The cost of mis-buying

9th February 2015

The pension changes announced in the Budget have given consumers access to a wide range of options, however, with freedom comes the risk of mis-buying. Earlier this year the Financial Conduct Authority (FCA) reported on its review of the annuity market. They found consumers are not prepared for the range and complexity of the decisions they need to make at retirement and that was when they just had to choose an annuity.

WEALTH at work are concerned that consumers will try to avoid paying for financial advice, not realising that with many products charges are deducted anyway, but they won’t have the same consumer protection that comes with financial advice. They also may not realise that with the right financial advice, tax could be saved which could often more than cover the fees.

WEALTH at work have highlighted five key areas which demonstrate where consumers could be better off taking advice, than trying to do it themselves.

1.    High broker commissions

If someone goes to a broker to purchase an annuity, or other financial product, they may think that they are avoiding paying for financial advice, as there is no fee. However, the broker will be paid a commission by the insurance company providing that annuity or financial product. This means that commission is factored into the rate paid to customers.  Taking annuities as an  example,  there is a commission payment, typically between 1 – 1.5% for a standard annuity, and when it comes to enhanced annuities, this is typically between 2.5-3%  and can be over 5%.

A typical fee from a regulated adviser is between 1.7% and 2.5% and this has to be declared upfront.  In money terms, based on the average annuity bought last year (£35,600), doing it yourself could cost  £1,068 (based on 3% as it is estimated that 60% should have been getting enhanced annuities) but could be as much as £1,780 (based on a tied/restricted deal at 5%). Yet using a professional adviser will generally cost between £605 and £890, and can provide not only personalised advice, but greater consumer protection.

It is estimated that approximately 32% of pensioners that retired in 2013 may have been eligible for an enhanced annuity, but only purchased a standard one. Those with a standard pension pot, depending on their circumstances, may have missed out on £14,100 over 20 years, which could have been avoided by using a professional adviser typically charging less than a DIY option.

(The £14,100 calculations are as follows. Enhanced annuities pay up to 40% more than standard annuities. Industry research concluded that the average ‘worst’ standard single life annuity rate June 2014 [for a 65 year old in the open market] was 5.02%, so just over 7% for an enhanced annuity [Using the average ‘best’ rate of 5.73% the uplift would give a rate of 8%]. An average pension fund of £35,600 would receive the standard annuity of £1,787 p.a. and those receiving the enhanced annuity would receive £2,492, a difference of £705 p.a., £14,100 over 20 years [£21,000 using best rate].)

2.    Using the wrong assets for income  

If someone has a range of assets such as defined benefit company pension schemes, ISAs and other savings, they may be better off using these for income instead of cashing in their defined contribution pension schemes. This is because if they cash it in, 75% of the value of the pot is treated as taxable income (tax of £3,200 on the average pension pot of £35,600, assuming full personal allowance is available). If they don’t have any plans for it, there’s a good chance it will just sit in a savings account, with a low rate, and even that will typically be subject to savings tax at 20%.  Most advisers would recommend that they live off their Defined Benefit scheme, and ISAs where needed, allowing the Defined Contribution scheme to continue to grow in its tax efficient wrapper until needed.

3.     The accidental higher rate tax payer

Those wanting to cash in their pension funds as a result of the pension changes coming into force in April 2015 could benefit from taking advice. For example if someone has a defined contributions pot of £42,000, and decides to cash it all in they would generally have to pay tax on 75% of it. If they are still working it is possible that this additional £31,500 income will take them into the higher rate tax bracket of 40%. Someone earning £38,000, would be taxed as though they earned £69,500. £4,385 of the pension pot would be taxed at 20% rate and a whopping £27,115 at the higher rate of 40% making a tax payment of £11,723 on their pension. An adviser could advise someone to phase their withdrawals to avoid higher rate tax, and instead perhaps make large purchases using hire purchase agreements or interest free loans, which should be available at a rate significantly below a tax charge rate of 40%.

(The calculations are as follows based on 2015/16 tax rates and allowances;

Pension = £42,000 less 25% tax free cash = £31,500

Earning = £38,000 less personal allowance of £10,600 = £27,400

Income subject to tax is £31,500 + £27,400 = £58,900

First £31,785 of income charged at 20% tax rate, remainder of £ 27,115 (£58,900 – £31,785) charge at 40% tax rate.

20% x £31,785 = £6,357

40% x £27,115 = £10,846

Total tax = £17,203)

4.    The risk of ruin

The risk of ruin, the American gambling term used to describe the risk of losing all of your savings, when used to talk about pensions, is the risk of underestimating just how long retirement might last. People often underestimate how long they might live and it is difficult to manage money to achieve an income of 30 years or more without financial advice to help take account of inflation and changing income requirements throughout retirement.

5.    Maximise your inheritance

The government’s decision to make significant changes to the taxation of death benefits is great news for pension savers. If an individual dies pre age 75, a nominated beneficiary (whatever their age) will be able to take their entire pension free of tax from April 2015, whether it is taken as a lump sum or accessed through drawdown.  However if an individual dies aged 75 or over, payments to a nominated beneficiary will be subject to income tax at the beneficiary’s marginal rate. There is an alternative temporary option (until 5 April 2016) which allows the beneficiary to receive the benefits as a one off lump sum payment, subject to a tax charge of 45%. It is more important than ever that those approaching retirement understand their options, and how to benefit from income drawdown to maximise their income during retirement whilst also maximising the amount their beneficiaries receive.

Jonathan Watts-Lay, Director, WEALTH at work said, “If you see a regulated financial adviser then not only is there more protection as a consumer with regard to the advice received, but also it is more likely that paying unnecessary tax could be avoided. If you do it yourself, then unfortunately it is down to you. As the costs of advice are generally about the same as the commission you’ll pay for a DIY service, it seems odd that someone would DIY unless they consider themselves an expert. The difference between getting it right and wrong can be many thousands of pounds and it isn’t worth taking the risk in my opinion.”

For further information please contact us now.

Further coverage can be found in:

The Times – Plot Your Route to the Best Pension Advice
The Times – Five Pension Traps to Avoid
Money Observer