April 2011 saw big changes to the rules on members drawing income from their personal pensions, but some adverse effects of these are now being seen more clearly. No one wants to advocate making changes to income drawdown again so soon but, when there have been so many (surely unintended) consequences, is it right to review and see if there is a better outcome for investors?
The good news
The changes to personal pensions in the Budget of April 2011 were not all bad, with many positive amendments made. The biggest was the return to three-yearly reviews from the previous five years. Investment volatility means that fund values can change significantly and waiting five years to review a member’s maximum income is just too long, particularly in current volatile markets. Things could change significantly over this time, either positively or negatively, but the ongoing impact is the same – waiting too long to review can have a negative impact on your client’s maximum income.
Many advisers review income needs for their clients annually, so this presents minimal issue for them. But consider the surge of execution-only self-invested personal pensions (SIPPs). The SIPP investors may be going into drawdown but not reviewing their income limits until the provider contacts them five years later. The drop in income due to the GAD rate reduction could come as a shock to many – some may have been blissfully unaware of changes to legislation – resulting in a possible significant impact on their lifestyle.
Another good news story was the introduction of flexible drawdown. While only affecting a small number of investors, it is safe to say that it has given real benefits, by simplifying planning or allowing investors to both plan their income and maximise death benefits.
Flexible drawdown is not for everyone and there are many investors who would not be eligible, but in the bespoke end of the SIPP market it proved very popular at the beginning of the 2012 tax year.
That may be because it has taken some time for people to plan their finances to meet the minimum income requirement of £20,000. There were also many investors wanting to take advantage of carry forward last year who may have wanted to maximise their contributions and fund before moving into flexible drawdown, after which no further contributions can be paid.
While flexible drawdown is clearly not a mainstream option, it provides real benefits for those clients who have planned well and so should help encourage more people to maximise their pension arrangements.
There is also good news for those aged over 75, because the GAD rates now go as high as age 85. This is a significant increase from the maximum incomes under the old rules that meant an 85-year-old would get the same income as a 75-year-old. In practice, at current gilt yield rates, this is a rise from £104 to £143 per £1,000 of fund value.
The perfect storm
In summer 2010, during planning, some of the income drawdown changes may have seemed fairly minor to the Government, being designed to protect investors from eroding their funds. But their effect has been multiplied many times by wider economic factors.
In addition to the reduction from 120% to 100% of maximum GAD that can be taken under capped drawdown, the Government revised the GAD tables to take account of increasing longevity, exacerbating the issue, particularly as investors get older.
For example, those aged 60 saw all gilt yields drop by £1 per £1,000 of the fund. For someone aged 65 the reduction is between £1 and £3 per £1,000, and this increases as the member gets older. This means that, although fund values are more likely to be protected, as you get older your maximum income is more likely to be reduced.
The next hit – as a result of economic factors – is the falling gilt yield, as illustrated in Graph 1. Just under five years ago in July and August 2007, gilt yields hit a high of 5.25%, a level that had not been seen since 2002. This starkly contrasts with February and June 2012 when they hit an all-time low of 2.25%.
The example in Table 1 shows how these factors work in practice. It is assumed that a client’s last review was in May 2007, when the gilt yield was 4.75%, and that they have made no further designations over this time. The gilt yield in May 2012 was 2.5%, representing a drop of 2.25 percentage points over the five years.
The example assumes a 60 year old in May 2007 had a crystallised fund value of £200,000 and took maximum GAD annually in advance. Their SIPP has a £650 pa fee, including a drawdown income fee. If their fund has not grown in value, they could be looking at a drop of as much as 58% in their maximum income.
Clients will hope, of course, that their fund will have grown over the past five years but, in order to maintain their income, they would need growth of 16% pa. On the other hand, if the old 120% of GAD rule was reinstated, the required growth rate would reduce to 12% pa.
Side effects
There are few, if any, people in capped drawdown who actually get through their entire drawdown funds before they die, so many will leave the remaining funds to their beneficiaries as a lump sum.
The knock-on effect of the significantly reduced maximum income levels is likely to be a larger residual fund on death than previously. If there is no dependant to continue the income, then the money will be paid out as a lump sum to be taxed at 55%, but with no inheritance tax.
Given the current state of the economy one might query whether it would be more sensible for the Government to gather more tax while people are alive rather than forcing them to keep it in a tax-privileged environment for years.
The reduced income limits may even keep some investors in the basic rate tax band whereas they may have chosen to take income that would put them into the higher rate band, reducing the tax take even further in the short term. A reduced income also means a lack of disposable cash, restricting their spending at a time when the Government wants to boost the economy. Financial planners often say that tax deferred is tax saved: maybe the Government should be thinking the opposite.
Short-term stop gap
As the reduced maximum income is due to the removal of the 120% rule, the introduction of new GAD tables and the reduction in gilt interest yields, a comprehensive solution would be complex. The simplest thing that can be done would be a reversion to 120% of the GAD rate.
Providers have operated this rule before and there are cases where an investor still on a five-year cycle would need their income recalculated on this basis, although not for much longer. This must mean providers have the ability to facilitate a change back at minimal cost and effort – there have already been calls by some providers for the Government to do this.
In a time when both more money in the economy and good pensions news are needed there is definitely an argument to be had here. Not everyone will use the maximum 120% of GAD by any stretch of the imagination, but the whole point of capped drawdown versus an annuity is the ability to take income as and when you need it. The flexibility of drawdown is currently being reduced.
Bigger picture, longer term
There are more wide-reaching options that need to be considered, but they would take time and should include a consultation. A key opportunity would be to have a complete review of the calculations used to work out the maximum income under drawdown. An alternative could be a connection with investments or a blended approach using equity and gilt returns to more closely mirror the likely investments.
A more radical review is surely not out of the question given the need to encourage more pension saving. Surely there is scope to look at some changes that will not only provide some much-needed income to the Government but also relief for investors and advisers alike?
Whatever is chosen should be based on the views of advisers and providers that deal with this on a day-to-day basis, rather than abstract academic principles.
Claire Trott is pensions technical manager at Suffolk Life