Pension reform: Ten hidden consequences

By Kevin Peachey Personal finance reporter, BBC News

A huge change in the way people fund their retirement is expected following the chancellor's "pension revolution".

Under the proposals, from next year millions of people reaching retirement age will be able to spend their pension pot in any way they want.



The move, announced in the Budget, will remove the requirement on many people with defined contribution pensions to buy an annuity, a financial product that guarantees an income for the rest of your life.


The government says that the overhaul will give retirees more flexibility to do what they want with their pension savings, but Labour says this policy has the potential to be "reckless".
So what are the potential hidden consequences?

1. New pensioners blow their savings

This scenario has been much discussed immediately after the chancellor's Budget speech, but George Osborne says that new pensioners can be trusted to organise their own finances.


Some people might decide that their pension pot, locked up during their working life, will provide a nice lump sum to use to celebrate retirement with a holiday of a lifetime, a massive party, or - as the pension minister admitted - a Lamborghini sports car.


But it will be clear to all that in doing so, they take away the option of using those savings when money is tight in retirement, especially if they underestimate how long they will live for.
The new flat-rate state pension will provide just over £7,000 a year of income to fall back on - described by the chancellor as "generous", but much lower than the vast majority of people are used to during their working life. At times, individuals will receive this years after they have access to their defined contribution pension pot.


In Australia, where people are already able to withdraw lump sums easily, recent evidence suggests that most retirees invest the money or use it to clear debts, but a few choose to buy holidays or cars.

2. House prices rise

Freed of the need to put their pension savings into an annuity, new pensioners may decide to use the money to invest in property instead.


Mark Giddens, partner of accountancy firm UHY Hacker Young, says: "With pensioners no longer being railroaded into investing in annuities, they will be looking for other higher-yielding investments - that inevitably means a huge boost to buy-to-let investments.
"Unfortunately, it is often the case that the higher the yield, the higher the risk."
There is also one other big hole in this theory. The City watchdog's recent review of annuities found that the average pension pot was only £17,700. That is hardly enough for a deposit, let alone a house or flat.

3. Older people get a shock tax bill Anyone who decides to take all their money in one go will not escape the taxman.

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"This [plan] gives people the key to unlock their pensions and take money out, but they must remember that there are tax implications," says Anne Redston, professor of law at King's College, London.

Put simply, the money will be categorised as income, and so will be subject to income tax. Anyone taking out a large amount in one go might find 40% income tax is levied on some of it.
Instead, retirees might decide to take it out in small chunks over the years, stick with an annuity, or seek advice for tax planning.

4. Con artists rub their hands with glee

Retired people are usually top of the hit-list among con artists.
Now, it is likely that people approaching retirement will be targeted with a string of investment scams.


Rogue operators will know that catching someone just as they have access to their pension pot could be very lucrative. The advice, as always, is that a deal that looks too good to be true usually is, and that no decision needs to be taken immediately.

5. Existing pensioners feel left out

This Budget was dubbed as a victory for pensioners, but this new flexible arrangement will not be available to most existing pensioners at all.


The new system is planned to be introduced fully in April 2015, but only for the 320,000 or so who retire each year with a defined contribution pension pot.
Those who have already bought an annuity are receiving their annual pension income and are locked into that deal for the rest of their life.


If this annuity was bought in the past few years, the likelihood is that it was not a very good deal, because of economic conditions and monetary policy. So the recently retired may feel as though they have missed out on greater choice and better deals.

6. Remaining annuity deals are less generous Millions of people are being signed up to defined contribution pensions, through the automatic enrolment workplace pension scheme.

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Pension schemes explained

• Final-salary scheme: Guaranteed pension based on earnings at end of your career and length of service. Also known as defined benefit schemes
• Career average scheme: Guaranteed pension based on your average pay over your career
• Defined contribution scheme: Determined by contributions and investment returns. Usually worth less than final-salary pensions. Savings used to buy an annuity, or retirement income - until now

It is very difficult to work out at this stage whether the changes will be better or worse for those who still decide to choose an annuity when they reach retirement.

Less demand could mean insurance companies are unable to offer such good deals, but fewer customers might mean they need to be more competitive.
"The new rules might mean that annuity companies improve the rates they offer. The excess profits made from captive customers will hopefully disappear," says Tom McPhail, of Hargreaves Lansdown.


But Paul Johnson, director of the Institute for Fiscal Studies (IFS), said: "It will likely make annuities even more expensive for those who do want to buy them."
Annuity companies may also concentrate on offering other types of financial product for pensioners, such as bonds.

7. The Bank of Gran and Grandad opens for business

The amount of money tucked away in pension pots might not be very big - not enough, as mentioned earlier, for most to buy a property.
Yet, a significant chunk of cash could be used as a loan to grandchildren who are struggling to get on the housing ladder, or facing the cost of paying for further education.
However, as explained earlier, taking out a big chunk of money in one go will probably lead to an income tax charge for Gran and Grandad.

8. Inheritance tax becomes a bigger issue

When you buy an annuity, your pension pot is spent on an annual income that lasts for as long as you live. The longer you live, the better value for money it is.


As a result, insurance companies selling annuities are making a calculation or bet based on how much longer they think you will live. Smokers and those with health problems can get a better deal, owing to the shorter life expectancy.


When you die the income generally ends, so cannot be claimed by your family.
Under the new rules, a pension pot can be taken as cash, become part of your estate, and be passed on to your children. However, unless it is invested in a way that avoids inheritance tax, it could push the assets left in a will over the £325,000 threshold that means inheritance tax will be levied.

9. The mis-selling threat picks up again

 
Millions of people will still save for retirement in a pension organised by an insurance company. This company will have your money and will try to encourage you to use it to buy one of their products when you reach retirement.


Clearly, there is nothing wrong in that, although it might not give retirees a clear picture on whether it is a good deal. With lots of financial firms wanting to get hold of that money, there is a danger of a minority of them overstating what is being offered.
The sector is regulated, giving individuals the opportunity to challenge and win compensation if they are mis-sold a product.


The government is also making it a requirement that retirees receive some guidance from their pension company, but it is not clear whether this will be impartial or free.

10. Companies lose a source of credit

 
The vast majority of annuity money is invested in bonds, which flows through to businesses.
If the annuities market were to collapse, then this would reduce this supply line of credit to companies, the BBC's business editor Robert Peston says.
That could make businesses more dependent on banks for credit once again