20th May 2014
By Merryn Somerset Webb
I listened to BlackRock’s Larry Fink speak at the National Association of Pension Funds conference in Edinburgh this week. He was very clear that everyone must save more; that his industry must somehow “communicate the urgency to save today” and that anyone who doesn’t act on this urgency faces a “miserable future”.
Of course, asset managers are always saying that. They would. The more we save, the more money they rake off in ad valorem fees. And there’s a large group of people who are following Mr Fink’s advice already, but also face a miserable future – or at least, a miserable tax bill. Far from under-saving, they are over-saving. Why? Because of something called the lifetime allowance. The LTA was introduced eight years ago with little fanfare and has fluctuated all over the place since then. It started at £1.4m, went to £1.8m and then fell back to £1.5m. And it’s about to change again: from April 6 it will be £1.25m.
You can apply to have your limit frozen at £1.5m but assuming you don’t, if on the day of your retirement you have more than £1.25m in your pension you will be taxed on the excess at a rate of 55 per cent.
Because these changes don’t get much media attention, it’s tempting to think they don’t matter. After all, surely only corporate fat cats and footballers have pension pots worth millions? Think again. The LTA sounds like a contribution limit, but it isn’t. I doesn’t refer to how much money you can put into your pension. It refers to how much you may have in your pension when you finally retire, which is a very different number.
One and a quarter million sounds like a lot. But add in investment returns, inflation and time and it’s nothing. Let’s look at it in terms of investment returns only. Over the past 50 years or so the stock market has given average real return of about 5.5 per cent a year. Go back further and it comes out at more like 7 per cent, so let’s take 6 per cent. Consider a 38 year old man with £250,000 in his pension. He probably hasn’t even noticed the change in the lifetime limit given that his current savings come in at a million under that.
But with 6 per cent annual growth, guess how much he will have in his account in 27 years (when he is 65) even if he stops saving right now? £1.2m. He’s effectively almost at the limit already, thanks to the magic of compounding. What if he makes 7 per cent a year? £1.55m. And what if he keeps contributing to his account to the tune of £500 a month until he retires? £2m. I’ve ignored costs in all of this, but you get the picture. The better he invests, the more risk he is running of a nasty tax bill at the end.
I have used inflation-adjusted returns here, which makes the implicit assumption that the lifetime limit will rise with inflation. But that’s hopelessly optimistic. Pension savings are easy targets for broke governments, and an easy way to both save on tax relief upfront and to claw it back later is to use fiscal drag to cut the amount people can save, either on an annual basis or in total.
The Liberal Democrats are already lobbying to cut the LTA to £1m, but lets assume for now that it stays where it is. Let’s then assume that inflation runs at 3 per cent a year until our would-be pensioner retires. That annual 6 per cent real return becomes a 9 per cent nominal one, which turns £250,000 into £2.5m. after 27 years. Double the permitted amount. His tax bill on his ‘Tax free’ pension is going to be.assu£687,500. Or maybe more’ BlackRock puts the annual total return without inflation adjustment on UK equities over the last 42 years at 11.3 per cent. If our man makes that, he’ll have £4.5m to his name, and he’ll pay 55 per cent tax on £3.25m of it.
This doesn’t make allowances for tax he will pay on the income he draws, either. Nor does it allow for any more contributions. If he tucks a little more away every month the bill will be even higher. The LTA is a classic tax on mathematical ignorance and inflation.
You will say that none of this is a given. You’re right. Investment returns over the next 27 years may be lower than usual (although valuations don’t really suggest that is the case). The LTA might even rise over time. But even if it rises with inflation, our man is still in trouble.
And I can’t see it rising with inflation. Pension tax relief is very expensive and politicians are looking at ways to reduce it without being too obvious Doing it via cuts in the real LTA has the twin benefit – from a politician’s point of view – of being simple to implement and hard to understand.
So what do you do about all this? The first thing might be to accept that this is the way of it. We live in a deeply indebted state that must somehow finance itself. The more you have, the more you are going to end up paying, one way or another. You might as well just keep saving and hoping for the best. The next is to look into the various Fixed Protection schemes, as explained here. But if you aren’t already overfunded – and I think a lot of you will find that you are – the best thing to do is to hedge your bets.
My own guess is that the LTA will fall to around £400-£500,000 in real terms. That’s the amount that yields enough of an income to stop you being a burden on the state in your old age. So, use your Isas first and once they’re maxed out, save no more than enough for the miracle of compounding to get you to half a million (in today’s money) by retirement. Then put your spare cash somewhere else.
Over the past 25 years, Andrew has held several key positions with major financial organisations including international life companies and asset management organisations.
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