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‘Unknown Unknowns’ … part 2 – PIPs (of the Pension variety)

Update July 2015 – in the ‘Summer Budget’, the Government announced a change to Pension Input Periods (PIP) which essentially brought the rules (which became effective immediately) in line with what most non-pension ‘consumers’ assumed all along – that the PIP is aligned with the tax year end. The Government also removed the ability to end PIPs early.

Like it or not, everyone’s PIP ended at midnight on 8th July 2015 and a new PIP opened up on 9th July which will then end on 5th April 2016.

I leave the following article as a testament of  ‘what once was’ given that this serves to demonstrate not only how things are not always as they appear, but also that legislation change is the norm for pension and broader financial planning…..

Original article: Pensions are (perhaps) one of the most complicated tax wrappers known to mankind – not only are they a source of amusement to politicians of all colours as a result the constant tinkering with various rules, attributes and regulations but they are also a source of huge misinformation and misunderstanding (but I’ll save that soap box rant for another day).

The irony is that not only can they be very complicated, they are also very useful – not least as a result of wide sweeping changes due to take effect next week which result in significant flexibility, increased tax effectiveness and the ability to pass wealth on between generations (again, something else I’ll save for another day).

So back to the task in hand – the wonderful world of PIPs…. not quite as complicated as quantum physics but not far short of that weird and wonderful subatomic world.

I wrote previously concerning the concept of ‘unknown unknowns’ (see here) – one area of particular ‘danger’ when it comes to pensions is the fact that the end of the personal tax year (i.e. 5th April) has virtually nothing to do with the amount that can be funded into pensions on an annual basis.

The amount you can fund is down to the Annual Allowance and how this is calculated is actually down to the Pension Input Period (the ‘PIP’) of the scheme/plan to which the payment is being made (i.e. NOT the tax year end).

The current annual allowance is £40,000 and therefore if someone funded £40,000 on 1st April 2015 (i.e. in the current tax year) and a further £40,000 on 20th April (i.e. in the next tax year) these are very likely to both form part of the same PIP and thereby that individual would have breached the Annual Allowance of £40,000 given that £80,000 has been invested.

However, as another example, two payments of £40,000 (i.e. a total of £80,000) could be made on 1st April to two different schemes (with different PIPs). This would initially seem foolish given that the Annual Allowance is £40,000 however if one PIP ended on 1st April and the other on 20th April then this £80,000 would be permissible given that the PIPs ended in different tax years!

I am sure that the notion of PIPs is alien to the vast majority of people who are funding pensions, but for those who are making significant contributions, this is something they need to be very aware of given that exceeding this would result in a tax charge (and in most circumstances, making the excess contribution arguably pointless).

Furthermore, aggressive funding can be achieved by clever use of PIPs (as demonstrated in the £80,000 example above).

Bring into the equation that those with multiple policies will have multiple PIPs, that the Annual Allowance has changed on numerous occasions recently, that unused allowances from previous years can be carried forward and that PIPs can be changed, then a simple question of ‘how much can I pay into a pension this year’ becomes a mammoth task of data gathering and ‘Annual Allowance testing’ before an accurate answer can be given.

So next time you ask a Financial Adviser the seemingly simple question ‘how much can I pay into my pension’ please don’t be surprised if you see their body slump a little as they take a deep breath and begin with…. “well, it’s complicated because….”

Alternatively, if they are quick to answer £40,000 you might want to flex your pension muscles and ask them ‘but what about my PIPs’!

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Missing the pension point?

In the run up to the changes to pension legislation, much of media (and political) coverage focused on costs and freedom. On the one hand, Ed Miliband seemingly couldn’t mention pensions without also using the term ‘rip off’ (Telegraph, Guardian, FTAdviser) whereas on the other, it would appear that Lamborghini (BBC) would be very busy come April….

5th April 2015 came and went and not a great deal changed for many – other than the small matter (for those interesting in facts rather than) that pensions suddenly became significantly more flexible and, potentially, even more tax effective.

Prior to April, pensions were primarily used to provide income in retirement; either a guaranteed income (an annuity) or an income which isn’t guaranteed but could potentially be paid at a higher level (drawdown).

Pensions, therefore, were all about providing an income stream and they essentially helped people defer income until a later date (and hopefully to a time where they pay less tax).

On death, funds in payment would either be taxed heavily (55% on lump sum death benefits in drawdown), potentially lost (if no death benefits were arranged on an annuity) or paid to a dependent. Dependent here being the key word – once benefits were drawn, the scope to pass on benefits became restricted and, potentially, subject to significant tax.

Moving on, we’re now in a new world….. two key things have changed.

Firstly, pensions do not have to provide income – funds can be withdrawn as the recipient sees fit and whilst the technicalities of this are outside the scope of these musings, the principle is that a quarter of those funds are tax free and the rest is taxable as income – irrespective of whether that ‘income’ is taken on the drip or as a lump sum.

At a stroke, this opened up control and flexibility…. and in turn, tax management opportunities.

Someone in semi retirement can top up their income using their private pension whilst they wait for the state pension date to arrive and if personal income tax allowances aren’t being fully used, funds can be withdrawn and whilst taxable, the proceeds would be tax free as far as they fall within the personal allowance (See here).

This also removed what could sometimes be seen as a hurdle to pension planning – the notion that you lose control of capital – whilst the fact remains that benefits can’t currently be accessed until 55 years of age at the earliest, thereafter access and control awaits the investor.

Secondly, there is much more control, choice and potentially tax effectiveness with regard to lump sum death benefits. For starters, if death occurs prior to 75 years of age all death benefits are now tax free – potentially saving the beneficiaries of those in drawdown a 55% tax charge on lump sum death benefits OR avoiding income tax where benefits are received on the drip.

Alongside that, it is now the case that income can be passed to non-dependents – anyone in fact – providing the provider permits it and you make the necessary arrangements to request it. What’s more, there is no tax charge on the transfer of assets to the beneficiary – giving them scope to ‘inherit’ the pension fund.

This therefore opens up the notion of ‘family pensions’ where funds could cascade between generations – something many may well see as a useful development.

Therefore rather than funds heading for the exits, our experience is quite the opposite – pensions are now even more tax effective than ever. Not only do payments attract Government tax relief, the funds still grow tax effectively and are generally are not liable to Inheritance Tax.

Once withdrawals are needed, a bit of planning can help to mitigate income tax as far as is possible – with funds now being withdrawn as and when needed.

As time moves on, there should be peace of mind that, when the time comes, the funds can pass on to other generations – providing the necessary steps are taken by the policy holder to arrange this – potentially giving the beneficiaries a head start to their own retirement planning.

The very nature of pensions has therefore changed and for many they may well need to look again at the opportunities they bring and whilst the treatment of their funds on death may be at the back of their thoughts, this may in fact need closest attention given that unless adequate steps are taken, the beneficiaries of the funds may find that they are unable to take advantage of the new rules.

Therefore rather than getting overly excited about sports cars or getting depressed about ‘rip off charges’, perhaps the message should be much more positive – financial planning has suddenly been blown wide open and, more than ever, people have the opportunity to live the retirement life they have perhaps always dreamed of.

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Marmite pensions and the importance of £14,133

Love them or hate them, pensions typically involve people having strong points of view whilst also being the subject of political interference.

Since 2001 we have had a raft of changes – the advent of stakeholder pension charge caps and the associated legislation on employers, the (now laughable!) pension simplification in 2006, changes to state pension provision (and timing), fluctuations in pension funding allowances, automatic enrolment obligations on employers and now the ‘pension freedoms’ which are due to commence in April 2015.

If anything keeps financial planners on their toes, it’s pensions – however those of you who are lucky enough not to need to keep up with the latest developments may well find that your views of pensions are clouded by misinformation, misunderstanding and – perhaps – a general detachment from reality.

There are key changes taking place in April and whilst there is too much to cover in a post like this (and if detail was provided, there is a danger of perceived advice!) there are some key (dare it be said ‘exciting’) developments taking shape.

Pensions have always offered a tax effective way to invest – giving people the ability to invest in assets which grow virtually free from tax, offering 25% of the fund ‘tax free’ whilst also deferring income tax (with the objective being that benefits are drawn in a lower tax environment that that when funds are invested). In summary, pensions typically offer a very tax efficient way of creating income in retirement.

The main ‘issue’ with pensions is that capital control is lost and whilst for those seeking to generate income in retirement this is not generally a concern, for others it can be a genuine objection.

From April 2015, however, this potential ‘barrier’ is removed once the age of 55 is reached given that access is permitted without restriction; however perhaps the greatest change is that pensions will be able to be passed on not only between spouses/dependents but also between non-dependent beneficiaries – therefore offering scope to cascade pension wealth between generations.

Pensions will therefore enable individuals to build up funds which will be paid free from tax in the event of death before 75 and if death occurs after 75, the tax charge on death on funds could be as low as 0% (currently, it stands at 55%).

Add to this the flexibility that individuals will be able to draw income or lump sums from their pensions as required – not only does a pension continue to offer the tax effectiveness it always has done, it opens up freedom of access once an individual reaches 55 and also offers a means to shelter assets from Inheritance Tax for longer!

For those who are looking to retire early and specifically have no other taxable income (i.e. they have not yet drawn their state pension) the new rules will provide the opportunity to potentially draw up to £14,133 (in tax year 2015/16) without any tax liability – £28,266 for a couple – with the expectation that this annual figure will increase in years to come.

Historically, therefore, pensions were used to provide income ‘on the drip’ – the new rules will permit investors much greater flexibility to generate tax effective income based on their personal circumstances.

Whilst ‘unknown unknowns’ can cause untold damage to financial wealth, it is also important not to overlook other potential opportunities that legislation change often brings – given all of the above and the number of misconceptions associated with pensions, it is therefore perhaps time everyone gave them another ‘look’!

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Apples, Apples and Pears

When considering a decision, it’s important that we compare ‘apples with apples’ in order to avoid comparing apples with pears.

In the past, ISAs and Pensions were quite different ‘tax wrappers’ and trying to compare them was indeed like comparing apples and pears.

Simplistically, an ISA is used to accumulate funds on which tax has previously been paid whereas pensions are used to defer income (and any resulting tax) until later.

Whilst ISAs could be used to provide both capital and income, pensions were most commonly used for creating a lifetime income in retirement. Add to that their very different tax positions and this results in an apparently simple question of ‘what is best an ISA or a Pension’ needing a very long answer – and ultimately the conclusion is often ‘you won’t know until you get there!’.

Things are about to change, however, and from April the benefits both ISAs and Pensions can provide are essentially the same – both will be able to provide income and both can be accessed for capital – and therefore they are now much more like each other.

However, it would appear that the media and other commentators have not picked up on this yet.

Let’s look at a possible ISA lifespan: whilst working someone funds it whilst they can afford to – perhaps taking some risk in order to hopefully achieve investment growth – and then perhaps once they retire, they reduce the risk and start to draw an income from it (perhaps with the odd lump sum to pay for a cruise or something similar!). How long that income will be paid will depend on his the fund grows and the income levels taken.

Now let’s consider pensions: under the new rules, whilst working someone funds it whilst they can afford to – perhaps taking some risk in order to hopefully achieve investment growth – and then perhaps once they retire, they reduce the risk and start to draw an income from it (perhaps with the odd lump sum to pay for a cruise or something similar!). How long that income will be paid will depend on his the fund grows and the income levels taken.

Spot the difference – nope – there isn’t any – and therefore whilst there is a tendency to worry about peoples pensions running out under the new rules, I’ve never read an article which discussed the risk of ISAs running out!

The key issue is that both ISAs and Pensions enable monies to be set aside for the future – ISAs are funded from taxed money, Pensions are funded from tax deferred monies (and therefore taxed on the output) – both equally carry the risk of running out.

If the big picture focussed on the importance of planning for income for the rest of someone’s life, they are more likely to become engaged with the strategies needed than if they read about the ‘risks’ and ‘dangers’ of their pensions running out. (….this article was written a little while back however an example of this ‘fear’ can be seen here – http://bbc.in/1AVSJUT)

Over the next few months the way individuals can plan and fund for their retirement will change dramatically given that the manner in which funds can be dawn will become much more flexible and, for many, potentially more tax effective –therefore the hope is that this will result in individuals taking a much closer look at their longer term needs and how they can fund them rather than worrying about doom, gloom and scare stories.

Let’s therefore hope that these changes engage people to plan for their retirement rather than give them even more to worry about!

Dobson Hodge No Comments

‘Unknown Unknowns’ … part 1

Donald Rumsfeld once outlined the nature of knowledge and the danger of not knowing what you don’t know (http://goo.gl/4vWDQ). His infamous ‘known knowns, known unknowns and unknown unknowns’ description resulted in some derision – notably the Plain English Campaign gave Rumsfeld its Foot in Mouth Award in 2003 (http://goo.gl/YEzDrQ).

However, he also received some support given that he made something quite complicated fairly straightforward as it focuses our minds on the fact (and potential danger) of not knowing what we don’t know.

Financial planning can be full of unknown unknowns and therefore there are dangers which many could be oblivious to. Some dangers may simply simply be down to a lack of awareness – others due to misinformation.

A good example is the FTSE 100 – the leading index used (for some reason!) to provide a measure of UK investments. (The fact that only a very small minority of people will solely invest in the FTSE results in this being a dangerous barometer for investment returns but that’s an altogether different debate).

The FTSE100 index does not factor in dividends – a crucial part of equity investment returns. Using the FTSE 100 as a measure of investment performance is like putting your money in the bank, ignoring the interest and then asking why your money hasn’t gained in value.

Some equity indices (e.g. the Dow Jones) do include dividends and therefore comparisons between the Dow index and the FTSE is like comparing apples and pears (something I’ve warned about here).

On 30th December 1999 the FTSE stood at 6930. On 28th November 2014 it stood at 6729. Almost 15 years on it therefore stands some 200 points lower.

Over the same period, the Dow Jones Industrial Average stood at 7133 and now stands at 11288 – some 4000 points higher.

Seemingly the FTSE 100 has therefore significantly lagged behind the Dow – however that is until dividends are factored in.

Once dividends are factored in, the FTSE 100 has actually delivered a gross total return of 61.5% over the period (whereas the Dow stands at 60.2%).

FTSE

Investors therefore need to be mindful when reading articles about the Dow hitting ‘record highs’ when, from a capital return point of view, it’s actually lagging the FTSE – which, to date, has not yet returned to the heady heights of the Millennium!

In this media savvy, ‘here and now’ culture, sound bites can imply one thing when the reality is very different and it’s for this reason Mr Rumsfeld’s words provide a useful warning that things are not always as they seem – 2nd December 2014.

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The price of everything and the value of nothing…

Many independent financial advisers will spend a great deal of time analysing financial plans and, invariably, the costs involved in the clients strategy.

Currently, there is much political and media focus on costs (‘rip off Britain’?) yet in the next breath there are also complaints wages aren’t rising fast enough (a cost in other words) and companies are too reliant on zero hours contracts (a means to control a variable cost). In other words, it feels like the aim is some utopian world where everyone is paid well but everything is cheap; and whilst this is perhaps a simple analogy, similar arguments are being made when it comes to pensions.

There has been much improvement in the transparency of costs over the recent years; firstly with the cost of advice being stripped out of the cost of the contract (though in some cases ‘integrated’ advice firms still bundle advice costs within their contract costs).

Since then, the cost of the investments themselves have also become ‘unbundled’ whereby the cost of the investment, the cost of advice and also the cost of holding that investment have all been separated – however in some cases, the result of this transparency is an increase in cost.

In the vast majority of cases, transparency is positive for the consumer – it’s a prerequisite of any trusted market – but care needs to be taken where transparency results in rising costs and a lack of consumer understanding.

There was coverage over the weekend of Ed Millibands warning of the costs of pensions once the new flexible rules are introduced (http://goo.gl/tsDDVt) and how consumers must ensure they are ‘not ripped off’ by financial firms.

This is interesting given that regulated financial advisers operate in one of the most tightly regulated professions in the UK – and yet there is still the focus on costs and these costs being ‘rip offs’. A further article this weekend in the Independent about “confusing and unfair (investment) charges” – (Simon Read, the Independent) further focussed on investment costs.

In a Twitter exchange, Mr Read was asked why he felt investment charges were unfair – (http://bit.ly/1Cr6I7U) – to which he responded that they were unnecessarily high. Whilst it was agreed that some funds were indeed relatively expensive, there are cheaper options – and even so, just because the cost is higher it doesn’t make them ‘unfair’ and Mr Read was therefore challenged on specifically what he felt was unfair – and to date no reply has been received.

And therein is the key point – costs are costs and, generally, something is worth what someone is willing to pay for it.

Not all fund managers disclose the full costs of their portfolios (though some are beginning to do so) and you can invest in funds with charges ranging from perhaps 0.1% per annum up to 3%+ – all working in different ways and, no doubt, all can justify their fees.

Is a fund charging 3%+ ‘unfair? – perhaps only if the consumer is being duped into paying it. If the investor chooses to pay it then everyone should be happy – after all, we don’t pay £10,000 for a new car and expect to drive off in a Lamborghini and whilst we may feel that a Lamborghini is expensive, there’s a difference between that and it being ‘unfair’ or a ‘rip off’.

A bug bear when considering charges is that the vast majority of us have savings accounts and we can identify the interest rate we’re earning; however ask the bank about the charges of them managing our savings and it is likely you will receive a quizzical look. So if 0.75% interest is earned on a savings account yet the same bank lends to mortgage borrowers at 4% (noting that borrowers will typically have set up fees too), can it be presume that the cost of the savings account is 3.25% per annum? Again, this is simplistic but the depositor is essentially lending the Bank cash in exchange for 0.75% and they in turn do the same yet receive 4%.

Is this unfair? Is this a rip off? Probably not – it’s market forces – however the key point is that the regulated investment environment has cost disclosure everywhere yet this doesn’t apply to the deposit accounts for which we are oblivious to the cost.

Whilst transparency of funds could improve by the entire cost of the fund management being identified, this could result in a conflict of interest between the fund manager and his clients (i.e. the fund manager may become mindful of significant dealings reflecting badly on his charges figure OR if the fund manger works to a fixed cost, any excessive dealing costs would fall on him even though the actions are for the benefit of the client). Furthermore, in the former example, such a charging figure will be retrospective and therefore is indicative.

Surely the biggest issue facing consumers is not whether their annual charge is 0.5% or 1% but whether they are aware of the big picture – will their funds run out before they die, are they receiving regulated advice or are they being ‘sold to’, is the advice even regulated and, ultimately, are they being promised the earth and they are about to stumble into something which could leave them with massive tax bills and penalties from the Revenue.

Our genuine concern and fear is that articles warning of ‘rip off’ pensions only succeed in making consumers focus on cost rather than value and totally miss the big picture.

If an investor seeks independent regulated advice and explains that costs are a concern and they want to invest in as cost effective way as possible then this objective can be achieved with no conflict of interest or bias and therefore perhaps the mainstream media furore should be more focussed on the dangers of people being ‘ripped off’ by non-advisers ‘selling’ unregulated investments than whether a fund should cost fractions of a percent less – edited 29/11/14