Investment options when approaching Lifetime Allowance

don9999

Am having a discussion with some colleagues, all around 50 years old.
Each of us have a mixture of frozen defined benefit pensions, and defined contribution pensions.

We have each calculated expected pension fund at age 60, and they all exceed £1 million to some degree or other.
I am already arranging a meeting with an experienced pension advisor, but want to gather as much information/understanding in advance so that I can ask the right questions and make the most of our discussions.

Anyway, we are considering our options over the next 10 years....
What do we do with a £100 investment from our gross salary?
Do we:
a) Continue to invest £100 of our gross salary per year into a pension, or
b) Instead invest £60 of net income into an ISA.
(am just using small numbers here, but of course it would actually be large multiples of these figures.)

In the first case we would be hit by a 55% penal tax charge (we are already over £1 million lifetime allowance).

I had imagined that it would be better to go via the pension option, assuming that even 45% of a larger pot would be better.
However, with basic calculations (using simplified assumptions) it 'appears' that the ISA option is actually financially better.
Unless..........we are missing something.....

Consider option 1) being the £60 investment each year into an ISA, with the cumulative pot growing by, say, 4%.
Option 2) would be the £100 investment into a pension, with the cumulative pension growing by an equivalent 4%.
My assumptions are that both funds could be invested in identical funds, with equivalent returns, and that fees would be similar (hence I will ignore).

Invest Fund at end of Invest Fund at end of
year with 4% int year with 4% int

Year 1 £60 £ 62.40 £100 £ 104.00
Year 2 £60 £127.30 £100 £ 212.16
Year 3 £60 £194.79 £100 £ 324.65
Year 4 £60 £264.98 £100 £ 441.63
Year 5 £60 £337.98 £100 £ 563.30
Year 6 £60 £413.90 £100 £ 689.83
Year 7 £60 £492.85 £100 £ 821.42
Year 8 £60 £574.97 £100 £ 958.28
Year 9 £60 £660.37 £100 £1,100.61
Year 10 £60 £749.18 £100 £1,248.64

Now the second fund ends up bigger, but withdrawing it incurs a 55% tax charge, leaving just £561.89 net.
Which is 25% less than the ISA fund (that is free from tax).

So.......this suggests that it is better for us to invest spare funds (net of income tax) into an ISA, rather than investing the gross amount.
Is that right......?

Of course there are a few advantages/disadvantages of each eg. ISA limits are limited to about £15k, with the pension pot we could take an income drawdown etc... But I think we could overcome most disadvantages eg. we could invest 2 x £15k each year (one for each spouse), and could manipulate an income drawdown from the ISAa by cashing one or more in each year after year 10.

Are we missing anything obvious.....?

(I forgot about NI contributions. Presumably I would also have to reduce the net amount to invest in the ISA by the NI contribution. No NI contribution deduction on the pre-tax pension contributions. But still don't think that would outweight the final 25% difference).

wjr4

Have you looked at taking our fixed protection 2016 and/or individual protection 2016?

EdSwippet

I don't see anything especially obvious that you missed, but there are wrinkles upon wrinkles with pensions that sometimes swing things in odd ways, so I'll mention some of those.

Remember that the LTA is supposed to rise with inflation. Whether it will or not remains to be seen; after all, the original £1.5mm at which it was set a decade ago now was also supposed to rise with inflation, yet it has actually fallen by around 50% in real terms. So you want to do your projections in inflation-adjusted numbers. Probably.

Individual protection (already mentioned) is possible only if you already held over £1mm at the start of this tax year. Fixed protection is possible only if you haven't already made any pension contributions for this tax year, and once you have it you cannot make any at all in the future forever more without losing it.

Have you factored in any employer pension matching? Any salary sacrifice NI uplift? If you were to lose either of these could you have them paid in another way (directly as salary, say)?

If your tax rate in retirement will be lower than it is now, 20% versus 40% say, you'd actually pay 'only' 40% on withdrawals. The 55% rate comes from a 25% penalty followed by tax at a 40% marginal rate on the remaining 75%, so 0.25 + 0.4 * 0.75 = 0.55. If your marginal rate in retirement is 20%, this becomes 0.25 + 0.2 * 0.75 = 0.4. No gain there over the 40% you currently pay, though; merely parity (but with the disadvantage that your money is locked away).

Finally, pensions are a perennial government political football, and so rules will change. Probably for the worse, unless there is a sudden outbreak of commonsense in the government. So prepare for that. Assuming you are under age 55, at minimum you might want to hold off doing anything that cannot easily be undone until after both the autumn statement and the next budget, at which point you may need to act fast, before the end of the financial year. Remember that pension contributions, once made, can generally never be 'unmade' except by drawing on the pension after age 55 (or later if the government again changes the rules here also).

zagfles

The calculation is far simpler than above. Multiplication is commutative, so when comparing a pension with an ISA you just need to compare tax relief going in with tax rate coming out. For an ISA both are 0.

For pensions, if you are a higher rate taxpayer now and expect to be basic rate payer in retirement, it's 40% relief going in compared to 15% on the way out (accounting for the 25% PCLS). That's assuming you don't exceed the LTA. So clearly you win on the pension.

If you do exceed the LTA, then it's 40% relief going in and 55% out if you take the excess as a lump sum. So clearly the pension loses.

However, you don't have to take the LTA excess as a lump sum. If you take it as income it's 25% LTA charge and then income tax on what you drawdown from what's left. This makes the same 55% if you're paying higher rate tax, but only 40% if you're paying basic rate tax.

It's perfectly possible to be quite a bit over the LTA yet still be able to drawdown keeping within the basic rate band. This would mean 40% relief going in and 40% tax coming out, which would make it the same as the ISA. Or if you use sal sac and get the NI saving then it's 42% relief and 40% on the way out making the pension slightly better. Plus of course you have your ISA allowance as well.

don9999

Thanks guys :-)

Just adds to my concerns that the situation is complex.....

As EdSwippet has stated, Individual Protection is not available to any of us (none of our pots have reached £1MM yet) and nor is Fixed Protection (because we have already made pension contributions this year) .

I think we need to play around with some more figures, since 'I' hadn't completely understood how the 55% was calculated and that it 'may' be less if we were Basic Rate Taxpayers as pensioners.

One thought we had late in the day was whether we might start taking out one of our pensions (perhaps one of the AVCs) at age 55 - 25% tax free, and maybe an additional small income if necessary, thereby keeping the total pension pot below £1M. But I suspect that the Lifetime Allowance is calculated in such a way that prevents this manipulation (I need to learn more about exactly how it is calculated - so far I understand that it is calculated on multiple occasions, such as when a lump sum is taken, or you reach 75 or die etc... - but I'm not sure what is involved in the calculation).

Sounds like my meeting with the Pension Advisor is going to be quite a complex one....

EdSwippet

The LTA works such that you use a percentage of it with each withdrawal. Once you reach 100% the LTA charge will kick in.

For example, suppose you have £800k and you withdraw £400k (£100k PCLS, the rest taxable). This is 40% of the £1m LTA, leaving you 60%. Because you are a canny investor you grow your remaining pension pot back to £800k in a year(!). You withdraw £600k (£150k PCLS, the rest taxable), using your remaining 60% of the LTA. £200k remains in your pension pot.

The £200k left in the pension would now cost you £50k LTA charge + marginal tax to access, as you have no LTA left. Note that even though you face an LTA charge on the remaining sum, at no time did your pension pot exceed £1m in total.

If you leave this £200k untouched the LTA charge is eventually assessed when you reach age 75. Google 'pension benefit crystallisation events' for more. This paper is dense, but gives a pretty full account of the unholy mess that the government has created with its meddling over the years.

Also worth mentioning is that at present pensions are a good inheritance tax bypass, so if leaving a legacy is one of your goals you'll want to factor that into your thinking.

ex-pat_scot

A couple of things to consider.


1. in spite of the penal 55% charge, I've been told by an IFA (St J Place) that they were recommending clients to continue where sal sac and employer contributions were continuing. The view was that these elements more than compensated for the additional tax charge.
2. the tax charge can depend on your marginal rate at retirement
3. I have zero confidence that the Annual Allowance & Lifetime Allowance framework will still be in place unaltered in 5 years' time (the earliest a current 50 year old will be able to access pension funds). I HOPE that the ambition to limit "excessive" tax relief on pension contributions will be made through reasonable AA, and that the unplannable LTA will be seen as an unnecessary duplicate and redundant. (ie you can plan with certainty the amount you contribute each year, but have very little chance of accurate projection of future earning streams, contributions, investment returns and market conditions between now and retirement).


It's rather too simplistic to note "nice problem to have". I have 7.5 years before it might be my problem too. Whilst I'm hoping that it won't be a problem by then, I expect that other headaches will have arisen as roadbumps in my clever plans.

wjr4

SJP are not IFAs!

fizio

I am in a similar boat (though just past 1.25 so went for IP2016) but have decided to keep on contributing as part of my pension is DB which means the value in LTA is at NRA. By retiring early, my DB valuation will decrease so my plan is to simply time my retirement (next 3-4 years) such that my total pot will be 1.25 at that point.

jamesd

Continue at least at the level that gets employer matching.

At age 55 you can take a tax free lump sum of 25% and the remaining 75% can be placed into flexible drawdown with no income taken. Take even a penny from that 75% and your money purchase annual allowance for pension contributions will be reduced to £4k a year (£10k until April 2017).

The gross value from which you take benefits is calculated as a percentage of the lifetime allowance and that percentage is then tracked in the future. By taking the money as soon as possible you've taken the later growth out of the future lifetime allowance calculation. Now only the new contributions are building up a pot potentially subject to the LTA if you're not over it yet at this time.

You can also choose when to take benefits. Say you wait until markets have dropped 20%. Or 40%. That's 20% or 40% less of the LTA being used. So if it's very likely to go over the LTA you might not do it all at age 55 but might do some then and the rest later, when market values are lower. Since you can choose when to do this you can wait quite a long time for markets to do the drop that you'd need.

So use the pension and let the routine market fluctuations do the work of keeping you below the LTA if just taking benefits at 55 and perhaps every year after that doesn't do the job.

zagfles

jamesd wrote: »

You can also choose when to take benefits. Say you wait until markets have dropped 20%. Or 40%. That's 20% or 40% less of the LTA being used. So if it's very likely to go over the LTA you might not do it all at age 55 but might do some then and the rest later, when market values are lower. Since you can choose when to do this you can wait quite a long time for markets to do the drop that you'd need.

So use the pension and let the routine market fluctuations do the work of keeping you below the LTA if just taking benefits at 55 and perhaps every year after that doesn't do the job.

You're taking a big gamble waiting for the markets to drop 20% or 40%. They might never be 20% lower than now let alone 40%. Attempting to time the market in this way is no different to attempting to time it for buy/sell decisions.

But we've had this discussion before and you didn't get it then