What are the new flexible retirement options?

When Chancellor George Osborne delivered his 2014 Budget on 19 March, he said it was a Budget for “the makers, the doers and the savers”. 

Flexible benefits retirement options

If you read nothing else, read this…

  • A number of changes announced in the 2014 Budget give pensions more flexibility.
  • Employees can choose to take their pension wealth as a lump sum, drawdown or as an annuity.
  • New tax rules will help provide greater flexibility.
  • A guidance guarantee will ensure pension members get advice on how to make the most of the new options.

It contained some far-reaching reforms to how members of defined contribution (DC) pension schemes will be able to access their savings. The biggest change is that, from April 2015, DC scheme members will no longer be required to buy an annuity, but can instead take their pension wealth as a lump sum, drawdown or as an annuity.

The government also introduced a new requirement for everyone retiring with a DC pension pot to receive free and impartial guidance on their choices around how to use their retirement savings.

Osborne said: “Thirteen million people have defined contribution schemes, and the number continues to grow. We’ve introduced flexibilities.

“But most people still have little option but to take out an annuity, even though annuity rates have fallen by half over the last 15 years.

“What I am proposing is the most far-reaching reform to the taxation of pensions since the regime was introduced in 1921.”

So what are the changes?

Maximum lump sum increased

From 27 March 2014, the maximum lump sum that an employee can take from a pension pot increased from £18,000 to £30,000.

The cash received is known as a trivial commutation lump sum.

This change adds flexibility to how pension scheme members can access their savings by increasing the total pension wealth that employees can have before they are no longer entitled to receive lump sums.

However, employers should be aware that the increase is subject to individual pension scheme rules.

Small pots

The number of small pots from which lump sums can be taken also increased on 27 March. Previously, 100% cash lump sums could be taken from only two pots; this has now increased to three.

The tax-free amount that can be taken out of an employee’s small individual pension pots as a cash lump sum has also increased, from £2,000 to £10,000.

This is regardless of an individual’s overall total pension wealth, and cash can be accessed from age 60. However, there are concerns that this change could hurt lower earners.

Tax-free lump sum

From April 2015, the tax treatment of cash lump sums withdrawn from an employee’s pension pot will be reformed. 

Individuals will still be able to take a tax-free lump sum of up to 25% of the value of the pension pot (as per current rules), but those that want to take more than the 25% tax-free amount from their pension as a lump sum will be taxed at the individual’s marginal tax rate and will no longer incur a 55% charge for full withdrawal.

Jeremy Harris, pensions partner at law firm DLA Piper, says: “This means that drawing the full benefit as a lump sum, with 25% tax free, the remaining 75% will be subject to tax only to the member’s marginal rate of income tax.”

Drawdown limits increased

From 27 March 2014, the amount a DC scheme member can draw down each year was increased from 120% to 150% of an equivalent annuity.

For flexible drawdown a DC member must a pension income of at least £12,000 a year before they are able to withdraw the full amount through drawdown. This has been reduced from the previous £20,000 income limit.

Capped drawdown  (150% calculation) does not have such limits.

Compulsory annuitisation scrapped

In the Budget, Osborne said: “As the nature of retirement changes, annuities are no longer the right product for everyone. People are living longer and their needs are becoming more varied.

“The introduction of automatic enrolment will dramatically increase the amount of pension savings. The landscape has completely changed.

“Moreover, the annuities market is currently not working in the best interests of all consumers. It is neither competitive nor innovative and some consumers are getting a poor deal. It is time for a bold, modern and progressive reform.”

Therefore, from April 2015, employees will no longer have to purchase an annuity to convert their pension pot into retirement income. Instead, they will be able to take their pension wealth as a lump sum, drawdown or an annuity.

Will Aitken, senior DC consultant at Towers Watson, says: “Clearly, buying an annuity is still an option. But taking the whole amount of money overnight may raise some implications. When taking into account these new flexibilities, an employee’s tax rate will have a big influence on the route they take.”

Guidance guarantee

With more flexibility and choice available, employees may need more support and guidance around their options at retirement.

In July, the government announced how it intends to deliver its guidance guarantee. Employees will have access to free, impartial guidance , which be provided by independent organisations rather than pension providers.

The guidance, which will come into effect from April 2015, follows the government’s consultation on how best to deliver the changes to how employees access their pensions.

The guidance guarantee will bring together a range of delivery partners, including the Pensions Advisory Service and the Money Advice Service, which already provide guidance and support to pension savers.

The guidance will be offered through a range of channels, including web-based, phone-based and face-to-face.

Stephen Greenstreet, a principal at Aspire to Retire, says: “With greater choice comes greater risk, and that leads to our view that people will need early education guidance.

“The guidance guarantee is a good idea but, if it is only being offered at the point of retirement, it is going to be limited in what that outcome could be.

“We believe early education guidance and information must be provided at an early date, but this is all positive news compared to where we were pre-March 2014.”

Changes to tax rules

There will also be a number of changes to tax rules to give providers greater freedom to create new products that meet consumers’ needs better, including allowing payments from annuities to decrease and permitting lump sums to be taken from annuities.

New tax rules will ensure individuals do not use the new flexibilities to avoid tax on their current earnings by diverting their salary into their pension with tax relief, and then immediately withdrawing 25% as a tax-free lump sum.

Future changes will also amend the 55% tax charge on pension savings in a drawdown account at death. The government says this is necessary because this charge will be too high when the new system begins in 2015. Changes around this will be announced in the Chancellor’s Autumn Statement.

But despite the changes, employers should be aware that in applying the reforms, they will not need to overhaul their pension administration. DLA Piper’s Harris says: “Schemes will have a ‘permissive statutory scheme rules override’, which enables, but not obliges, them to apply this flexibility without the need to amend scheme rules.”

Tim Smith

Tim Smith: New freedoms spell the end of pensions

Conversations around employees being unable to retire because they cannot afford to are likely to become increasingly common from April next year, when the government introduces radical changes to the rules relating to how individuals can access their pension savings .

Under the new rules, individuals will have total freedom over how they use their pension savings, which will mean that, from age 55, they will be able to withdraw their savings and use them to pay for home improvements, pay off debts or go on the holiday of a lifetime.

But what will this mean for employers and how should they respond?

From April next year, the flexibilities will mean a workplace pension scheme will essentially become a workplace savings scheme and employers’ pension contributions will no longer have to be used by staff to secure an income in retirement.

This means that employers could find themselves in the scenario described above, where staff that have paid a decent amount into their pension scheme and had the benefit of employer contributions still cannot afford to retire because they have already spent their pension savings.

Given that employers will not be able to force their staff to use their pension contributions to secure an income in retirement , they may wish to consider ways in which they can influence what employees do with their savings. 

This could include, for example, providing staff with financial education and training and/or rolling out a communication programme to help them understand their income needs in retirement and what steps they can take to achieve their retirement ambitions.

However employers respond, the way in which they, and their staff, view ’pension’ saving is set to change radically.

Tim Smith is senior associate in the pensions team at Eversheds