expect to have left to buy an annuity later on. It is important to be aware that they will carry greater costs in return for the guarantee provided.
A client that wishes to fully retire at a certain age is likely to be more interested in the more simple annuity approach, however some may prefer to stagger their retirement, may be working two or three days a week to start off with and then slowly ease into full retirement. This is where more complex solutions such drawdown is more appealing, as any additional income required to top up the loss of earnings can be generated on a more ad hoc basis and as tax efficiently as possible.
In conclusion personal pensions in their various guises represent a very useful and valuable way of planning for retirement and should play a large part in the higher rate tax payer's financial strategy.
Recommending of the use of a pension can only enhance your relationship with your client as can be using a good independent financial adviser to advise them.