In this article I’m arguing that in a world of  freedoms and investment pathways, cashing out your pension or at least stripping out tax free cash makes sense. People are not swayed by arguments about tax and investment optimization, they require better reasons for keeping money in pensions than they are getting today. 

There are too schools of thought about taking cash out of a pension.

St James Place’s answer will resonate with many people who have been looking forward to retirement as a new start.

In many cases it offers an opportunity to achieve a financial or lifestyle goal that requires a larger lump sum of money, such as paying off a mortgage, holiday of a lifetime or a big purchase.

Contrast this with the conclusions drawn from  research from Legal & General which concludes

 Britain’s future pensioners are putting their retirement future at risk by withdrawing cash from their pension pots while still in the accumulation phase. The findings were that some people are confusing their pension pots for savings accounts, which may have a detrimental impact on their retirement.

This comment , which appears in a blog published on a third party website is followed by further concern

Rather than its original intention of incentivising saving, tax-free cash allowances appear to have the opposite effect in practice – encouraging members of pension schemes to spend more before they retire and take their tax-free cash savings while they still have other sources of cash savings. This is a potentially very damaging situation for whole generations of future retirees.

For St James Place, tax free cash is seen as a way of creating immediate happiness and for Legal & General, or whoever wrote the second article, it is seen as an incentive to save. Is it one or the other or both?

So what’s the Government’s position on tax-free cash?

In its 2020 parliamentary briefing paper, Government points out that the current taxation system is very much about incentivising people to save. The pension taxation system

• should be simple and transparent. The government
  believes that greater simplicity and transparency may
  encourage greater engagement with pension saving and
  strengthen the incentive for individuals to save into a
  pension.
• should allow individuals to take personal responsibility
  for ensuring they have adequate savings for retirement. It
  should encourage people to save enough during their
  working lives to meet their aspirations for a sufficient
  standard of living in retirement.

The second bullet is important to tax free cash. Although you cannot take a charge on a pension , many people plan their pensions so that they can take a cash sum to repay a mortgage and create for themselves the concept which used to be known as a “pension mortgage”. This is entirely consistent with the aim of increasing saving as for every pound you  save to redeem your mortgage, you need to save three more to get your cash tax free.

So for many people, tax-free cash is used to achieve financial aspirations (paying off a mortgage which in itself releases income which otherwise is charged  as interest payments) .While at the same time – incentivising boosted savings which can be converted to a retirement income.

This is not damaging at all – it’s good financial sense.

Oh reason not the need?

The view that tax-free cash is getting in the way of retirement planning is backed up by qualitative research from Legal & General.

Nearly three-quarters of those who access their tax-free cash believe that the main purpose of their pension is to provide an income for life. However, 76% of respondents do not intend to use their tax-free cash to provide them with an income in retirement.

As mentioned above, if cash is used to release income, then there is method in taking tax free cash at outset , but it seems we just can’t resist spending our money on having a better life.

Over 50% of those who had withdrawn their lump sum said they did not need to take as much at that time and of those who decided to withdraw a lump sum, the most popular choice of what to do with it (27%) was to spend it on home repairs and improvements.

Not much income deriving from the new patio I suppose, but I can’t see what is wrong with people spending that part of their retirement savings available as cash, on cash intensive projects. “Oh reason not the need” as King Lear protested!

People aren’t stupid – they consider their happiness carefully

But the Legal and General data does give us an insight into the kind of financial buffering that drives investment minded financial advisers mad

Over half who had withdrawn their lump sum said they did not really need as much right away and that they could have taken less. Meanwhile nearly one-third (29%) said that they could have used other savings instead of taking the lump sum out of their pension.

Hear I have more sympathy with the conclusion drawn. The happiness gained from having a healthy balance in your bank account is a pretty sad kind of happiness. The allure of putting your money to work is born out by the long term advantages of investment returns. The value of liquidity (the cashpoint or contactless card) is minimal, if you never spend cash!

The analysis  of L&G’s research goes on to compare the behavior of those with big fat pots (£250k+) who nurture their tax free cash for tax optimisation

By contrast, we learn that the pension pot poor don’t have any plans to take their tax free cash as part of regular pension payments

only 13% of those with less than £10,000 in their pension – two-thirds (65%) of whom haven’t yet worked out what monthly income they will need in retirement.

Even more shocking…

Over half (53%) of those with pots of less than £10,000 agreed with the statement that tax-free cash is ‘there to spend, like a bonus or a windfall’ compared to less than a third (30%) of those with pots of over £250,000.

Let’s get this into perspective, a pot of less than £10,000 would attract a tax bill to someone in or around the income tax threshold of up to £1500 , leaving £8,500 to be enjoyed. Many people with small pots will pay less income tax, I appreciate that there might be implications for means-tested benefits, but these sums are game-changers for those used to living with virtually no financial headroom. The economic utility (happiness) of cash in the bank, to those on low incomes is considerably higher than for those with high incomes.

People aren’t stupid, they consider their happiness carefully. Pot size is a key determinant of financial behavior and rightly so.

Reckless conservatism … and the advantage of advice.

Wealth management  is often about convincing people to take more risk than they naturally would. This is , I suspect why I came across the L&G research on our blog run by Waverton Wealth Management. This conclusion hints at the frustration that IFAs must feel when rich people do dumb things.

But even among more financially well-off savers, there is an aversion to keeping their tax-free cash invested in their pension. While nearly half (48%) of those with pots of over £250,000 say they believe their lump sum is something to ‘invest elsewhere, for better returns’, those with pots of over £250,000 are three times more likely to keep their tax-free lump sum in cash rather than invest it (54% in cash savings versus 18% in a Stocks & Shares ISA or other investments).

If all you do with your tax-free cash is to swap it for another tax-incentivized savings account, then what was the point of the pension in the first place?

The answer to that question isn’t quite so easy to answer as you’d first imagine. Until we have a genuine advantage in turning out pension pot into a pension, it might as well sit in an ISA.

So my original question may be better asked…

What’s the point of a pension?

Of course I can answer that question; most people need a wage in retirement as they do not have sufficient liquidity for their wealth and have no idea when they are gong to die. ISAs and Sipps do not provide answers to the pension question. But I consider that we can provide people with a Pension Pathway that could be an acceptable alternative to an annuity and would restore confidence in pensions.

That must be the immediate priority, worrying about tax and investment optimization of tax free cash is a side issue. When we make the pension option attractive enough, then people may start behaving differently with regards the taking of cash.