Have you been asking yourself – “is it worth putting a lump sum in my pension?”.
If you are approaching retirement age in the UK, then you may be concerned about your future, given the current high levels of inflation and the drop in the value of global stock markets. You are right to be concerned. I have never known such volatile markets and uncertain conditions.
It becomes more of a concern when you reach your retirement age in the UK, as that’s when your employment and earned income stop. Your future income will arise from a combination of state pension, employer’s pension, and any private pensions you may have. Your family’s future standard of living – your pension lifestyle – will depend on how much you have contributed towards your pension arrangements, and how well they have been managed, and continue to be managed during your working life.
If you are concerned about your future lifestyle, then contributing the maximum to a pension scheme still makes sound financial sense, especially if you take care to follow the five steps.
Step 1
Develop a deep understanding of your pension before making any further payments.
Before you reach your retirement age, we suggest you find what funds are held in your pension fund.
On retirement, the monies in your pension pot will depend upon three factors:
- the amounts you or your employer have contributed,
- the charges, and
- the investment returns made by your pension funds.
In addition, the trustees of the pension will often phase their fund into ‘lifestyle mode’, eight or ten years before retirement. This essentially increases the percentage of fixed interest bonds held in the portfolio in the years before retirement (life styling was originally introduced to prepare for switching a pension fund into an annuity).
But are fixed interest bonds as safe as they were in past years, not with interest rates rising.
The future returns on fixed interest bonds are unclear.
If you are a member of a large pension fund with Scottish Widows, Standard Life, Legal & General, or Aviva, then the challenges of having large numbers of pension scheme members may mean that the trustees’ focus is on the administration of the scheme and not your individual circumstances.
Their range of investible funds may be between a relatively small number to hundreds of funds, but most people will “go with the flow” and tick the default fund option suggested by the scheme.
The regulations that govern occupational pension arrangements normally result in members being bombarded with paperwork and attending briefings that leave them none the wiser.
Very little time is spent on discussing the choice of funds held by the pension.
As I mentioned previously the choice of investment funds and the combination of different asset classes within the funds is critical in growing the future value of your pension fund.
This process is known as asset allocation; it is essential that this provides diversification and that it is regularly reviewed.
Despite all the dramatic changes in the financial and economic behaviour of the central banks and the disturbing geo-political threats in the world, the financial services industry and pension industry are still promoting asset allocation models that are based on a white paper that was written 70 years ago, that is at odds with the current economic climate, and future predictions for markets.
The models they promote are not influenced by the volatility of the market, and adherence to this out-of-date approach requires complete ignorance of the investment markets, as the portfolio models are defined by fixed geographic percentage split percentages and an accompanying narrative that in the future markets will eventually normalise.
That is why I suggest that you find out more about your pension scheme (whether it is an employer scheme or a private pension before you contribute more money to it in the future.
I recently contacted pension trustees of a large pension fund on behalf of a client of mine; I asked them to identify the funds held by my clients and was informed in a very posh voice that “Don’t you realise Mr Best all our pension funds are blended”. After my research, it transpired that they were 100% invested in equities. The fixed asset allocations of the large employer scheme (blended) are in the blue image, and one of our more highly diversified portfolios is in the pink image.
The flexible asset allocation follows trend investment techniques and in order to provide this type of portfolio advice, we devote a considerable amount of time to investment research.
As you can see, there is a considerable difference in the results.
If you have pension funds in excess of £500,000 and would like to have a 30-minute chat, do contact us.
Step 2
Is there a limit to the amount I can put toward my pension, both now and in the future?
In any given tax year, you are permitted to contribute to your pension up to 100% of your yearly earnings, up to the annual amount of £40,000, whichever is lower.
You are still permitted to make a pension contribution of £3,600 gross (you pay £2,880 net) even if you or your partner did not have any relevant income during any tax year.
HIGH EARNERS’ LIMITATIONS
Whether an individual’s adjusted income and threshold income exceed the thresholds determines whether the annual allowance will be reduced.
The annual allowance is therefore lowered for people whose threshold income is over £200,000 and adjusted income exceeds £240,000.
Key elements:
- The annual allowance is reduced for those whose “adjusted income” is £240,000 or more.
- The annual allowance is decreased by £1 for every £2 above £240,000.
- The maximum deduction is £36,000 when “adjusted income” exceeds £312,000.
- The reduction does not apply to anyone with a “threshold income” of less than £200,000.
Starting on April 6, 2020, individuals with taxable incomes over £240,000 will have their yearly allowance for that tax year reduced. According to this, their annual allowance is reduced by £1 for every additional £2 in income beyond £240,000. Their annual allowance is rounded down to the nearest full pound.
£36,000 is the largest reduction. Therefore, a £4,000 annual allowance is available to everyone with an adjusted income of £312,000 or higher. High-income people who are subject to the restriction might need to reduce their own or their employer’s payments to avoid paying an annual allowance charge.
However, those whose “threshold income” is less than £200,000 are exempt from the tapering reduction.
Between April 6, 2016, and April 5, 2020, the annual allowance for people with adjusted incomes over £150,000 was capped. For each additional £2 of income their adjusted income above £150,000, their annual stipend was reduced by £1. An annual allowance of £10,000 and a maximum deduction of £30,000 was applied to anyone having an income of at least £210,000.
Income modifications vs threshold income
It is critical to comprehend what is meant by adjusted income and threshold income to assess whether someone is subject to the tapering decrease.
Both include all taxable income, demonstrating that this is an issue across the board. Included are all types of investment income and in-kind benefits, such as employer-paid health insurance premiums.
Simple enough: Adjusted income includes all pension contributions, including employer payments, while threshold income excludes pension contributions.
However, HMRC’s explanations of adjusted and threshold income can generate some confusion because they start with the phrase “net income.” Although “income after taxes” could be interpreted as what this says, it is not the case.
Net income in this context is total taxable income less various deductions. The most significant (or at least frequently made) of these deductions are the member contributions to money purchase and defined benefit occupational pension plans made under the net pay arrangement. Here, the sponsoring company for the pension program deducts PAYE-compliant employee contributions from workers prior to tax.
The additional deductions include things like trading losses, share loss relief, and some charity contributions. A comprehensive list of the deductions is provided in Section 24 of the Income Tax Act of 2007.
If we take a more realistic view of taxable income, we can better comprehend the two definitions. When someone says, “I make £x,” they often do not mean the amount after net pay arrangement contributions have been subtracted. Therefore, it is reasonable to assume that someone who earns £160,000 and receives £20,000 in contributions under the net pay arrangement will report making £160,000 rather than £140,000. The £160,000 includes the pension contributions.
TRADING COMPANY DIRECTORS
Many directors believe they are unable to make meaningful contributions to the business pensions since they give themselves low salaries and high dividends. While their ability to contribute personally might be limited, their company is not constrained in any way. Without any constraints on profits, their firm may contribute up to the standard personal maximum.
I recently met with a client who owns a business. His accountant estimated that he could contribute a maximum of £11,000 to his pension; however, after investigating, I was able to confirm that his company could contribute up to £120,000 if they so desired.
One of the primary components of our incredibly effective Total Planning System for business owners is creative pension planning for Directors of S.M.E.’s.
Step 3 CARRY FORWARD of the ANNUAL ALLOWANCE
Is it worth making a lump sum contribution to my pension?
If you have not been able to make your maximum allowable contributions in past years. You are allowed to look back over the last three years and make a contribution higher than the annual allowance. Do take professional advice before you do so.
Pensions are a legal way to lower your income tax cost and making more pension contributions will allow you to deduct those payments from your tax liability at the maximum rate.
Normally, a net amount of £40,000 would be paid to fund pension contributions of £50,000. (Please note the tax relief is added to your pension and may take two months to arrive).
If you pay taxes at a greater rate than the average, you can claim additional tax by including the higher gross amount of your contribution in your tax return.
Therefore, for a net cost of £30,000, a contribution of £50,000 might be made.
After 10 years, you will have accumulated a total of £81,445, assuming your pension grows at a compound rate of 5%.
The accumulated amount would have climbed to £89,542 if the real growth of your pension exceeded the presumption and expanded at a 6% compound over the ten years.
That is more than the cost of your net contribution.
Our second opinion service is available. We provide two complimentary appointment times each month available on a first-come, first-served basis. If you would want a more in-depth talk about your pension or financial planning arrangements.
Step 4 TAKE ADVICE
Before you think about your pension planning in isolation, we advise you to seek comprehensive financial planning advice; ideally, you should meet with an independent financial adviser for a full review because there may be other aspects of financial planning that are more urgent and need to be put in place first.
If you earn a high income, you should seek counsel as well. If your high income is a recent development, you may be able to escape some of the contribution limitations and tax relief outlined above.
Step 5 DEATH BENEFIT
Since pensions are typically kept in trusts, the trustees of the pension fund have discretion over who will receive the death benefits after you pass away. As a result, when creating an expression of wish and nomination form, you must be explicit about your wishes. You should also make sure that your Will is current and well-written.
Leave a very detailed, signed, and witnessed document outlining the reasons why the beneficiaries in your Will and your expression of wish disagree. You won’t be able to ask questions when you pass away.
Your beneficiaries and possibly their descendants may be able to gain from a wealth-transfer cascade if nominations are stated clearly and appropriately.
If your pension or associated investment funds are currently valued in excess of £500,000, we would be happy to provide you with a second opinion on your pension. To apply click HERE.
