Saturday, 23 January 2016

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:
Assessment of Pension Value vs Lifetime Allowance (LTA)
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:
Sensitivity Analysis of Pension Value vs Lifetime Allowance (LTA)
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?


  1. I wonder what will happen about salary sacrifice. I negotiated with my employer to pay me minimum wage and put the rest into a pension, converting a modest wage into a huge pension contribution, and avoiding the higher NI contributions at lower levels. But this makes my nominal rate of relief unclear. If flat rate relief comes in, I guess salary sacrifice must go, and I'll need to renegotiate my contract.

    I too keep doing the numbers about the £1m limit, and will need to stop contributing soon, perhaps Osbourne's changes will finally persuade me to push the button.

    1. It will be interesting to see how that plays out. I too salary sacrifice heavily. This of course saves me the tax + employees NI contributions but additionally my employer gives me 10% of the 13.8% employer NI that they save. Every little helps...

  2. Hi RIT,

    Thanks for the site, it's very inspirational! I think your dates are wrong in this article though. If you are aged 43 now, you will not be able to take your DC pension until at least age 57.

    In this paper:

    it states "The transition to this age [57] will need to begin before 2028". This seems to mean that private pension age will be 10 years behind the state pension age schedule:

    There is some more explanation here:

    This isn't actual legislation yet as far as I know but in the absence of anything more concrete, I'd say the private pension age for anyone 44 or under is at least 57.


    1. The uncertainty is to whether the access age is 10 years below your projected state pension age, or 10 years below the age currently in force. The consultation document has a footnote about transitional changes starting before 2028, but that is omitted in the response to the consultation, (July 2014), which states

      2.36 The government believes that increasing the minimum pension age meets the guiding
      principle of fairness and reflects changing expectations of how long people will remain in work
      and in retirement. The government confirms, therefore, that it will increase the minimum
      pension age from 55 to 57 in 2028. It will remain 10 years below State Pension age thereafter.

      I've not found anything more official than this. As someone who is 47 3/4 now, I'm hoping 2023 will be a Lamborghini year

    2. Thanks John, that sounds more hopeful. I wish they'd legislate one way or the other so we'd know for sure and can plan accordingly.

    3. Thanks for challenging here Geoff and thanks for jumping in John. It's right to challenge all points as it will make sure we have the latest and most correct information.

      It does however demonstrate nicely that the pension rules are about as clear as mud. If 3 people who are actively interested in this stuff are scratching their heads what chance does the average wo/man on the street have?

      A few weeks ago I sought clarification from my employers expensive insurance company based scheme pensions advisor on a few of these issues and the amazing thing was that he replied with information that was wrong. When I challenged him he went off and did some more research returning with confirmation that I was right. About as useful as a chocolate teapot... I guess it's lucky that he was quick to confirm to me that as a pensions advisor he couldn't offer advice. I'm glad my expenses cover his salary...

      Back on topic John has the latest information that I have. I will be 55 in 2027 which makes me currently believe I will be able to buy my Lamborghini at age 55. That said the government can of course tinker again and correct their 'omission' quite easily.

    4. Thanks both. I'll be 55 in March 2028 so in either scenario, I still don't know my private pension age! If it's a step change to 57 on 5th April 2028 then I'm good. If the change occurs on 1st Jan 2028 then it'll push my date to 2030. If it's a transitional change 10 years behind the SPA schedule then that'll be 2030 (or 2031?)

      So hopefully it'll be 5th April 2028 when that change takes effect. My gut feeling though is that the transitional change approach was just an omission from the latest document, and it's still likely to happen.

      If it is a step change, I'll have a window of a few weeks to retire. Those who reach 55 on 4th April 2028 would have 1 day to retire and if they miss it they'll have to wait 2 more years!

  3. If your plan is to use this year's allowance next year then you will probably get flat rate relief. You could end up getting 25% instead of 47%.

  4. The reduction in the LTA allowance has been staggeringly quick, with a really aggressive tax charge if you go over it. I suspect quite a few of us will get stung by it. A wealth tax on top of an income tax, how very oppressive!

    That's been offset by an almost as staggering increase (although not to the same magnitude) in the annual ISA allowance over the last few years.

    A real return in excess of 6.8% annualised could be possible, you never know! I suppose it would take a substantial real return for the tax on the LTA excess to, also, become excessive. And that would presumably mean your ISA and taxable accounts are also flying along.

    Highlights how important it is to diversify between vehicles. I'll be 57 in 2039...who knows where the state pension will be at by then.

    Enjoy your Lamborghini in 2027 :)

  5. I hate the LTA more than anything else the government has done. I would much rather a lower limit of contributions if that is what they want as at least I can plan for that but to tax my returns at a penal rate if I make great investment decisions really makes me cross.

  6. Quite right, pfd. You'll also hate the LTA for ISAs when it's introduced, though the greater flexibility of ISAs would make it less onerous.

  7. This is nothing to do with the above - but I thought you might
    find this of interest at some point.

    A Better Approach to Measuring Aggregate Geographic Risk - 28/1/2016 Fact Set. Have a look.

  8. The cynic in me thinks this is all an attempt to force ever more money into the property market, via third party corporations.

  9. Hi RIT,

    Do you ever consider potential changes to the taxation of pension withdrawals in your choice of destinations, in the future?