THE BIG QUESTION

SHOULD YOU TAKE A CASH LUMP SUM

FROM YOUR PENSION?

THE RICHER RETIREMENT SPECIALISTS

www.avantiswealth.com

ROD THOMAS INVESTMENT

The recent changes in pension legislation have raised a hugely important question for many people approaching retirement age. With the option of taking up to 100% of their pension fund in cash, how much, if any, should be withdrawn?In talking about the new pension freedoms, the pension minister recently confirmed that someone really could cash in their pension and buy a Lamborghini! That caught the imagination of many, and resulted in a ripple of concern.

The government is now worried that people may not understand all the issues involved in making a decision to withdraw cash from their pension. So a national support network has been created to provide ‘guidance’ for everyone who wants it. Since this ‘guidance’ is going to be generic and not delivered by professional financial advisors, it remains to be seen how valuable it is.

This article covers my personal views on the important question of whether to draw cash, and if so how much, from your pension fund. It is not personal advice since everyone’s circumstances are different. However, with the information I’m sharing, you will be better prepared to consider this choice. I recommend that you take financial advice from an approved advisor before making any final decisions.

From what pensions can a 100% withdrawal be made?PENSIONS FALL INTO TWO MAIN CATEGORIES.

Defined contribution (DC), also called Money Purchase schemesThese pensions have a final value that is determined by market forces. Your pension managers have built up a fund during your years of contribution, the value of which is determined by the total contributions and the investment performance of the fund.

Historically, most DC schemes (which could be personal or works pensions) have allowed a 25% tax free lump sum, with the balance taken as an annuity (or income for life). More recently many people have decided to keep their fund invested (going into ‘drawdown’) and not buying an annuity.

Any pension holders who have a DC scheme will be able to take advantage of the new pension freedoms and withdraw up to 100% of their fund. This is true whether it is a personal or a company pension scheme.

Defined benefit (DB), also called Final Salary schemesThese pensions have a value that is determined by a set of rules that usually relate to your salary in the last few years of employment. DB schemes usually allow you to take 25% tax free cash on retirement, then provide a pension for life.

A DB scheme does not allow you to take the rest of your pension as a fund to keep for investment, or to take the rest of your scheme in cash despite the new regulations.

Therefore those people with DB schemes, now wanting to benefit from the new pension freedoms and withdraw more than 25% from their fund, need to transfer their DB scheme to a different DC scheme.

The Government has decided that there is a considerable risk to the public finances if too many government employees with DB schemes decided to transfer to DC schemes. This would require the payment over of the full cash funds – possibly amounting to hundreds of millions of pounds!

Therefore there is no opportunity for government employees to benefit from cash withdrawals above what is already allowed in their existing scheme. And government employees are banned from switching from a DB to a DC scheme. Employees in the private sector are still be able to switch from a DB to a DC scheme, subject to getting advice from an IFA.

What are the new rules about withdrawal of cash from your pension?• From April 2015, many people reaching

retirement age (minimum age 55) who have an appropriate pension, are able to withdraw up to 100% of the value of the fund.

• The first 25% of the fund can be withdrawn free of tax. (This is the existing position).

• Any further withdrawals will be taxed at your marginal tax rate, at the time the withdrawal is made.

• You do not need to make one big withdrawal, but can spread them over a period.

• It is worth remembering that you do not have to make any withdrawals at all!

Seven basic principles to bear in mind

1. Before we start our discussion of the pro’s and con’s of taking cash from your pension, it’s worth keeping in mind a handful of fundamental principles that underlie the concept of pension provision. Pension provision can be considered in two parts. The first part, up to retirement, consists of building the largest pension fund possible. The second part, after retirement, consists of turning this fund into the largest income possible.

2. Any cash withdrawal from the fund, at any time, has a negative impact on your ability to generate income.

3. The larger the amount of cash you take, the greater the negative impact on your income.

4. Taking money from your fund sooner rather than later also has a negative impact, because you don’t allow the fund to continue growing through investment performance. Therefore taking cash at age 55 is far worse than taking cash at 65!

5. Money accumulating inside a pension grows tax free. Money growing outside a pension is mostly taxed at your marginal rate (with few exceptions like ISA’s). Therefore there is an underlying benefit to keeping your fund inside a pension wrapper unless other factors override this advantage.

6. Since the first 25% of cash is tax free, but everything further is taxed, a distinction needs to be made between what part of the fund is being taken.

7. if you need money for any purpose, it is almost always advantageous to find it from tax paid money outside your pension than from tax free money inside your pension.

To take or not to take, that is the question! With core principles and understandings covered, let’s consider the key decision points about taking cash from your pension.

WHAT DO YOU WANT THE MONEY FOR?

Perhaps the most fundamental question to ask. There are six key categories that your cash withdrawal may fall into:

1. Payment of pressing debtI’d say this category is sad but necessary. If you are in the unfortunate position of being in financial difficulty and only a cash payment will sort it out, you may have to make a short term decision that takes precedence over longer term retirement plans.

However, I’d still be looking for ways to reduce the debt – definitely take professional advice – and only use your pension fund as a last resort.

2. Purchase of non-essential goods or servicesOne of the largest categories of reasons to withdraw cash, including everything from cars to holidays to house improvements to cosmetic procedures! The list is endless. I’ve got dreams and plans for my retirement. I deeply understand the urge to fulfil them when your pension fund can unlock what you have wanted for, perhaps, many years.

However, in the cold light of day, we have to balance the benefit of indulging ourselves with the potential long term consequences to our future income.

It’s a matter of balance. If we have £500,000 in our pension fund and we take £25,000 for non-essential expenditure, it frankly matters little.

But if we have £100,000 in our pension and we want to take £50,000 to indulge ourselves I’d start to raise the alarm bells.

Consider carefully any expenditure in this category and balance it against the loss of income that will result.

3. Investment outside the pension schemeThis is probably the single biggest reason that people consider withdrawing capital from their pension fund. And generally it is the most mistaken!

This is such a big point I’ve given it a whole section later in this article. However as a brief introduction it is worth keeping in mind these two key points:

• If an investment provides the same top level return inside and outside a pension scheme, the benefit of tax relief always means that it is always better to invest inside the pension.

• If you aren’t getting 7%-15% annual return inside your pension, change your pension investments so that you ARE getting the best possible income and/or growth. Ask my company, Avantis Wealth, for a no-obligation pension review!

4. Business supportMaybe your business needs a cash injection for growth that will improve profitability. I’d say that’s a good call. Alternatively we may need a cash injection to rescue a business that has been struggling. That seems more challenging to me.

The difficulty is this. We may have an emotional attachment to our business which means that we inject more capital, only for it to be lost in years to come. That would be a very bad thing to do with a pension fund that we have carefully developed over our lifetime, and where there is no time to do it again. Perhaps the best suggestion is to say that if you are considering supporting your own business, if you have the slightest doubt about the safety of the investment get an accountant to give you an independent view.

5. Paying off the mortgage on your own houseThis is a common reason for wanting to draw cash from your pension. There are two aspects to the decision – the purely financial one and the emotional one.

From a financial perspective it rarely makes sense to take pension fund money to pay off a mortgage. Typically you will be paying between 2% and 5% p.a. interest. And your pension fund could – if invested wisely, be used to generate income of circa 10% net annually. Perhaps three times the level of your mortgage payments.

An alternative to paying off your mortgage using a capital sum would be to make sure you are getting maximum income from your pension fund, then use that money to pay off your mortgage far more quickly than you are currently doing.

The second perspective is an emotional one. I fully understand the security we can feel of knowing that our house is owned outright. This could be particularly important if our income sources are somewhat unreliable.

The third aspect of this decision is the scale of the mortgage, in relation to the size of the pension fund and other investments. If we have a huge mortgage, and modest investments, then it probably makes more sense to trade down to a smaller property than to deplete our retirement income by withdrawing a high percentage of our pension fund.

Alternatively, if we have a small remaining mortgage and a large pension fund, paying off the mortgage is more like a ‘tidying up’ exercise than a major life decision.

As with all other reasons for withdrawing cash from the mortgage, there is no black and white answer. However, consideration of the points raised in this

section will help you make the right decision for your circumstances.

6. Medical emergenciesA medical emergency is just that. An emergency. And life and health come before anything else. So if you are in the situation when money is called for – somewhat rare in the UK – then it clearly takes precedence over any other future use of the money.

But again I counsel you to use your pension fund as a last resort, and look to fund this from any other source first.

Your marginal tax rateOnce you get beyond the first 25% tax free cash withdrawal, you will pay tax on capital withdrawals at your highest tax rate. If you are a zero or even 20% tax payer the impact is relatively minor. If you pay tax at 40% or 45%, a considerable part of the cash you take is going to disappear back to the Government.

Therefore it follows that higher rate taxpayers should consider cash withdrawals with greater care to ensure that the planned benefit will outweigh the significant tax bill that will arrive.

It may be that your income in retirement is not regular, and therefore you have years where your taxable income is lower and your tax rate falls. You may be able to arrange your affairs to take lump sums from your pension in years where your tax rate is lower.

Investment performance inside the pension schemeOne of the most common discussions I have is with clients whose pension is performing badly. Perhaps there has been no real growth for years, or even losses. They plan to withdraw funds to invest outside their pension.

This could be a really good move, or maybe not! There are important aspects to weigh up:

Can you do better with investments inside your pension? If you can, then it is very questionable whether it makes sense to take money out of a tax free environment and invest it in a fully taxed one. This goes to the core function of what my company, Avantis Wealth, offers clients. We focus on investment that deliver 7% to 15% net annual return and for most clients are transformational in terms of on-going income and/or growth.

Let’s consider an example, where the investment returns are the same inside and outside a pension. We will assume that you are a 40% taxpayer. You wish to invest £100,000, and your investment produces 10% annually before tax.

Inside your pension the full £100,000 is invested, and produces £10,000 annually. This is not taxed. This has two potential benefits. Firstly, if you don’t actually want to take the income, then none of it will be taxed and it can all be left to grow your fund. Secondly, if you only want to take part of it, then you will only be taxed on the part which you decide to withdraw as income.

Contrast this with taking £100,000 from the pension. With tax at 40% you can only invest £60,000. This reduced capital creates income of £6,000 which is subject to tax at 40%. Therefore the net income is £3,600 a year. Even if you don’t want to take the income, only £3,600 is available for reinvestment – a massively lower amount than if the £100,000 had been invested inside your pension.

My experience is that many people make a fundamental mistake in thinking that investment outside a pension is automatically better. Absolutely not the case.

Of course there are situations where it makes good sense to withdraw cash from the pension fund and invest outside. Here’s a scenario where you would be better off withdrawing cash:

1. You have little income and pay tax at 20%

2. You need to live on the income that is created from your fund

3. You can generate a much greater investment income outside your pension than you can inside the pension (unlikely!)

4. You have a relatively small fund (say less than £30,000) where the benefit of transferring your pension to an alternative scheme that enables more productive investment is doubtful because the costs are too high in proportion to the value of the fund

And here’s a scenario where it makes no sense to withdraw cash from the fund – even the 25% tax free cash

1. You pay tax at 40%

2. You don’t want to take the income yet, preferring to let the fund grow

3. You can achieve similar investment returns inside your pension as you can outside it

My company, Avantis Wealth, specialises in offering property investments with an 7%-15% net annual return, most of which can be included within a pension scheme. So if your pension scheme is not achieving, year after year, this kind of regular income we should be talking. Of course all pension transfers must be fully advised by an IFA and our clients are referred appropriately.

Health and lifespanIf you suffer from impaired health, or a statistically reduced lifespan due to certain lifestyle choices (like smoking for example), you may make the decision that your pension fund does not need to provide for so many future years of income. In these circumstances you may choose to withdraw greater amounts from your fund to enjoy life for the shorter period available to you.

Of course the opposite is also true. If you come from a long lived family and can expect to survive into your 80’s or 90’s, any lump sum withdrawal now could prejudice the life you want to live perhaps 20 or more years into the future.

Income needsYour income needs have an immediate and critical bearing on whether you should be withdrawing cash from your pension fund or not. You can’t have it both ways – either you have the biggest possible pension fund and therefore the highest level of income. Or you don’t!

And in the worst case, withdraw and spend all your capital and you have zero income from your pension. Of course, if you have income from elsewhere this might not matter, but this is an area that repays important review.

In simple terms, take away 50% of your fund and you take away 50% of your income. That could mean an income of £2,000 a month becoming £1,000 a month.

Other investmentsLet’s say you have other direct investments outside your pension scheme. And these other investments provide most of your income.

Then the importance of your pension scheme is diminished, in the grand scheme of things. And as such you can be more relaxed about taking capital from your fund. If the impact of what you propose to do, on your whole retirement plan, is relatively minor – then you may only need a cursory check before going ahead.

On the other hand, if you have little or nothing in the way of other investments, and your pension scheme accounts for all or most of your income, then taking out capital sums from the fund could be critical to your future income.

There is no right or wrong. Just a question of balance and what’s right for you.

Five simple guidelines This has turned out to be a far longer article that I anticipated, but there was a lot of important ground to cover. I hope it has been helpful. Here’s a quick summary condensed into five key guidelines:

1. Start from the basis that it’s better for your retirement income not to take any cash lump sum at all.

2. If you think you have to take cash, weigh up what you will gain against what you lose.

3. If you are a higher rate taxpayer, restrict the cash to the 25% tax free element.

4. If you are planning to withdraw cash to invest outside the pension, review whether you can make the same return through better investments inside your pension (ask for examples from Avantis Wealth).

5. Always take a holistic view of your retirement planning. Consider the impact of taking cash from your pension fund on your total retirement income, the reduction in available capital, and the benefits that using the cash elsewhere will bring.

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THE RICHER RETIREMENT SPECIALISTS