Four years of pension freedom: the unintended consequences

We examine the successes and risks of the new regime, and assess which areas are likely to be the focus of future attention.

It’s four years since the introduction of pension freedoms giving retirees greater flexibility around when and how they access their retirement savings. While there is little evidence that people have blown the lot on Lamborghinis, there are some lessons to be learnt from our pension spending habits.

The new flexibility has certainly proved popular. According to the latest figures from HMRC, more than a million people had taken advantage of pension freedoms by the end of 2018, releasing £23.6 billion through more than five million withdrawals.

Steve Webb, director of policy at Royal London and pensions minister at the time the freedoms were introduced, isn’t surprised. “When you think about where we’ve come from, it’s a huge improvement,” he says. “Before April 2015, most people were forced to buy an annuity to access their pension. Greater flexibility is very welcome.”

As well as giving retirees more options around how they access their pensions, this also fits well with modern retirement. Rather than hanging up their work clothes one day and drawing a pension the next, a growing number of people are staggering retirement. “An annuity isn’t fit for the way we leave work,” says Nathan Long, senior pensions analyst at Hargreaves Lansdown. “More and more people are extending their working lives, with many going part-time, self-employed or having a portfolio career. Being able to draw a flexible income from a pension can support this shift.”

A table showing flexible payments from pensions

Boosting savings

Knowing your pension savings won’t have to be swapped for an annuity is also making it more attractive to save for retirement. Research conducted by Aegon in 2016 found that 15% of the working UK public, equivalent to some 6.2 million people, were saving more into their pension as a direct result of the reforms. “The fact that there’s greater flexibility has made people more willing to save into pensions,” says Steven Cameron, pensions director at Aegon. “They like the security that once they reach age 55 they can get it back if they want.”

The pension reforms have also benefited other areas of financial planning. Relaxing the rules around passing on pension benefits at death has created more inheritance tax (IHT) planning opportunities.

Previously, those inheriting your pension pot could find they had also been left a tax charge of up to 55%, but under the new regime your beneficiaries no longer pay any tax on your pension if you die before age 75. If you live longer, they’ll be taxed at their marginal rate when they take income from your pension. Patrick Murphy, managing partner at Zen Wealth, says this adds to the appeal of pensions as a savings vehicle. “If someone has money outside of their pension, it’s usually sensible to spend that first as it will reduce a future IHT liability,” he comments.

Spending frenzy

Unsurprisingly, while the new rules that make it easier to take money out of a pension have resulted in some significant benefits, they have also created a number of substantial risks that could prove costly.

Stephen Lowe, group communications director at Just Group, says there’s a real risk that people will deplete their funds too quickly. “The idea of pension freedoms is an unhelpful message because it depicts pensions as prisons for money that must be liberated, rather than fortresses that keep it safe,” he says. “This has resulted in people taking out pension cash early and for no reason.”

To support this, he points to Financial Conduct Authority (FCA) figures which show that more than half of pots were accessed by people at age 55 and that 53% of pots accessed were fully withdrawn. However, to put this in context, the average size of pension pots fully withdrawn was only £14,500. Long says this suggests more of an administration decision than reckless spending. “More research into why people are cashing in their pensions is necessary, but many of those who do have another plan in place,” he adds.

However, while some may be spending their cash wisely, there are also concerns that many withdrawn pensions end up sitting in savings accounts. Fiona Tait, technical director at Intelligent Pensions, says: “People won’t lose money if they do this, but earning low levels of interest will affect how long their retirement savings last.”

Running out of cash

Withdrawal rates for those taking an income from their pension is another concern. Lowe questions whether these are sustainable. “FCA figures show that of those making regular withdrawals, over half are taking more than 6% a year. Of the key 55-64 and 65-74 age groups making regular withdrawals, 53% and 47% respectively are exceeding 6%,” he says.

Taking a pension at this rate means there’s a real risk it runs out before your retirement does, and Tait would like to see the regulator exploring this area more deeply. “If it’s a positive decision and these people have other savings and capital for their retirement, it’s not necessarily a problem,” she says. “But we need to know this is the case.”

Also biting into people’s hard-earned pension pots is tax. Any withdrawals beyond the tax-free cash are subject to income tax, so taking a large payment from a pension can result in a chunky tax bill.

Pension companies will highlight this tax liability with customers, which can deter some from taking large amounts. Unfortunately, though, this still leaves many hit with emergency tax when HMRC assumes a one-off withdrawal will be a regular income and adjusts the tax accordingly.

Figures from HMRC show that pension savers have been overtaxed by £400 million since pensions freedoms were introduced; while it’s possible to get it back, it’s a situation that Tait would like to see revised. “Four years down the line, it’s ridiculous that HMRC is applying emergency tax to pension withdrawals,” she says. “Billions of pounds have been withdrawn: it’s a normal course of action.”

Losing your potential

Another risk that’s often overlooked when enjoying these freedoms is the way it can affect future pension saving. Crystallise a pension by taking more than the tax-free cash, and the maximum value of pension contribution on which you’ll get tax relief falls from £40,000 a year to just £4,000. “Nearly a million pension scheme members are now subject to the lower allowance,” says Lowe. “This affects their future pension savings and adds administrative complexity.”

Further, while some of these will be happy to switch from saving to spending, a survey by Canada Life found that of those who had accessed their pension pots without advice, one in five didn’t realise it affected how much they could pay in in future.

While the sheer complexity of the pension freedoms rules means it’s possible to make a mistake or jeopardise your future retirement income, this landscape has also proved fertile grounds for scams. “Of all the things that could go wrong, the worst is a scam,” says Tait. “Whether it’s being encouraged to move your pension into something unsuitable or even something illegal, it’s possible to lose the whole pot to the scammers. The cold-calling ban will help, but we need to do more to prevent scams from taking place.”

Future focus

Greater understanding of the way pension freedoms work will come with time, but the government is also keen to ensure that people don’t inadvertently fall foul of the rules. As well as monitoring activity, the FCA is also proposing a ‘wake-up’ pack should be sent to everyone with a pension at age 50, instead of the current 55.

The new version will also include a one-page summary of the key information. Cameron says this is a good move. “Waiting until someone reaches 55 is too late,” he says. “Sending the pack five years earlier gives them time to think about their options. Depending on what they plan to do, it might be sensible to change investment approach or even contribute more.”

Support for individuals who don’t take advice when they access the freedoms is also coming under scrutiny, with the FCA currently consulting on a system of investment pathways. This would recommend four different investment options, depending on what the individual plans to do with their pension over the next five years.

Although it’s still under consultation, there are some reservations. “On the surface it’s a good idea,” says Long. “But I’m slightly worried that it will gloss over some of the nuances and issues, and make it easier to go into drawdown without a good understanding of the risks.”

Staying alive to the risks and ensuring the right protection is in place is a must. But, with pension freedoms delivering the flexibility that more and more people want in retirement, it’s a reform that is very welcome.


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