DIY investor: Your pension pot vs the tax man

If further proof were needed of the importance of the “grey vote” to the outcome of the general election, it arrives in April. The series of moves to grant pension savers greater freedoms over what they can do with their money—the surprise centrepiece of the 2014 Budget—formally comes into force on 6th April, one month before polling day and just in time to provide a feel-good frisson for better-off voters approaching retirement.

The government will have done itself no harm by realising that the previous system had offered an extremely unattractive deal for a long time. The vast majority faced an effective obligation to buy an annuity, incomes from which have plummeted in recent years along with interest rates. And anyone wealthy enough to escape the “annuity trap” faced a different disincentive, namely that anything left in their pension fund when they died would be taxed at 55 per cent before the remainder was passed on to their descendants. Small wonder that for most people pension savings had come to look like dead money.

Now all that has changed, in theory at least. Those aged 55 and over have the right to tap their savings as and when they wish, 25 per cent of the total tax-free with the rest treated as income. The punitive “death tax” is also gone. Instead, anyone with a defined contribution pension who dies before reaching 75 can pass on everything that’s left to their heirs tax-free. If you make it past 75, you can still pass on your unspent funds but your beneficiaries will have to pay income tax on anything they withdraw.

This all adds up to a much more attractive proposition than people faced before. A pension is no longer just a way to provide for one’s declining years; it now doubles as a useful tax-planning tool for the elderly. This is undoubtedly shrewd politics, but is it a genuine boon for most of us or simply an attractive-sounding idea with some less obvious downsides?

My guess is the death tax changes won’t make a lot of practical difference for most people in the way they imagine, because withdrawing meaningful sums from an inherited pension in one go—for example to fund a deposit on a home—will push the recipient into the higher rate tax band, which at 40 per cent is charged at the same rate as inheritance tax. So there doesn’t appear to be a net gain here, at least for those hoping to inherit decent sums of capital as opposed to a stream of additional income.

However, I suspect there are some other, more subtle effects of the tax change that will also start to exert their influence. In general, concentrating on tax issues is not a good way to work out the right thing to do with one’s money: too often the tax tail wags the dog. These pension changes, to my mind, increase the risk of that happening again. Once you start looking at your pension as part of your estate that can be handed down, you shift the focus further from the real issue that most of us face as we get older, which is how to ensure that we don’t run out of money in old age and find ourselves at the mercy of an increasingly insolvent state.

The possibility of passing on your pension fund in a tax-efficient way is a boon for those who die relatively young and would previously have seen their savings die with them in an annuity they had barely used. But in general, this new freedom reduces even further any incentive that remains to think about an annuity as a way to insure yourself against outliving your money. I’m no fan of poor value annuities, but I also think that longevity insurance is important and that there are going to be better ways to purchase it in future, later in retirement and consequently at more attractive prices.

Setting up incentives that militate against that is risky—even if it is smart politics in the short term.