With pension freedoms come responsibility

Although there are probably few people over the age of 55 who do not know they can take their pension as a cash lump sum, very few people probably understand the basics of retirement income planning, and without this knowledge there is a risk that many people will make decisions they may regret in the future.

There are a number of technical and behavioural aspects of retirement income planning that financial advisers and their clients need to understand. Some of the technical aspects may seem basic to many advisers, but many of the behavioural aspects may be far from basic. Clients who take advice will benefit enormously from an adviser who has all the relevant knowledge. But what about those people who either do not have access to financial advice or choose not to take advice? Pension Wise or the new ‘second line of defence’ will surely do a good job of explaining the options, but the fear is that it will simply not to go into sufficient depth to ensure their customers understand the key issues. In short, the concern is that some advisers and many individuals will have a knowledge deficit which may result in poor decisions being made.

One way to tackle this knowledge deficit is to have a ‘back to basics’ campaign. At a time when there is so much hype and expectation about the new pension freedoms, especially concerning the option to take pension pots as a cash sum, most people will benefit from a better understanding of some basic financial concepts.

The list of important issues includes some of the obvious ones: tax, death benefits and risk. But what about the less obvious ones? These include the importance of considering a more holistic approach to retirement income and taking a longer-term view of income requirements.

Perhaps the most important basic message is that retirement income planning has changed for the good, and if anybody had good reason to be sceptical of insurance companies in the past they should be comfortable that many of the previous practices that might have worked against the best interest of customers have been consigned to the bin. In the past, pension providers were constrained by the rules that restricted consumer choice, but these have now been replaced by a set of options giving people almost complete freedom to spend their pensions in any way they wish.

It is understandable that in the past many people did not fully engage with their pensions, and when faced with a complex series of options at retirement simply took the highest income on offer without considering other important issues.

The important point for the wider public is that pensions are now one of the most attractive financial policies, with many advantages over other forms of savings and investing. So people should think twice before simply taking their pensions in cash. It might be to their advantage to leave their money inside a pension wrapper, especially if they need more than 25 per cent of the fund as a cash sum.

One consequence of the general scepticism and distrust of pension providers is the mistaken belief that better returns can be obtained outside a pension plan. How many times have I heard people say: “I could do more with my money outside a pension”?

Many people think the grass looks greener on the other side of the pension fence, but it rarely is. I am not just talking about annuities; I am also talking about investment and income options as well as death benefits.

The new pension freedoms mean that pensions may have the following advantages over other financial policies:

 In many cases they are more tax-efficient.

 The death benefits may be more attractive than those of other policies.

 If annuities are to be purchased they are better purchased as pension annuities.

 The investment options may be better within a pension.

Although pension income is taxed at the marginal rate, investment fund growth is largely tax-free. This means that anybody considering taking their money out of a pension fund only to re-invest it where they will pay tax on interest or growth may wish to think again. People should not underestimate the importance of the new death benefits. If the policyholder dies before age 75 their beneficiaries can receive a tax-free income, and after 75 the funds can be transferred to any named beneficiary who will only pay tax on income at their marginal rate.

If it is right to purchase an annuity, at retirement age or later, the rates for pensions annuity are generally better than for purchased life annuities even though the latter have a tax-free capital content element. I envisage a strong market for annuities, but the buying patterns may change. For example, they may be purchased at older ages. Finally, some of the investment options for pension drawdown may be more appropriate than investment options in non-pension wrappers.

This is obviously a brief summary of some of the benefits. The important thing is that the general public appreciate these advantages because they might reconsider before blindly taking their pensions as cash.

It is easy for pension professionals and policyholders to talk about the longer term, but those without much money and who have significant debt have to fight today’s fires rather than worry about the longer term. Therefore it is understandable if those who need immediate cash take it – but there will be many people who do not need cash who will be tempted to take this option simply because it is available.

The challenge for these people is to have a plan that will provide sufficient income in later years. There is a need for foresight – that is, care in providing for the future. But spending all your money at once shows little foresight.

Freedom is not licence. Just because people have the freedom to spend their pensions as they please does not mean they have licence to spend their money unwisely.

It is lazy thinking for people to think that advice is not important, or that the adviser community is simply out to feather its own nest.

My hope is that more and more people will realise that they owe it to themselves to make good decisions about their retirement income, because if they get it wrong the only people who will lose out will be themselves and their families.

Billy Burrows is a director of Retirement Intelligence and associate director of Key Retirement

Key points

* Probably very few people understand the basics of retirement income planning.

* People should be comfortable that many of the previous bad practices of the insurance companies have been consigned to the bin.

* The new pension freedoms give advisers a golden opportunity to explain to potential new clients what they can gain from advice.