Navigating the Never Ending Changes to Pensions

In recent years it feels like every Spending Review, Autumn Statement and Budget presented by our wonderful government includes pensions tinkering which is usually detrimental to what I and many others are trying to achieve.  I'm now at the point where prudence means I have to run some simulations to ensure I don’t fall foul of some new rule or other.  This has forced me to do some research and so in the spirit of sharing here goes.

Wealth warning.  I am not a pensions expert nor a financial planner.  I've also made investment mistakes in the past and will certainly make them in the future.  I also don’t know every pension rule and regulation out there.  I dread to think how long it would take someone to learn all of those.  Therefore this is not a recommendation of any type but instead hopefully provides some terms and tit bits that you the reader may not be aware of which will then encourage you to do some research like I have been.

At their heart defined contribution pensions are nothing more than a tax deferral scheme.  The deal is that you agree to lock up your money for the future and agree to follow the (continually changing) terms and conditions.  In exchange the government (currently) allows you to not pay tax on it now but rather when you unlock it in the future.  I agree to participate as for me it has the potential to be quite beneficial to wealth building as my current effective tax rate is now 47% (45% additional rate + 2% national insurance) and in the future that tax rate could be:

• 0% and maybe a bit of 20% if we stay in the UK.  On top of that current rules will allow 25% to be taken as a tax free lump sum (TFLS);
• 0%, 15% and 25% if we head to Malta; or
• 0%, 19.5% and 21.5% if we head to Spain

That is a big enough incentive for me to use pensions as part of my overall investment strategy.  To maximise the benefit I want to get as much into my pension wrapper as possible while ensuring I keep enough outside of the wrapper to cover all costs and government tinkering between early retirement and my private pension access age which is currently age 55.  I think the first is an easier thing to calculate than the second given current government form.

The age you can access private pensions is certainly one area governments have tinkering form.  It was raised from age 50 to 55 in 2010.  I'm currently still allowed to access at age 55 however some younger than me are not so fortunate with the age being raised to 57 for the least fortunate.

If I’m piling money into my private pension then I need to watch the Lifetime Allowance (LTA).  In 2010 it was £1.8 million however over time it’s been steadily reduced.  In 2015/16 it’s £1.25 million and in 2016/17 it’s being reduced to £1 million.  It’s then being held at £1 million for 2017/18 before then being increased each year at the rate of inflation (CPI).  That all sounds like a lot of money but a lot can happen between now and age 55 and you don’t want to get it wrong.  Do that and the government will hit you with a tax charge of up to 55% on savings above your LTA.

Having manoeuvred myself to a point where I'm paying additional rate tax I acknowledge I’m in a very fortunate position by being able to avoid worst case 22% tax (47% effective tax now minus 25% if Malta is the choice in retirement).  For higher earners the government is however in the throws of further tinkering.  Read that as reducing the benefit for higher or additional rate tax payers to grab yet more tax now.  There has been talk on Pensions ISA’s or a levelling of the relief for all tax payers.  What the later will mean for me is that I’ll be paying tax on the way in and on the way out.

I therefore want to get as much into my pension wrapper before the rules change.  This article in the Financial Times (h/t Monevator, free FT link or Google ‘Pension tax perks for high earners are set to be abolished) is the best I've found on the topic so far and sounds like it has been written by someone who knows someone reasonable close to the tinkering coal face.  If true it looks like we have the remainder of this year and then the 2016/17 tax year before the rate of tax we ‘high earners’ pay is increased.

I therefore need to make contribution hay while the sun shines.  I currently have the ability to contribute about £40,000 per annum.  Great the pension annual allowance is currently £40,000 so let’s crack on.  If only.  From 2016/17 those with an ‘adjusted income’ of over £150,000 will begin to see their annual allowance taper until it reaches a low of £10,000 at £210,000.  So much for encouraging people to take responsibility for their retirements.  I'm of course caught up in all of this.

I do however have knights in shining armour in the form of Carry Forward which allows me to use unused annual allowance from the previous three tax years and the quirk where from 08 July 2015 to 05 April 2016 the government is running a transitional period to align Pension Input Periods (PIPs) with the tax year allowing an annual allowance of up to £80,000 for 2015/16.  Sound confusing?  Yes it was for me as well but this white paper helped a lot.  It was fairly heavy going but worth it.  Do make sure you understand the difference between a Pension Input Period (PIP) and the tax year.  Also make sure you understand pre-alignment and post alignment for 2015/16.

As always get your Annual Allowance or Carry Forward calculations wrong and there is a penalty.  Any contribution amount over is taxed at your highest marginal rate.  So you’re taxed as though you didn’t lock your money up in a pension but it is.  Not a good situation to be in.

So that’s the theory I can now run a simulation based on my situation.  Firstly the assumptions:

• I have 3 months of pension contributions in 2015/16 remaining which is about £10,000.
• Assessing my taper penalty and available carry forward including the 2015/16 transitional period quirk I can continue to contribute about £40,000 in 2016/17.
• In 2017/18 I will have exhausted most of my carry forward but with a fair wind I’ll actually FIRE three or so months in meaning a total contribution of only £10,000 or so anyway.  Bring on the government tinkering at this point.
• From 2018/19 the LTA will increase by inflation (CPI).  Since 1988 CPI has run at an annualised 2.7% so I’ll bake that into the cake.
• I’ll assume my pension investment return is a real 4% per annum meaning a nominal return (real return + inflation) of 6.7%.
• I have £372,000 in pension wrappers as of today.
• I begin drawdown in reasonable chunks from age 55.

Piling all that into Excel and I end up with:

Click to enlarge, Assessment of Pension Value vs Lifetime Allowance (LTA)

In tax year 2027/28, the year I can currently access my defined contribution pension at age 55, the LTA could be £1.3 million and my pension value could be £950,000.  So far so good.  A quick sensitivity analysis also as I don’t want a small amount of outperformance to put me in punitive tax charge territory:

Click to enlarge, Sensitivity Analysis of Pension Value vs Lifetime Allowance (LTA)

Nominal annualised return would have to exceed 9.5% for there to be problems.  To me that seems unlikely so I’m set for the pensions run in to FIRE ... at least under the current government rules.

It’s a pension minefield out there.  Have you learnt anything new recently that’s worth sharing?