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Pension tax relief going soon

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Decumulate your pension with care

Decumulate your pension with care

The new pension freedoms effective from 6th April will enable many more people to hold their pension funds in investments and draw income from them. But many people are likely to underestimate the risk.

If you draw more than the natural income – dividends, interest and rents – from your investments you risk capital erosion. Quite how severe this can be depends on the pattern of returns as much as their size. Research shows that if your investments fall significantly in value in years 1 or 2, at a time when you are withdrawing capital to supplement income, there is a high probability that your money will run out before you do, even if returns are good thereafter.

The market does not deliver straight-line returns

Contrariwise, if you get a storming bull market in years 1 and 2 of your investment, then even if you do withdraw capital at a steady rate the chances are that your money will outlive you.

Neither of these patterns are captured in normal linear compound interest projections, where exactly the same rate of return is assumed each year. That is not a significant problem for the accumulation of capital, because if you are investing a regular sum, then the outcome from a linear compound rate won’t differ much from a variable pattern of short-term returns that sum to the same rate. In fact, more volatility generally benefits pound-cost averaging during accumulation – you buy more units when prices fall – whereas on the contrary, big variations in year to year returns when you are drawing more than natural income can result in “pound cost ravaging”. If your portfolio value falls by 15% and you withdraw 5% of the original value, you will now need a 25% increase to get back to your initial value.

Investment advisers are struggling to come up with sensible decumulation investment strategies that work regardless of whether years 1 and 2 are good or terrible, which is of course unknown and will be unknown at the start of any period of decumulation.

decumulate your pension with care
Total return over 84 months
decumulate your pension with care
Total return over 60 months

Since “cautious” portfolios with no more than 50% in equities fell in value by as much as 30-40% in 2008, it is almost impossible to design a conventional “long-only” portfolio that would not risk repeating this performance in similar circumstances.

The problem is compounded because fixed interest, which can be a bolt-hole in normal circumstances, could now be defined as offering “return-free risk”. Investment managers may say they can see bond yields staying flat for yet another year or even longer as more waves of QE suppress yields, but I would not like to make my retirement dependent on picking the right moment to switch out of bonds into equities. And going into decumulation now with, say, a 40% exposure to bonds strikes me as taking on colossal risk for two reasons: one, bond yields are already low and interest rates are likely to rise, with possible sharp reductions in the capital value of bonds; and two, inflation is low but could easily return to levels of 2-3% and eat into both capital and income.

Holding cash is safest

In any case, if you want – as many people will – to draw an income of 4% or 5% from your fund, gilts are useless since none of them yield that much. To get 5% you need to buy lower-grade corporate bonds verging on high-yield or junk. But how many pensioners really want to bicycle along the edge of a cliff?

The old-fashioned answer to the problem of risk at the start of decumulation was to park a capital sum equal to the first two, three or four years’ income in a deposit account and invest the rest in a standard “balanced” portfolio with 60% in equities. This was fine when you got a return of inflation-plus-2% on your deposit – but now that your interest is less than the core rate of inflation? Still, this remains the least risky way to cope with the unknowable “sequence of returns” problem.

The financial engineers are busy creating packaged solutions and you can expect to see many featured in the financial pages over the rest of this year. Here is an initial list, which I will update with more detailed comments in coming months.

Four ways to reduce risk

Guarantees. A big insurance company can offer a guarantee either of the capital value of a portfolio or of the income it generates. It can even offer an upward-ratchet guarantee to underpin the income. But with an annual cost of about 2%, the guarantees are at present so expensive that few people will consider this worthwhile.

Absolute return. Cash-plus or absolute return style investing using “global macro” hedge fund techniques has done pretty well since 2008, with some funds having generated a steady annual return of 7%. A large chunk of your fund invested in this way would insulate your capital from doomsday, but you would be wise to spread it across several carefully selected managers. You could use a set of these funds to hold your first few years’ income.

Multi-asset. In theory, spreading capital across many non-correlated asset classes can reduce the risk of 2008-style capital loss. The trouble is that many of these asset classes are either illiquid (like physical property or private equity) or are in fact simply sub-classes of listed equity, all of which will tend – as they did in 2008 – to rush towards zero together in a crisis. Still, you can expect some convincing spiels from managers of new-style multi-asset funds along with the results of a variety of mathematical “stress tests” proving how resilient the fund will be.

Tactical. Tactical asset allocation is the current term for very active trading between asset classes, usually using low-cost Exchange Traded Funds. Managers use technical indicators, especially those relating to volatility and correlation, to assess relative risk and signal timely switches. History suggests that since consistently correct market timing is the hardest and most elusive skill in the investment world, the wheels will come off at some point.

If you are moving into the decumulation phase, you need to review your investment strategy. “Path-dependent” stochastic modelling is the latest adviser fad and will tell you the probability of reaching certain financial goals or of running out of money, but unfortunately you need a maths degree to understand the assumptions on which the stochastic modelling engine is built. So my preference is to use simple linear projections but then apply common sense to the investment solution.

Historical data tells you the maximum peak to trough loss incurred in the indices of the major asset classes – about 45% in equities, 20% in high-yield bonds and 10% in gilts. Many individual securities and funds fell by half as much again in the 2008 crisis. If you could not withstand falls of that magnitude on your current portfolio – together with a 3-year delay until recovery – then I suggest you may want to make some judicious adjustments.

Chris Gilchrist, March 2015

Use your pension fund to avoid IHT

Use your pension fund to avoid IHT

In the last issue I pointed out that the new pension rules effectively make your pension fund the best tax shelter available in the UK. Not only does it avoid capital gains tax and income tax on rents and interest and higher rate income tax on dividends, it now also escapes inheritance tax. For many people, this creates the opportunity to revise investment strategies to minimise IHT.

The key issue is the 40% inheritance tax rate. Many people will have sufficient assets to be exposed to significant taxation at this rate. A couple, who can have combined assets of £650,000 before becoming liable to IHT, will still face a £40,000 tax bill on a £750,000 estate.

Under the old rules, where pensions had a 55% tax charge on death, it was better to keep the capital in ISAs. The new rules have changed the balance of advantage. While ISAs are exempt from income tax and capital gains tax – identical in treatment to pension funds – they do not benefit from tax relief on contributions, nor are they exempt from inheritance tax.

So, all other things being equal, most people will be better off by transferring capital from ISAs to pension funds if their estates will be liable to IHT, assuming they can get tax relief on the pension contributions.

Here is a simple example for a basic rate taxpayer.

£10,000 invested in an ISA yields 4% to produce an income of £400 net.

£10,000 invested in a pension fund attracts 20% tax relief and is boosted to £12,500. This sum yielding 4% generates an income of £500, which is subject to basic rate tax at 20% giving a net income of £400.

In income terms it is even stevens. But the capital in the pension fund is £2,500 higher, and the avoidance of IHT on £10,000 is worth £4,000.

And here is an example for a higher rate taxpayer who expects to pay basic rate tax when they withdraw income from their pension fund.

£10,000 invested in an ISA yields 4% to produce an income of £400 net.

£10,000 invested in a pension fund attracts 20% tax relief and is boosted to £12,500. This sum yielding 4% generates an income of £500, which is subject to basic rate tax at 20% giving a net income of £400.

The pension fund contribution attracts a further 20% tax relief (of the grossed up contribution, hence £12,500 at 20% = £2,500), which is received by the taxpayer.

So they now have capital in the fund of £12,500, at a net cost of £7,500; on top of which they have saved £4,000 in IHT.

In fact, the pension fund investor’s position is better than this since they are entitled to withdraw 25% of the fund tax-free at any point after age 55.

So for both basic rate and higher rate taxpayers, it can make sense to recycle some existing capital held in ISAs into pensions. For higher rate taxpayers, the optimal level of contributions is that which matches the higher rate tax liability for the year.

For some people, it will also make sense to draw down capital within an estate while preserving pension funds outside the estate.

For example, someone with £250,000 each in a pension fund and ISA could draw £15,000 a year (6%) from their pension fund as income. But if their estate will be liable to IHT they would be better off drawing that sum from their ISAs and leaving the pension fund intact. Effectively the £15,000 drawn from the ISA has a net cost of £9,000 assuming it would be liable to 40% IHT on death. People currently using flexible or capped drawdown schemes will be able to alter their future income withdrawals to whatever level they like.

Perpetual tax shelter

You can nominate as many beneficiaries as you like for your pension fund. The normal method is to specify the percentage share of the fund for each beneficiary. But note that you will need to check with your pension fund provider that they have the ability to administer benefits in this way – if not, you may need to switch your fund to another provider. If you want more flexibility, you can set up a spousal by-pass trust to receive your pension fund on your death, but it will cease to qualify for income and gains tax exemptions. So for most people, keeping the capital within the tax-exempt pension vehicle will probably be preferable.

Experts’ interpretations of the new rules – which will undoubtedly require more detailed guidance notes from HMRC in due course – suggest that someone nominated as a pension fund beneficiary can, on their death, leave their share to someone else, and so on in perpetuity.

Under these new rules, the pension fund can be used to provide a stream of tax-free income.

  • Dependant with taxable income below their personal allowance. Typically this will be a spouse with no pension rights and only a state pension. An amount equal to the difference between the state pension and the personal income tax allowance can be drawn each year tax-free.
  • Grandchildren. Each has their own income tax allowance, so if they are named as beneficiaries they (or their parents on their behalf) can withdraw up to that amount each year tax-free.
  • Non-resident. Anyone non-resident in the UK for tax purposes can draw benefits tax-free.

The new rules provide substantial opportunities for tax avoidance, but given the complexity of the interaction of taxes and reliefs, I recommend obtaining professional advice. I fear that given the obvious attractions of the new rules, there may eventually be legislative changes that erode these benefits. Make hay while the sun shines.

Chris Gilchrist, January 2015


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Pension changes more news to come August 2014

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A brave new world for pension investors May 2014

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