2 Mar 2015, 3:30pm
personal finance:
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  • SIPP opportunities for DB pension workers who want to retire early

    Pensions are the Cinderella of personal finance because they only deliver when you’re old, and the people who can do most about their personal finances are those who are still working. People’s situations vary much more when they have a lifetime of working life behind them. Most people who leave university and have a job have a shedload of student debt, and hopefully a shedload of human capital. Those coming up for retirement have had a working lifetime of  variation between having some of that money stick to the sides or all being used for living plus incurring debt, they may or may not have a partner, they may or may not have had kids, they may have been buffeted by the vicissitudes of Divorce, Disease or Death (of close family), the divergence in circumstances just goes on an on. So pensions are terribly hard to generalise about, and much of what you would do has been made even more complicated with Osborne’s pension freedoms.

    I know a few employees of The Firm read this, and it’ll loosely apply to others coming up to early retirement (55 plus) with a defined benefit pension – most public sector workers, and a fair few private sector workers if they were in scientific/technical roles and haven’t changed jobs for 15 years or more…

    Note that pensions are complex, hard to generalise and vary from scheme to scheme. Employees of The Firm – take up the Wealth at Work seminars that are offered for free – and everyone, DYOR and consider taking independent financial advice before making irrevocable pension decisions.

    A DB pension is valuable because it is defined. It lacks flexibility because it is defined

    A typical DB pension is quite accurately defined, but the other side of that coin is that it lacks flexibility. One of the great things that seems to be have happened over the last five years or so is that more people are thinking about when and how they want to retire. I have to confess that I never did think about this – I joined The Firm’s pension scheme over 25 years ago and from that point I thought I would retire at 60, which happened to be the NRA of that scheme. Job done, end of thought. It was a total intentional living fail. That was excusable in the late twenty-something Ermine because like all young people I was never going to get middle-aged never mind old 😉

    But the years did pass, and this fail got less excusable. I failed to address one of the most important things a wage-slave can think about – which is in the great balancing act between time and money that we have in the flight of the sparrow through the mead-hall that we call Life 1, is the balance right for me? It is the age-old balance between the important and the urgent, where all too often the urgent gets all the attention and the important gets lost.

    DB pensions were children of times when spending a large part of your working life at a single company was normal. Those times were more stable, and some might argue staid, and one of ways this is expressed is that retirement is not very flexible in a DB pension without taking massive knock-on costs. You can usually draw your pension early in a DB pension, but there is a reduction to account for the fact that it will be paid for longer. In itself that is fair enough, but the reduction usually disfavours the early retiree disproportionately more than other members. Obviously if you are going to retire before NRA you ideally need some money to pay yourself up to NRA.

    Until about this time last year a SIPP was useless for that because they were meant to be a pension for life

    because you either had to buy an annuity of go into drawdown at a modest rate that was designed to last a lifetime (typically 20 to 30 years), unless you had over £20k of guaranteed pension income p.a. in which case you were sorted. What you really wanted was a pension you could flatten over a short time, capital and all – the few years your early retirement until NRA. It doesn’t matter that you flatten your capital before you die if another pension comes along and picks up the heavy lifting. In my case that period is 55 to 60, on other cases it may be 55 to 65. In future it will be for 10 years (5x to 6x where currently x will go to 7 in a few years)

    So in the past ISA savings were the priority for DB early retirees

    There is no capital base behind a DB pension, but the estimated capital amount is valued by HMRC by taking the pension payable at NRA and multiplying by about 16. You can take up to 25% of the pension as a pension commencement lump sum, but this is hard to qualify with a DB pension – the amount of pension you lose to fund that PCLS is often disproportionally high.

    However, The Firm’s scheme allowed me to build up a defined contribution component called an AVC – I targeted this to be a third of the estimated DB capital amount, so the entire AVC could be taken as the 25% PCLS. There’s nothing stopping DB pension holders taking out a SIPP, but then you can only take out 25% of the SIPP as a PCLS which isn’t as good as the AVC deal.

    The reason for using pension savings was purely to get the tax benefit – the savings from not paying 42% tax/NI or even 32% tax/NI are too large to ignore. If I give up £58 and end up with £100 that is a return of 42/58 or 72% ROI. You just can’t ignore that if you are within a few years of getting it. But I couldn’t use it to retire early without losing part of the main pension due to drawing it early 2

    But to pay my way until NRA I also saved into ISAs. Freedom from The Man was important enough to me to do without all the consumerism fun for three years. The great plus of ISA income is that it is not set against your personal allowance.

    A short SIPP is now a great alternative as long as you don’t pay tax on it

    The personal allowance is about £10,600. Many fifty-something people I know have BTL income with the deep religious significance of property in the British psyche, which is apparently taxable income. The Ermine gave up the property religion many years ago, so I have the full £10,600 available to me, because all my income is investment income. Although some of it is unwrapped that is still tax-free for these reasons. As it is I am still running down cash because I saved a shitload of cash before retiring so that gets reinvested.

    Five years is a short time, there’s no need to wrangle with equities. So if you are retiring soon at 55 or later, load up a SIPP for as much as you can draw out tax-free before your DB pension NRA. If that’s 10 years you might consider holding some equities for the later years

    How much can you draw out tax-free from a SIPP?

    Take the number of years you will draw from it, until NRA. At that point your SIPP will be empty – the aim is to flatten it 3

    In my case that’s easy – five years, because the vast majority of my DB pension was based on a NRA of 60, and the earliest I can draw on the SIPP is 55. Each year I can draw tax-free £10600, so if I could put 5*£10600 = £53000 into the SIPP I wouldn’t pay any tax on taking it out.

    But there’s more. You can take 25% of the money out right at the start of drawing it down as a PCLS. So the money I draw year on year is three parts out of four, so I can add on a third more, about £17600, making a total of £70600. The first tax year I draw £17600 + £10600 = £28200 and the subsequent four years I draw £10600. All tax-free. I have therefore turned a profit of £70600/5=£14120 because the taxman will add in that much, meaning I only have to save £56480.

    The computation is simple – take the personal allowance × the number of years you want to draw the SIPP for until NRA and multiply by 4÷3 to allow for the 25% extra PCLS. That is the upper limiting case of how much you can save in a SIPP and get a guaranteed no-strings attached 20% return on your cash, less fees and inflation. It will cost you 80% of the total amount if you are a basic-rate taxpayer, less if you are a higher rate taxpayer or 45% rate.

    Beware the annual limit

    of about £40,000 or your entire salary whichever is lower. If I were working – I would be wise to save this over two years, £28240 one year (ie becomes £35300 in the SIPP)  and the same the next. DB pension holders also need to knock off this the effect of any pay rise that raises their DB pension – this HMRC guidance note is your friend. It is easy for moderately Big Cheeses towards the end of their careers to fall foul of this. Imagine Mrs Roquefort on £50,000 with a pension payable at NRA  of £25,000 and she’s in the last couple of years before NRA. If she gets a 10% pay rise on a she’s up for a £2.5k*20 = £50k lift so she’s SOL.

    But I don’t have that much cash!

    Bearing in mind that you will get the 25% PCLS and £10600 back as soon as you turn 55, you might consider borrowing it 😉 Even if you have to use the entire PCLS to pay the loan back you are still up on the deal by 20% less loan interest less fees. You should never borrow to invest, but this is not investment return – it is a return of the money you earned that was taken from you in tax.

    Both borrowing money and having enough annual limit are easier when you are still working, so you probably want to play this game in the last couple of years of working.

    Beware the Pension Recycling Rules

    Note – this is my opinion, it is not advice. DYOR etc…

    Another point in favour of spreading yourself out over a few years is this HMRC guide. Basically HMRC consider you are taking the piss when all of these apply

    1. the individual receives a pension commencement lump sum,
    2. because of the lump sum, the amount of contributions paid into a registered pension scheme in respect of the individual is significantly greater than it otherwise would be. Further guidance about what is a significant increase in contributions is at RPSM04104940.
    3. the additional contributions are made by the individual or by someone else, such as an employer,
    4. the recycling was pre-planned. Further guidance about determining whether the recycling was pre-planned is at RPSM04104930.
    5. the amount of the pension commencement lump sum, taken together with any other such lump sums taken in the previous 12 month period, exceeds 1% of the standard lifetime allowance , and
    6. the cumulative amount of the additional contributions exceeds 30% of the pension commencement lump sum. Further guidance about the cumulative basis of the recycling rule is at RPSM04104950.

    Condition 5 is a PCLS of £12,500 or more (before Miliband gets in there). In future from Osborne’s changes you will be able to forgo taking a lump-sum PCLS and spread it out as you take the pension (ie take out 25% of your yearly SIPP income tax-free – this would equate to an annual tax-free SIPP amount of £14133 if that were your only taxable income) which would avoid that restriction because two amounts in the two-year scanning window is £8266 which is below condition 5.

    It’s also worth noting pension recycling rules are all about the pension commencement lump sum. If you restrict your PCLS to £12,000 which invalidates test 5 and you keep your annual withdrawals below your personal allowance you still get a 20% boost to your money even if you premeditate, borrow the money and ramp up your contributions at the last minute 😉 There also is no law saying you must take the full 25% PCLS

    Even ermines of independent means can do something here

    I use this with Hargreaves Lansdown. Because Osborne made his changes after I had stopped work, I save purely in cash but because I am economically inactive I am limited to £3600 a year, I don’t think I can use my investment income as the level of income, it seems only selling time for money sort of income counts. Hargreaves Lansdown are piss-taking bastards on their fees for funds and equities, but as it happens for SIPP cash savers they don’t charge a holding fee (presumably they get interest on your cash). There’s a £354 account closing fee if the account is open for less than a year or  £30 if it’s been open longer.

    Because of the lousy imitations on what can be saved I’m not going to be in danger of pension recycling.

    What are the risks?

    There may be a change of Government in May. Miliband has already staked a claim on pension tax relief, and possibly dropping the annual allowance to £30,000. Although stories about abolishing the 25% PCLS do the rounds regularly before Budgets it hasn’t happened yet, and it forms a part of so many people’s pension planning it would be a little bit surprising if a politician wanted to pick a big fight like that. But it is a risk.

    The Lifetime allowance continues to come down, Miliband is proposing £1m, and it is possible that this would spike the guns of people with a FSP of more than £50,000 at NRA (I have scaled HMRC’s £62500 down by 1.25 because the current lifetime allowance is £1.25 million). But to be honest if you’re earning a six-figure sum and coming up to retirement then damn well pay for pensions financial advice here because you will probably find it worth the fees 😉

    I wouldn’t count on being able to use this  ruse in five years time. But usually once you have started a pension even if Governments do piddle about with the rules they allow you to grandfather your existing rights, usually in return for not being able to contribute any more to a pension.

    Sundry Government and HMRC meddling – this is always the problem with pensions. I’d be surprised if the Osborne pension freedoms are largely scaled back. The most obvious target in my view is higher rate pension relief. There are already calls from Miliband to ice that for 45% taxpayers and from Lib Dem Pensions Minister Steve Webb and Michael Hoban (a senior Tory) to flat-rate tax relief at 33% for all.

    Mark Hoban, former financial secretary to the Treasury, said the present system, which allows savers to claim tax relief on pensions contributions at marginal rates as high as 45 per cent, was “skewed to the interests of higher earners”.

    FT

    But in the end if you are a higher rate taxpayer then you may want to consider paying clever people with detailed knowledge to advise you 😉 Others will only gain from that change.

    Notes:

    1. Venerable Bede , Ecclesiastical History of the English People
    2. This is no longer strictly true though it was when I formulated the plan. I could and may move part? of it to my SIPP to make it up to the £70k described later. Before last year I would have had to have taken it as an annuity.
    3. the exception to this is if your DB pension is below the personal allowance – in which case you may as well aim to top it up tax-free in the SIPP

    Hi ermine, this is all very timely for me (as you know :-)) so the time and effort you have taken to explain things is much appreciated.

    I do have one (more) question though. This is concerning the annual limit and the amount by which a DB pension has grown in value in that year. The HMRC site simply says that the figure that counts towards your allowance is “Any increase in the amount your pension provider promises to give you when you retire”. Using my own case as an example my LGPS (which is now a 49th CARE scheme) increases by about £530 for each year I work – does this mean that the value of my pension has therefore risen by £530 x 20 (£10,600) and this is the amount I should deduct when I am working out how much I would be allowed to pay in?

    My last pension statement says “Total value of your … pension fund annual allowance for 2013/2014 = £5380” – this was the figure I was thinking I should use but I admit to being a little confused by this.

    Any light you can throw on this would be very welcome.

    @Cerridwen your last statement seems to imply you got a decent payrise last year – if so congratulations! The annual allowance for the period 13/14 was 50k, you need to establish from the wording whether the £5380 is really what is _left_. That implies that your salary went up by £50k-£10k (the amount of the yearly accrual increase*20) = £40k, -£5380 (left over) ~= £35k then /20 =~ £1800 yearly payrise

    What you describe is the value of the extra pension that you accrue each year, but if you get a payrise then the change is magnified because of that 20* factor. On the upside you can carry forward up to three years of allowance and these amounts were more generous in the past. Hit up the HMRC allowance calculator – you will need the last three eyars statements of your pension.

    The BBC has a nice worked example, that shows among other things that I erred on the pessimistic side and HMRC actually use 16x as a scale factor, perhaps I had the SWR on my mind!

    Pensions have been seriously complicated and it’s worth considering getting advice by someone who knows the specifics of your scheme. Unions often have financial advisers – beware that they will of course push specific funds, but it may be worth paying a little to get inside knowledge. And of course this isn’t advice, it’s opinion 😉 The information should be there on your pension statement.

    The Firm had this on the intranet, there was a specific calculator that computed this. I printed screeds of stuff from this because I was frightened of going over the Annual allowance because I tossed the rest of the redundancy money into my AVCs to avoid paying tax on it. I was lucky enough to benefit from the carry forward of the 2010-11 £225,000 annual allowance although I didn’t use that much of it 😉

    At least you have a month to get hold of this information from your pension provider to enter into the HMRC calculator. And maybe consider seeking specialist pensions independent financial advice – although I am with Monevator with IFAs and general investing, you don’t usually retire more than once and it’s easy to miss subtle wrinkles like using a SIPP in favour of an ISA, and in my case I probably shouldn’t have paid down my mortgage until I got my PCLS from the AVCs.

    Overall, however, you are the person Osborne was thinking of this time last year 😉

    Hi ermine. I certainly didn’t get a big pay rise last year – I’ve forgotten how much, but it was no more than 1% (if we got one at all). We’ve done a little better this year at 2.2%.

    The pension scheme was a 1/60th final salary scheme in TY 2013/14 and for most of the TY I was earning around £33,000. I’ve now gone part time so earn around £27,000.

    I will take advice on this even if it is just talking to my pensions section and/or phoning HMRC.

    (btw I was reading the £5380 as the value that had been added to my pension, not what was left over. The 3 year carry forward will help in any case.)

    Thanks again 🙂

    Aha – in which case the thing to understand is why the amount of allowance used up is half the initial estimate. Correcting the 20x to 16* helps bring it down to 8480, but it’s still off. CPI was about 3% over the period which would be used to inflate the start amount (reducing the difference) – if it was a 1/60th scheme then every year you accumulate 1.6% towards the end of your career so maybe the difference comes from this. Hopefully if you put that year’s pension and the previous one into the HMRC calculator they agree better!

    Still trying to find my way through the thicket of UK retirement plans. I think they roughly correspond to Canadian experience – or maybe not.
    We have DB plans for sure in Canada or at least we did in the past. My wife and I benefited from them although in my case I got in later and had to take a discount to get out at 58.
    DC has largely supplanted DB even in some quasi public service jobs. We never got the option to combine the two with AVC.
    RRSP is our tax deferral retirement scheme and there’s no time restraint on taking the money out although you’ll pay at your marginal tax bracket when you do. You have to draw down after age 71 though.
    TFSA is a new plan where you contribute after tax money, there is no tax on growth or interest inside the plan and no tax penalty when you withdraw. We contribute to TFSAs now but they were not around during our career years. TFSA and RRSP together are a mighty combination if you have the money.
    Canada Pension Plan is a government scheme that you must contribute to , and it gives you a nominal pension at the end of your work life. You can start as early as 60 but it’s discounted if you do.
    OAS is a universal seniors benefit which provides a pittance to the very poor and a top up to our income. You get that at 65 but it’ll soon be raised to 67.
    OAS/CPP can provide a couple with ca $30,000 Canadian at age 65 but if you want to live on that good luck.

    @Ray By the looks of it the equivalence is
    SIPP = your RRSP (a SIPP used to be very restrictive but now is very flexible as of last year)

    Our ISA = TFSA (you can draw the money at any time, an ISA is not specifically a retirement product). And indeed and ISA and a SIPP are a grand combination!

    The Canada Pension Plan would match our State Pension, with the difference that the State Pension can only be taken from 67.

    The closest equivalent of the OAS is I think called pension credit. This is for people who haven’t got enough contributions and no other income/savings

    CA$30,000 sounds quite generous to me at about £16,000. The UK State pension is about £12,000 for two people claiming. There’s a vague general consensus that a couple with a paid off house can live a retired middle class lifestyle in the UK on about £20,000 p.a.

    @ermine Thank you for the clarification.
    The Canadian government isn’t quite as generous as one might think. To get the Canada Pension you have to work and contribute to it (actually 30 years for the maximum payout.)
    If you didn’t work (say a stay at home mom) and were left with no other income after Dad passed away, it’s pretty grim. You’d get about $16K Canadian with a topup called GIS. A couple would get up to $22K. But it’s pretty rare to have a couple retired where neither one worked at some point. There are lots of older widows trying to get by on $16K though.
    In Canada the general consensus is you need $42000 pa for a “middle class” retirement.That is about 10% more than in the UK at current forex rates.

    @Ray That’s interesting – this site would indicate that the general cost of living is lower in Canada than the UK. I guess the odd 10 or 20% difference could be in the qualification of middle class retirement 😉

    Like the Canada Pension the UK State pension is contributory, needs 30 years of payments similar to Canada’s. That’s moving to 35 years soon, and I will be short a couple of years contributions. I might chose to be self-employed on a part-time basis and make up a couple of those years by paying voluntary contributions.

    5 Mar 2015, 2:05pm
    by Rowan Tree

    reply

    Ho Ho!
    ” a couple with a paid off house can live a retired middle class lifestyle in the UK on about £20,000 p.a.”
    We should be able to do the £20,000 p.a. pension with our savings, does that mean I will be able to walk past Lidl and Oxfam, and shop in Marks & Spencer when we are retired? 😉

    Thanks for the link to Monevator’s “5 ways to reduce tax in retirement” (July 2013) – I had missed that. I need to understand as much as I can in this complex environment so no one can pull the wool over my eyes.

    Of course, the new flat rate State Pension of £150 for “everybody” was a lie. (Need 35 years and never been contracted out ever!) But not everyone knows that. Not even the pension manager in my husbands company, where new reductions in the company DB pension (in consultation) have been based on “everybody” getting the full amount right away!

    @Rowan Tree – John Lewis and Waitrose stand ready at your service 😉

    Note that that 5 ways article was written before Osborne’s changes so some things have changed – the latest is here

    “in consultation” –

    We had one of those too. Boiled down to “we say and you do”.

    That change to 35 years is a drag – I have 32 or 33 years. It’s possibly worth me becoming self-employed on a small income and claim the small earnings exception. The self-employed rate of £140 a year is a lot cheaper than the unspecified general slacker rate of £700 so it’s worth the tedium of a SA form for a year and a bit, then returning to professional idler status 😉 Funny old world, eh?

    @ermine here is the reference to Canadian retirement amounts:
    http://www.moneysense.ca/retire/how-much-money-you-need-to-retire

    Also I was wrong about the Canada Pension Plan Maximum. To get that you’d need to contribute the maximum possible amount every year for 39 years. Very few Canadians will accomplish that.
    http://www.thestar.com/business/personal_finance/retirement/2014/05/04/how_retiring_before_60_affects_your_cpp_pension.html

    Good luck finding a financial adviser that can give you good advice on a DB pension scheme such as the NHS pension.

    @Marco – it may not be as tough as all that. The usual ‘good advice on DB pensions’ fo people who are in normal health and retiring early is ‘leave well alone and draw at NRA if possible’. The reason for that is the actuarial reductions usually favour retire at NRA, and a DB pension is, defined, but only clearly defined at NRA.

    So the requirements boil down to

    “what is the best way of using DC SIPPs and ISAs to manage the gap between retiring early and NRA” with second-order effects around a varying income/partial retirement, mortgage commitments etc. All of which should be very well in an IFAs turf.

    I don’t normally advocate taking financial advice, and haven’t myself apart from attending the wealth at work seminars, but there are a lot of subtle wrinkles to pensions, and some of the decisions are one-offs that impact the rest of your life – like whether to take an actuarial reduction etc. Some are counterintuitive and some downright obscure, like the recycling rules.

    6 Mar 2015, 4:46pm
    by lowercase

    reply

    Slightly off topic – how would one go about sourcing a good financial adviser? I don’t mind spending the money, just don’t know how I could ever find one that I could trust!

    @lowercase Tough one that, and since I have never done it I can’t speak from experience. Take a look at Money Saving Expert’s guide to that. It looks pretty good to me.

    I raised financial advice in connection with pensions, because pensions are an absolute bastard to wrap your head round for several reasons: you accumulate a pension over 30-40 years, you only know if it worked at the end, you don’t get to do it over again, most of us won’t have many 40-year periods of life to learn from experience if we cocked it up the first time. The tax issues are complicated, they change over time, some of the regulations are obscure as hell, there are a range of products that we only ever encounter at pension time (annuities, PLAs, drawdown, RPI inflation adjustment) and for those with children there are all the inheritance tax ramifications. Most of us only retire once, so unlike normal investing the opportunity to learn from experience is limited. As an example, I discharged my mortgage pre-55 and I have a AVC that would easily have covered the capital repayment. That was a dumb thing to do in a low-interest rate environment for an early retiree. I don’t get to do it over.

    Where it comes to the general principles behind non-pension investing, you either have to do the reading yourself or just go passive indexing. You need to know why you are putting up with the capricious volatility of the stock market for long term investing. And most folk find that hard to get their heads round, and a decent financial adviser might be able to get that across, and why volatility is not equal to risk

    I have some sympathy with the POV that in the five years I’ve spent giving this more attention than most people I could have been listing to the birds, reading great literature or making useful stuff. On the other hand I got to retire early – I’d have about five and a half more years of being a middle management miserable Excel and PowerPoint junkie.

    But not everybody wants to give it so much thought, and MSE’s guide should help. A guide on where not to end up is this cautionary tale

    The NHS pension is extremely difficult to work out. It is not as simple as waiting till NRA because lifetime allowance and annual allowances start to come into play for higher earners.

    To make it even more complicated your annual allowance does not = the amount you pay in each year or even the amount your “pot” increases by so it becomes difficult to work out if you can top up into a SIPP.

    @Marco I can see how the falling annual allowance (and LTA) can catch out higher earners. Is there something specific to the NHS pension that makes it more difficult to compute or is there something missing from my understanding in that it is the increase in the pot (the difference between last year’s 16*pension @ NRA and then adjusted for inflation and this year’s 16*pension @ NRA)?

    If it’s peculiar to the NHS pension it this looks like an opportunity for an enterprising IFA to specialise in!

    […] early and losing a third of my pension contributions 1. From 55 which is not so far now I can use a short SIPP to give me a DC pension for five years before drawing my main pension at the NRA for The Firm, so no actuarial reduction […]

     

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