The March 2014 budget has changed the financial planning landscape dramatically with the single biggest shake up to pensions in our lifetimes. The announcement that “no one will have to buy an annuity” turns the personal pension plan from an intangible and illiquid future income stream into a savings account with unrestricted access.
For people negotiating their divorce now, there needs to be an immediate re-evaluation of your pension’s worth. This article summarises our view of the paradigm shift in pensions and divorce.
Unrestricted Access and Off-setting – Is 15% the new 25%?
From 27th March 2014 anyone over 55 with a secure pension income of £12,000 per year can have unrestricted access to their remaining pension pot. The government are also consulting on legislation that if passed would see savers able to fully liberate their pension funds from April 2015 regardless of the size of their pension income. Pension funds can be withdrawn completely with the first 25% paid tax free and the excess added to taxable income.
When offsetting a money purchase pension plan during divorce negotiations a starting point is typically a 25% reduction. This figure in part reflects a deduction for valuing a gross pension fund knowing that it would suffer income tax in the hands of the receiver. It also factors in the willingness of the parties to trade off the pension fund’s uncertain future income stream for the certainty of cash in their pockets today. The change announced in the budget means that one need no longer regard a pension fund as an income product but more like a readily realisable liquid asset.
Peter is 54, earns £25,000 per year and has a pension valued at £100,000. Under the proposal, in a year’s time he could access 25% as a tax free lump sum (£25,000) and have the remaining £75,000 paid over five years at £15,000 per year so that only the 20% basic rate tax is deducted (five instalments of £12,000 is £60,000). In total his £100,000 pension fund can be converted relatively quickly into £85,000 in his pocket.
So shouldn’t the starting point for offset negotiations on money purchase pensions now be 15%?
Divorce Settlements with New Pension Contributions?
The increased flexibility provides divorcing couples with an opportunity to enhance their overall financial position through making new pension contributions.
Julia earns £81,865 per year and is getting divorced from Chris who earns £25,000 per year and is over 55. Julia invests £40,000 into a new pension at a cost of £24,000 (as the full sum enjoys higher rate tax relief). The couple apply a 100% pension sharing order on the new plan. Under the proposed legislation Chris then cashes in the investment over two years. Each instalment of £20,000 is returned 25% tax free (two lots of £5,000) and the remaining instalments of £15,000 has 20% basic rate tax deducted (two lots of £12,000).
In total, Chris has withdrawn £34,000 into his bank account over a period of one year and a day at a cost of £24,000 of marital assets.
Triviality, Small Pots and Help with Buying Two Homes
Also from 27th March 2014 people with a pension pot worth less than £10,000 who are over 60 can ask for the pot back as a lump sum. The lump sum will be paid 25% tax free and the rest added to taxable income. They can use this small pot rule three times. If after completing this exercise their remaining pots are valued at under £30,000 they can access them under the triviality rule as a lump sum too.
Richard and Tracey each earn £15,000 per year, are 60 and have combined personal pension pots totalling £120,000. There is £200,000 equity having sold their home but they both consider that they need £150,000 now to set them up in new homes.
They split the pension pots evenly to have an equal £60,000 and arrange for a partial transfer so that there is £30,000 in one pension pot and £30,000 in another. The first pot is set up in three segments of £10,000. They exercise their right to withdraw the three segments as lump sums using the small pots rule. They then exercise their right to triviality with the remaining £30,000 pot in the next tax year. After 25% tax free lump sums and after 20% tax on the remainder, Richard and Tracey have £51,000 each in the bank account from their pension funds to add to the £100,000 each from splitting the equity from the sale of the home.
Help with Legal Fees
The small pot rule of £10,000 (and the ability to segment or partially transfer into up to three pots of less than £10,000) means that the over 60s have a new option for paying legal fees. They simply cash in a pension plan. The same rule also presents an opportunity for the tax man to make a small contribution as the following example shows.
John is 60 and his lawyer has presented him with a bill for legal advice of £8,500. He makes a pension contribution of £8,000, grossed up by basic rate tax to £10,000. He uses the new small pot rule and takes 25% tax free (£2,500) and the remaining £7,500 is added to taxable income and after 20% tax is deducted has a further £6,000. He now has the £8,500 to pay his fees.
For Defined Contribution Plans Only
The planned changes relate to Defined Contribution (Money Purchase) pensions only. The government are concerned that the increased attractiveness of Defined Contribution plans could lead to transfers out of Defined Benefit plans and that this might have unintended consequences to the wider economy. Consequently they are consulting on various options, one of which is to ban transfers from Defined Benefit plans to Defined Contribution plans. The consultation paper does not discuss whether any potential ban on transfers might influence whether Defined Benefit schemes will be prevented from insisting on an external transfer to a Money Purchase plan on receipt of a Pension Sharing Order on divorce.
Assuming that external transfers will continue to be allowed for Pension Sharing Credits, the increased access could give rise to planning opportunities for divorcing couples that may not be available to non-divorcing couples.
Jim and Alison are 65, retired, and after selling the marital home and a recent payment of a tax free lump sum they have cash of £500,000. Jim has the only pension; a Defined Benefit pension in payment valued at £500,000. They would ideally like £300,000 of cash each and to equalise the pension. For simplicity we’ll assume the CEV generates the same level of income for each. They apply a 62.5% sharing order so that Alison has £312,500 of CEV and Jim has £187,500. In return, Jim has £300,000 of cash and Alison £200,000.
Alison uses £187,500 of her pot to generate an income for life commensurate with Jim’s income. She uses the remaining £125,000 to withdraw tax efficiently at 20% basic rate over a few years and it generates £100,000 of cash after tax.
Greater Demand for Multi-Disciplinary Collaborative Practice?
Buying an annuity meant that people had an income guaranteed for life and didn’t need to worry about whether they might run out of money. They also didn’t need to worry that they might be too cautious and die leaving too much money that they could have enjoyed. That’s ultimately the area where modern financial planners thrive – helping people make informed decisions about how best to spend their wealth, to manage investment risk and to manage their wealth tax efficiently. Now there will be an increased number of people needing to manage their pots into retirement, many of whom would unquestionably benefit from a Financial Planner helping them manage their finances.
The government recognise that this change will introduce more choice and complexity for citizens and part of their announcement included a guarantee that pension savers will have access to face-to-face, impartial financial advice at the point of making a decision. This advice could include a suggestion to seek further full independent financial advice.
The government also cite Australia and the United States as countries with similar unrestricted access to pension funds as is proposed to apply here. In both countries financial planners often play a more integral role in collaborative divorces than has been the case in the UK. These changes could be a catalyst for greater involvement of financial neutrals in collaborative cases, and even greater desirability for collaborative divorces, in a world where personal finance choices, options and complexity have increased considerably.
The UK equity market retreated in November, only the second month in 2017 where we saw a meaningful fall in the key FTSE 100 Index. Comments made by Mark Carney, following the November Base rate rise, highlighted the Bank’s view that inflation will be a problem for some time to come and how business and consumers react to this will determine the path for the UK economy over the coming months. The Bank said in a statement: “The decision to leave the European Union is having a noticeable impact on the economic outlook.
The Bank of England’s decision at the start of November to raise interest rates for the first time in 10 years was widely expected and caused little initial stir in the markets. Since then the FTSE 100 has fallen a couple of percentage points at the time of writing. Perhaps the combination of negative talk around Brexit combined with the prospect of rising interest rates are starting to bring back a little fear to the market which has, for some time, felt like it has been in a state of complacency.
Most commentators expect interest rates in the UK will rise for the first time since July 2007 when the Monetary Policy Committee (MPC) of the Bank of England next gets together for its monthly meeting on 2nd November 2017. Indeed, Mark Carney said on the BBC Today programme, shortly after the minutes of last month’s meeting were released, “What we have said is that if the economy continues on the track that it has been on - and all the indications are that it is - in the relatively near term you can expect that interest rates will rise”. He went on to say, “We are talking about just easing a bit off the accelerator to keep with the speed limit of the economy”, which has been widely predicted to mean that rate rises will be gradual and measured.
Our reason for showing these graphs is to highlight that the VIX index is trading back at 2007 levels of low volatility while stock markets are at all-time highs. We can no more see the future than anyone else but we do know that when it comes to investing, the most money is often made when every sinew in your body is screaming that it is madness to invest, and that sometimes the opposite is true.
It has been a strong start to the year for investment portfolios, mostly driven by signs of continued strength in the US Economy and the promise of more to come under the Trump presidency. Markets always move ahead of the economy so to make money, investors will position portfolios to benefit from what they think is around the corner. But what if the promise does not materialise? One fund manager described this recent wave of enthusiasm as the “Trump Bump” and that this may well be followed by the “Trump Dump” if the new President is unable to deliver on his campaign promises due to lack of support from political colleagues. In this respect, it seems that the failed repeal of Obamacare has given investors pause for thought over the last week or so.
While some asset classes are looking expensive, on an individual basis, there remains optimism amongst fund managers. Those who particularly seek to invest in undervalued, unloved but robust companies can see plenty of scope for increased valuations in their investment pool.
Eight years have now passed since the FTSE 100 hit its Credit Crunch low point. In investor memory, particularly among younger investors, we are getting to the point when the slide that started in summer 2007 down to its nadir risks being forgotten. We don’t know what the future holds but the past tells us that investing needs time on your hands to ride out the tough times. We’re confident that investing remains the best long term strategy for your money but make sure that you understand the strategy you are taking and that your portfolio is right for your attitude to investment risk and your time frame.