Pensions: are you on shaky ground?
First published 24 September 2015 • Updated 25 July 2017
Pensions have always been complicated, but these days there is much more information to get your head around. Because of the radical changes in 2015, much of what you have previously assumed may turn out not to be true after all. How many of these pension misunderstandings have you made?
‘I used to be “with it”,’ complained Homer’s elderly father in The Simpsons. ‘And then they changed what “it” was.’
Someone else who feels like that is Bob. As Bob nears retirement, he’s forced to admit he doesn’t understand as much about pensions as he thought. Having saved into a pension all his working life, he feels he ought to know how they work. But now the time is approaching when he’ll have to start living off those savings, he’s feeling on shaky ground. Bob was never an expert to begin with, but so much has changed lately that he’s no longer sure where he stands. For example…
What he thought: ‘Pensions now work like bank accounts.’
What he’ll discover: Bob has heard that pension freedom gives full access to his savings. ‘Like a bank account’ is the phrase that he keeps reading everywhere. But that’s misleading. Unlike money in a bank account, most of the money withdrawn from a pension counts as taxable income for that year. So drawing on his pension too freely could cost him dearly.
What he thought: ‘Every year I can withdraw 25 per cent tax free.’
What he’ll discover: This is another common misunderstanding. It’s true that 25 per cent of every pension pot can be withdrawn tax free, with income tax payable on the rest. But that doesn’t mean you can take out a quarter of it this year tax free, and then do the same next year with the remainder, and so on. Once you’ve taken that 25 per cent tax-free lump sum, that’s it. (Although another way to do it is with a series of smaller withdrawals, with 25 per cent of each withdrawal being tax free.)
What he thought: ‘I can access my pension when I reach retirement age.’
What he’ll discover: For a long time Bob assumed he could draw his pension only when he reached state pensionable age. Only recently has he discovered that under the new rules, people can access their money much earlier. This means that Bob, who has a few years to go until he can receive his state pension, could start to supplement his income from his pension pot, and so maybe enjoy a phased retirement. (Meanwhile, state pension age is gradually rising – check yours here).
What he thought: ‘Pension freedom covers all types of pension.’
What he’ll discover: As well as his main pension, Bob also has a small final salary pension from a previous employment. He thought he’d be able to access this money as a lump sum too. Instead he’s told he would have to transfer it into another scheme – but can’t do so unless he takes independent financial advice. Bob should listen carefully to his adviser, who may well say that even a small final salary scheme is worth hanging onto.
What he thought: ‘When I die, my pension dies with me.’
What he’ll discover: Bob already knew a bit about annuities (products that pay a guaranteed income until death) and was aware that some annuities will continue paying income to a surviving spouse after the original holder’s death. But he didn’t know that pension freedom means that any unused pension pot or drawdown fund can be passed on to beneficiaries. What’s more, this is free of inheritance tax.
By not fully grasping how his pension works, Bob is potentially missing out on opportunities to improve his lifestyle in retirement – and could also be at risk of making serious mistakes or even falling victim to fraud. Fortunately, he visits unbiased.co.uk to search for a financial adviser – and so puts his retirement plans back on firm foundations.