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In this article we are going to examine some of the options available in terms of pensions and saving for retirement. Well aim to provide some specific focus applicable to higher net worth individuals and exploring the important points we all need to consider when deciding how to save for retirement. As well as the typical pension arrangements we'll also touch on some of the other options available including ISAs and VCTs.
We should stress that this article is not to be seen as specific advice, as everyone's personal circumstances are different it is best to consult a professional financial adviser.
The Modern Day
Pensions in some way, shape, or form have been available since the Medieval times. Now, in the modern day, we have various options when saving for retirement and with more people contributing to pension schemes than ever, they are still serving an important part.
Before looking at some of the options available to savers we'll first cover some of the important figures and limits everyone needs to be aware of.
Annual and Lifetime allowances
Although there are no limits on how much any one person can contribute to their pension scheme in any given year or over the course of their lifetime, there is a limit on the amount of tax relief available on those contributions. It is very important to understand these limits and the potentially expensive consequences of exceeding them.
The annual allowance is the amount one can save into a pension each year, without incurring a tax charge. These allowances have changedÂ in recent years, coming down from the heady sums of £255,000 in the 2010/11 tax year, to the current limit of £50,000 for the 2013/14 tax year. This is due to be reduced again to £40,000 for the 2014/15 tax year. Contributions measured against the allowance for each tax year will be the sum of all pension contributions in the schemes "pension input periods". As pension input periods do not have to conform to the actual tax year (6th April - 5th April), care must be taken in ensuring pension contributions, in all input periods ending in the current tax year, do not breach the annual allowance to avoid incurring a tax charge.
This should be kept in mind especially with the reduction coming into effect as of the next tax year.
An important point to note with the impending reduction of the annual allowance is carry forward, this is where any unused allowances from three previous years can be brought forward for that contribution to be made in the current tax year or pension input period where different. However, caution should be exercised because any enhanced eligibility for a contribution would still need to be tested against the current year's net relevant earnings to ensure it could be made and achieve tax relief. Where the carry forward contribution is made as a personal contribution and is in excess of the individual's net relevant earnings, it will attract the same penalty as any other excess contribution. A carry forward contribution can be made solely as a personal contribution, and employer's contribution or a joint contribution between employee and employer
As with the annual allowance, similarly, the lifetime allowance is the amount that one can accrue in pension savings throughout their lifetime without incurring a tax charge.Â This has also dropped over recent years from an allowance of £1.8m in the 2010/11 tax year to the allowance now standing at £1.5m, with a further reduction due in the 2014/15 tax year to £1.25m. The Lifetime allowance can be tested at various stages but most likely to be tested when benefits are taken. More information on these stages can be found in "RPSM11102020 - Technical Pages: Lifetime allowance: When you test for the lifetime allowance: The eleven benefit crystallisation events", available on the HMRC website.
With the reductions in the lifetime allowance over the years, an element of protection was offered so that savers who had saved more than the new lifetime allowance could protect their current pension pot and not be subject to a penalty for exceeding the new allowance. Where pension scheme members do not already have protection on their pension pot the government are introducing "...fixed protection 2014..." to benefit those who have accrued over £1.25m but less than the current £1.5m allowance. To benefit from this any member will need to apply before the 6th April 2014. Fixed protection will enable pension savings up to £1.5m to be taken without incurring the lifetime allowance tax charge. Once obtained fixed protection cannot be given up but can be lost in some circumstances, including but not limited to having contributions paid into a currently held money purchase pot or starting a new scheme.Â
Another type of protection is due to be announced called Individual Protection 2014, details on this haven't been confirmed but what you can expect can be found on the HMRC website.
A certificate will be issued to those who have applied before the specified dates and should be kept safe as it will be needed to verify their protection with the scheme administrator when it comes time to take their benefits!
The current tax charge for anything in excess of the lifetime allowance stands as follows.
- If taken as lump sum: 55% on the lump sum
- If taken as a pension (no lump sum): 25% on income payments
Anything in excess of the annual allowance is added to the savers annual income for that tax year which should be monitored as it could push them into a higher tax bracket.
Types of Pension Schemes
Within the myriad of pension options there are a few staples. The main types of pensions we see today are either Occupational or Personal Pensions. Within a scheme there can be a few different types of arrangements which will determine how your pension is paid out in later life. These arrangements can be; money purchase or defined contributions, defined benefits, cash balance or a hybrid. We'll look at each in turn.
With defined benefit arrangements the member is promised a certain amount, each year, at retirement. This is normally based on the person's salary and length of service. These are usually occupational schemes, including the following common examples.
- Final salary schemes: The pension available is based on the member's final pensionable salary at the company and the numberÂ of years they've been with the employer.
- Career average: The pension available is based on the average earnings of the employee, over their period of employment.
- Lump sum only: These types do not provide a pension, only a lump sum at retirement. This is based on a percentage of the member's final pay for each year of employment or membership of the pension scheme.
- Hybrid arrangements: These are usually a combination of defined contributions and defined benefits arrangements. The member will not normally know what their pension benefit is until they are to be taken.
Money Purchase or Defined Contributions
With these types of arrangement the member will not know in advance how much pension they will be entitled to in advance or retirement. They will make regular contributions which will grow to form a "pension pot" the value of this pot will also be determined by the funds that are chosen and how they perform over the investment period. The pot will be used, at retirement, to secure a pension payment option. Amongst other schemes, Personal Pension and Stakeholder Pension schemes tend to fall into this category
Guaranteed Minimum Pension (GMP)
This is the minimum pension which an occupational pension scheme has to provide for those employees who were contracted out of the State Earnings-Related Pension Scheme (SERPS) between 6 April 1978 and 5 April 1997. The amount is said to be 'broadly equivalent' to the amount the member would have received had they not been contracted out. Different levels of GMP will apply based on the date of contracting out.
From 6th April 1997, GMP was no longer accrued with the system being replaced.
We'll outline some short details about the main types of schemes and contracts below.
Personal Pensions (PP)
Personal pensions are a staple addition to the basic state pension, where the potential investor maybe doesn't have access to a Group or Workplace scheme and wants to save a little more for retirement. Contributions are flexible, with members being able to contribute regularly or in one lump sum. As we've mentioned previously the amount available at retirement is dependent largely on the performance of the investment funds selected. The range of pension funds within these types of contracts is usually quite diverse with access to various "Life-styling" options make them for flexible contracts.Â
A quick note on life-styling!Â
Life-styling portfolios, as they are sometimes known, are usually a range of funds set up by the scheme provider. The aim of these portfolios is to move the scheme member into lower risk investment funds the closer they get to retirement, with the idea of safeguarding any growth achieved in the early stages. A downside to these options is they are often a specific range of funds run by the scheme provider and not very flexible.
Stakeholder Pensions (SHP)
Stakeholder schemes are a type of personal pension. These schemes were brought in by the Government in 2001 to encourage people to increase their long term savings. These schemes had low minimum contribution and a cap on the charges a fund could impose, with the idea of making them more attractive to those on lower wages. Before the introduction of auto-enrolment employers with over five employees were required to offer a Stakeholder option where no other employee scheme was available, however this is no longer the case. An unfortunate downside to the low charging restriction means the contracts have a smaller fund range to choose from and may not be very attractive to the more adventurous investors.
Even with the limited fund range, the right choice of provider could result in a relatively low cost savings vehicle with a good, if limited, selection of funds.
Group Personal Pensions (GPP)
A Group Personal Pension is another type of personal pension, as the name might suggest. Due to the way they are set up they can offer the potential for better deals and can sometimes work out cheaper than taking out personal pension on its own. The build-up of the pension pot works in the exact same way as a personal pension with the benefit of contributions being taken directly from the employees' wages. Employers will usually offer to match an employee's contributions into the scheme.
An option called Salary Sacrifice is generally available whereby the employee can elect to 'give up' a portion of their salary which is then paid into the pension scheme by the provider. This is generally a good option for higher rate tax payers as it can in effect reduce the employees annual salary; potentially bringing them down into the basic rate tax band, reducing the amount of tax paid.
Self-Invested Personal Pensions (SIPP)
SIPPs or Self Invested Personal Pension Plans are yet another form of personal pension. The main difference with a SIPP is the flexibility allowed with the scope of investment. In other words, they're able to invest in more the interesting areas and not just funds.Â Areas such as; commercial property, individual company stocks and shares, traded endowment policies and gold can all be accessed. The types of SIPP available in the current market place range from the more restricted "Deferred SIPP" which invests mainly in insured funds to the "Hybrid" and the unrestricted "Pure SIPP" which has a more open architecture. The costs associated with SIPPs tend to rise in correlation with the amount of flexibility available and because of this, a SIPP will usually be more appropriate for those with a significant amount of money to invest.
"Sipps are just an efficient tax wrapper and it's what's inside that matters. If you're not prepared to take any risk with your pensions then Sipps might not be for you."
SIPPS, under certain circumstances, can also make loans to unconnected third parties, as long as certain rules are observed. Care must be taken when making the loan available as certain areas such as acquiring taxable properties are not permitted reasons to provide a loan. The following rules need to be observed.
- The loan should be prudent and care must be taken to ensure a borrower is capable of making the repayments.
- Interest rates should be at a level similar to those available in the commercial market place and should not be excessive.
- The loan needs to be secure; generally unsecured loans are not acceptable.
Another advantage of a SIPP over a personal pension is the ability for a SIPP to borrow up to 50% of the fund value. This offers the SIPP owner the potential to purchase a commercial property or land with the aid of a SIPP. A reasonable rent must be paid by the business using the property, usually equivalent to typical market rates. There is also the option of purchasing another rental property from which the rental income can be used in a tax efficient way to fund the SIPP income payments when the scheme owner decides to take their benefits. Certain things must be considered when purchasing a property, such as liquidity issues, if the need arises for the SIPP to sell the property to provide benefits. Slumps in the property market can also make an impact.
Small Self-Administered Schemes (SSAS)
A Small Self-Administered Scheme or SSAS is a workplace pension scheme with similar investment options as those available within a SIPP. The main difference between this workplace scheme and other occupational schemes is that they are not set up by an insurance company; they are normally set up by up to 11 company shareholding directors, who act as trustees for the scheme, with a sponsoring employer. As with other trust, trustees must abide by the rules set out in the trust deed.
As with SIPPS, the increased flexibility of these schemes can mean higher charges, however the more scheme members (up to the maximum of 11) the more likely they scheme is going to be better value for each member than an individual SIPP arrangement.
A SSAS, as with a SIPP can make loans to unconnected third parties, providing the same rules and guidance mentioned above, in the SIPP section, is complied with. SSAS arrangements, however, also have the ability to make a loanÂ to the sponsoring employer company, ensuring the following rules are followed.
- The loan amount must not exceed 50% of the scheme's net assets at the time the loan is made.
- The initial loan term must not exceed five years. Although a single extension of another five year term may be allowed.
- The rate of interest charged on the loan must be a minimum of 1% above the average base rate of six clearing banks.
- Repayment of the loan must be made in equal instalments throughout the term of the loan.
- The loan must be secured on a company asset, such as a commercial property.
SSAS rules on property purchase are the same as those for SIPPs, mentioned above.
A SSAS can also invest up to 5% of its net value into the sponsoring company. This can potentially mean the SSAS owning 100% of the company as long as this does not account for more than 5% of its net value.
Executive Personal Pensions (EPP)
Popular plans before A-day, these plans are not as widely available, in the current market place,Â as they used to be.Â A large benefit to these schemes was the potential for a larger tax-free cash option over and above the normal 25%. They were set up specifically for company executives. The flexibility of the plans made them easier to tailor to specific executive benefit packages. The options for borrowing and loaning, as with SIPP and SSAS arrangements above, are also available to an EPP scheme.
Other Options for Retirement Savings
Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS)
VCTs and EISs were originally set up to specifically encourage investment into small, high risk companies not listed on the stock exchange. Investments into either an EIS or VCT will be a purchase of shares. In the EIS this will be shares issued direct from the company, with the VCT it will be shares issues by the trust, which itself invests within a number of companies, spreading the investment risk. Both are considered higher risk investments with the main benefit of these investments being the tax advantages. Investing in a VCT or EIS offers both Income & Capital Gains tax benefits.Â
The Income tax benefit comes at a rate of 30% and tax free dividend payments. The Capital Gains tax (CGT) benefits allow the investor to avoid paying Capital Gains tax on any disposals.Â Investors can only claim tax relief on up to £200,000 worth of shares for VCTs and up to £1,000,000 for EISs. Shares must also be held for a number of years to qualify for tax relief, for EISs this is three years and five years for VCTs.
Another point to note is that as the investor avoids paying CGT up to these limits, they will unfortunately not be able to offset any losses on these shares, against other CGT liabilities.
Individual Savings Accounts (ISAs)
Individual Savings Accounts are a 'tax wrapper'. Tax wrappers offer particular benefits to any investments that can be accessed through them. As the name suggests other investments are wrapped up in them, somewhat like a present. In an ISAs particular case, the gift is any investments held within the wrapper will benefit by being free of Income & Capital Gains tax liabilities.
ISAs are subject to certain restrictions, the main one being a total annual limit of £11,520 all of which can be invested into a Stocks and Shares ISA. Alternatively up to £5,760 can be invested into a cash ISA, with the remaining going into a Stocks and Shares ISA. These limits are reviewed each tax year. Another restriction is that an investor can only open one of each type of ISA per year, however multiple accounts can be held over the years.
As such ISAs should always be considered an important part of an investment portfolio and it is certainly worth shopping around for the best deals for both cash and stocks & shares ISAs.
Maximum Investment Plans (MIPs)
Maximum Investment Plans have largely been killed off in recent budget announcements where an annualÂ investment limit of £3,600 has been applied, where previously no such limit existed. They are essentially savings plans with a moderate amount of life assurance attached to the policy. The result is that if held for a period of 10 years with regular contributions being paid any gains achieved on disposal after the 10 years would be free from tax liabilities.
There are very few providers in the market place still offering MIPs, but where available may be another avenue worth exploring.
Employer Funded Unapproved Retirement Benefits (EFURBS)
There are two types of EFURBS, FURBS which are Funded Unapproved Retirement Benefit Schemes and UFURBS which are Unfunded Unapproved Retirement Benefit Schemes. These types of contracts have again, since A-day, lost many of their tax benefits and are now considered less attractive than they have previously been. Much like MIPs they may be an option for higher earners to consider as a top-up to an approved pension scheme when other options have been explored and exhausted. The tax treatment of these schemes is complex and beyond the scope of this article and expert tax advice should be sought.
Options at retirement
When the time finally comes, there are two main options when choosing how to receive an income at retirement. These are lifetime annuities and income drawdown.
Lifetime annuities can be purchased at retirement and will generally offer an income until the annuity holder's death. The income payment received will be dependent on their life expectancy and annuity rates at the time; this will be calculated by the insurance company. The annuity market is largely rate drive, which means it's best to shop around to find the best rates available, as you would with, say, an ISA.
Income payments will either be level or escalating. Level payments will remain as they are throughout the payment period where as escalating options will increased overtime and will increase at a set rate or will be linked to an index such as the Consumer Price index or the Retail Price index. This can help reduce the effect of inflation as time goes by. Escalating arrangements generally start of at a significantly reduced rate of income than level payments. The money advice service has suggested that it would take up to 12 years for the escalating annuity payments to catch up with that of a level arrangement. Generally once the annuity holder dies all payments will cease and the policy will end, no money will be returned, even if the annuity holder were to die early.
If there are dependents a joint life option could be considered which will pay an income to the surviving spouse for the rest of their life. This income payment will either be equal to or a portion of the original annuity holder's income payment.
For those with serious health problems Impaired or Enhanced annuities are available and will generally pay a higher income payment due to the shorter life expectancy of the annuity holder.
There are also guarantees available which can mean income payments continue for a stated number of years if the annuity holder dies early, although should there be someone financially dependent on the annuity holder it may be more beneficial to consider a joint life policy. There is also the option of protecting the lump-sum used to purchase the annuity, less any income payments made. This can then be paid to the estate of the deceased. Both of these options will mean a lower income payment to take into account the cost of providing a guarantee.
A pension or income drawdown policy is also an option at retirement. This will keep the pension pot invested and income can be taken annually. In times of poor growth this option can result in the income payments being taken from the pension pot itself, reducing the available pot. The benefits include being able to vary the income payments over the years. It can also help to mitigate Inheritance Tax liabilities by making annual gifts. On death the remaining vested pension can be returned to the beneficiaries of the estate and remain in income drawdown free from any IHT liability.
Drawdown contracts can be more expensive than regular annuities and it would be worth discussing the tax benefits in more detail with a tax specialist.
This is an option where part of the pension remains invested and a portion is used to buy an annuity. Further annuities can be purchased at a later date potentially taking advantage of higher annuity rates but running the risk of annuity rates being less favourable. An advantage of this is a tax free lump sum can be taken with the purchase of each new annuity.
To sum it up
In conclusion the pension arena is a wide and competitive environment with a lot to consider. Whether you are just setting out on your retirement planning journey, are already on route or have arrived at retirement, it is worth shopping around. Although it is possible to do it alone it is worth obtaining professional advice to get the best for your individual circumstances!