AVCs and tax relief

jdfox

I am due to take early retirement in a few months. I attended a pensions presentation by Prudential, selling AVCS, who were doing a hard sell on investing as much of the last year's pension as possible in a money-purchase AVC, the argument being that you save all the tax on that money, especially if you are a higher-rate tax-payer. Is there really a good case for doing this, or is this just a sales tactic?

Academic

This is a particularly useful approach if your pension scheme allows you to take your AVC contributions as part of your tax free lump sum. Check the scheme rules to determine if this is the case with your particular scheme.

I'm in the University Superannuation Scheme (USS) which still allows this method; I know of several colleagues who have paid virtually their entire final years salary into an AVC in order to maximise the tax benefits.

dunstonh

Is there really a good case for doing this, or is this just a sales tactic?

Prudential are obviously only doing it for sales rather than giving personalised advice.

Many people continue to pay into a pension after retirement or give it a boost just before they retire if the pension meets their objectives. Would use of the pension tax wrapper meet your objectives or would another tax wrapper be more suitable? (modern investments can be held in different "tax wrappers". Pensions, ISAs & Onshore/offshore Bonds for example. These are known as tax wrappers due to their different tax positions. You also have unwrapped investments as well. So nowadays you dont pick so much pick a product. You work out which tax wrappers meet your objectives).

The use of AVCs is largely obsolete nowadays. Only if there is some employer enhancement or you can use them in conjunction with the main scheme to redirect the tax free cash from that to the AVC are they often considered the better option.

Loughton_Monkey

There is some sense in this, although there are 'complications'.

If I assume you are not 'exceptional' - so you have not exceeded the lifetime £1.8 million, and we are not talking of exceeding any £50,000 annual contribution limit. Here's how it works:

Assume you could afford to 'invest' an amount of £20,000 - and that if you do nothing, this 'top slice' of your salary gives you £12,000 'net' (after higher rate tax). This £12K is yours, and you can keep it in the bank and spend it when and how you choose.

If, on the other hand, you choose to make a 'one off' extra contribution to your pension AVC, then because of the 'full' tax relief, the total of £20,000 is invested in the pension. Just for the moment, I am going to assume it does not change value over the next year or so before retirement.

At retirement, you have the ability to draw 25% tax free. That's £5,000. The remaining £15,000 is available to buy an annuity. This will give you an annual income which depends on your age. If, for example, you were 60 it might give you approximately £900 a year for the rest of your life. This income would be taxable. On the assumption that upon retirement, you cease to be a higher rate tax payer, we are talking only of 20% tax. So £900 a year gives you £720 net cash flow for your whole life.

So you can see that this does represent an excellent investment for you, provided you are happy with the 'drip feed' payment method. The AVC cost you £12K net. You have £5K net in your pocket, and so your net investment was £7K. For that, you are getting about 10% net income on this for as long as you live.

All these figures are 'rough', but you can see the 'profit' comes from receiving 40% tax relief on your contribution, and subsequently you only have to pay 20% tax on 75% of the rest, in instalments.

Provided you can afford to do so, then 'on paper' the more you throw in, the more you are 'winning' on this equation. The negatives, though, are:

1. It leaves you 'short' of income in your final year or so, because a large chunk of your salary now goes into AVC.

2. Although an excellent 'investment', you are, to an extent, required to take the money in the way limited by pension laws. You cannot simply draw the whole lot out as cash.

If you are retiring, say, in 12 months time, then you can do this for two tax years, because a new one starts 6th April 2011.

There are two further points that are extremely relevant.

1. Your pension contribution is invested. It is normal to consider pension investments as 'risky' and equities can (and do) rise or fall by 20% or more in any one year. Hence it would be vital to ensure that your contributions are placed in the safest of funds available. You would need advice on this. But there are funds that will be relatively 'safe' but you could find yourself losing (or gaining) a couple of percent on the 'investments'.

2. There are (in your favour) new 'Flexible Drawdown' rules available next tax year. If you fall inside the criteria (basically having £20K a year on your 'main' oension plus State pension) then there is a way you could take the whole £15K (that's £20 after the 25% lump sum) and draw it more flexibly, still at 20% tax. This is a complex subject and I cannot go inot the details here.

Loughton_Monkey

PS

Yes, further to my above post. I endorse comments above. I should confirm that there is no 'magic' in doing an AVC unless there are specific 'special' rules tied up with your main pension scheme giving you cash lump sum advantages. This is rare these days.

So my point refer to the concept of throwing the extra lump sum into "a pension scheme".

There is equally nothing magic in doing it with Prudential. You have a choice of any provider. And of course this is a 'sales technique' from Pru, but there is some sense in it. But do understand the pros/cons.

There is also no requirement for you you 'take' the additional pension at the same time that you retire. You could leave it invested for a few more years, and even pay up to £3,600 more per year into it from your retirement income.

jdfox

Thanks to all, and especially to Loughton Monkey for this very full and helpful reply. I am not a natural with figures (and I see now that I even asked the first question wrongly, writing ‘pension’ where I meant ‘salary’), but I understood most of your explanation. In answer to your PS, by the way, I am in a pension scheme (USS) that has a cash lump sum + income.

I take your point about the investment risk, and since I am risk-averse, I would be looking for the safest fund, which would no doubt lower the income.

Can I ask you two related questions, if you have time to answer? If I return to part-time work on buy-back for the two years after retirement (which is a possibility), I would probably remain (just) a 40% tax payer. Would the AVC investment still be worth doing in these circumstances, assuming I left the money invested and didn’t ‘take’ it until the point where I was no longer receiving that extra income?

Secondly, is the purchase of an annuity the best way to go with the money invested? The Prudential advice I have offers me the following options:
‘Your Money Purchase AVC (MPAVC) with Prudential can be taken in one of three ways, once you take the main USS benefits:

1. As tax free cash (up to your limits)

1. As added years from the USS

1. As an annuity from any pension provider known as an Open Market Option’

Perhaps added years from USS would be a safer or better option than an annuity?

dunstonh

I take your point about the investment risk, and since I am risk-averse, I would be looking for the safest fund, which would no doubt lower the income.

There is no such thing as a risk free option. Even the lowest risk carries risk. Maybe not investment risk but instead it is replaced with inflation risk or shortfall risk.

For example, someone with 40 years to retirement could be taking a greater risk using cash savings than equities. They are almost certainly going to suffer inflation risk and shortfall risk with the impact greater than investment risk which may have short term issues compared to long term.

You may not have 40 years to consider (may do) but 20-30 years is still possible. Sticking too low down the risk scale could be more damaging than taking a more sensible and balanced approach.

I would probably remain (just) a 40% tax payer. Would the AVC investment still be worth doing in these circumstances, assuming I left the money invested and didn’t ‘take’ it until the point where I was no longer receiving that extra income?

Probably better on a personal pension/stakeholder to give you extra flexibility on timescale. However, 40% tax relief is not to be sneezed at. As long as you are not going to be a higher rate taxpayer when you want to commence the benefits later on.

Secondly, is the purchase of an annuity the best way to go with the money invested? The Prudential advice I have offers me the following options:
‘Your Money Purchase AVC (MPAVC) with Prudential can be taken in one of three ways, once you take the main USS benefits:

As tax free cash (up to your limits)

As added years from the USS

As an annuity from any pension provider known as an Open Market Option’

Perhaps added years from USS would be a safer or better option than an annuity?

They are not the only options available. They are the only options available that Pru offer. Hence why relying on sales is not as good as relying on advice. Are they saying with the tax free cash that it can be used to pay the tax free cash from the main scheme as well as the AVC or just the AVC only? (key consideration as if they can pay the TFC from the main scheme from the AVC then that is a valuable option. If its just limited to 25% of the AVC value then its bog standard and therefore offers nothing that cannot be achieved on a more flexible SHP/PPP/SIPP.

Added years, if it is still available, is typically a valuable option and often the most cost effective. However, the cost can appear to be expensive at first glance.

Loughton_Monkey

I don't consider myself properly qualified to answer all of your points - particularly the financial 'chemistry' involved with the USS.

But attacking it from 'first principles' it remains definitely a viable proposition to dump significant extra money in. Even at 20% tax relief there are financial gains to be found, but at the cost of lower flexibility on when you can draw the money. At 40% tax relief, it becomes extremely lucrative.

If it cannot be avoided, then a couple of years of paying higher rate is a relatively small 'cost' provided it is only temporary. You are going to live far longer than that (we hope) so don't worry too much.

I had not appreciated that you could use the money for 'back years'. This option can often be very lucrative in itself (over and above any tax considerations) and so do keep that option on your radar. If, for any reason, buying back years turns out to be not the best option, then you have many, many, options for the AVC money. You can leave it there, to grow, (even pay more into it if you wish), and 'take' it only when you choose. [Perfect for smoothing out your total income to avoid 40% tax)].

You can convert it to an annuity (of various types) any time you choose [and yes ask Pru to quote by all means but another provider will almost certainly give you better rates]. You can even put it into 'Flexible Drawdown' provided your 'base' pension income is £20K or above. Flexible Drawdown can be a complex subject, and can involve further charges/risks - but a bit of googling might help explain it to you.

So in summary, if you are in the fortunate position of being able to "max out" large proportions of your remaining salary - then to dump this into a subsidiary pension arrangement at 40% tax relief is almost certainly 'financially efficient' and worth doing.

Perhaps what you need to do now is some rather more detailed planning - using actual figures that might apply in your case - and consider the 'fine tuning' that will optimise you overall tax and cash flow in retirement.

Newly_retired

Well it IS a sales tactic but in your case seems to be a particularly good one for you as you can take it in added years.
I had a Pru AVC but could not take it in added years to my teacher's pension scheme.
After I retired I went for the open market option as my IFA found another annuity scheme was better than the Pru. But although AVCs are not much used now, I was glad to be able to add to it in my final year of work and get the tax benefits.