If you were to create a word-cloud of associations people make with pensions, I bet “tax-free cash” would feature prominently. I tried to google such a word-cloud but got a lot of constructions that look like they’d been made up by the asset management industry – for whom cashing out 25% of a pot as quick as possible is neither PC or conducive to embedded value!
“We love tax-free cash – it’s the best bit of our pension….”
This is a quote from a couple I’m friends with – and I’m sure they’re not the only ones. They are only a year into drawing their pensions.
Tax-Free Cash is hugely emotive and the threat that it is about to be removed, a standard tool in the pension salesman’s armoury.
Invest now for the end of TFC is nigh.
We are so appalled at the prospect of being taxed on our pensions and retirement pots at some undetermined rate, that we will self-harm our financial well-being to get out of pensions tax free.
Scammers know this only too well, it was a standard tactic of those liberating pensions to suggest that taking money abroad would liberate both the pension and the tax liability.
Actuaries know how to arbitrage using this perverse behavioural bias. When I came to taking my defined benefit pension , I was offered a commutation factor of 1 for 10 , meaning I’d have to give up one pound of pension for every 11 pounds of cash. If I wanted to take cash instead of pension , I could get over three times a better exchange rate. And yet less than 1% of pensioners turn down their tax free cash. Which proves Turner’s killer fact that only half a percent of us take pension decisions in a rational way. I refused my tax-free cash BTW.
Giving up a quarter of your pension pot is not a rip-off in the way that many DB schemes’ commutation factors are rip-offs. But they are still an incentive that most of us should avoid unless the cash is needed.
If you don’t need cash when you start drawing down from your pension , then it makes more sense to take your tax-free cash as you go along, because your cash is invested for longer (though you have to be confident that you’ll live to see the benefit!)
Tax free cash can be used to boost your pension – not a lot of people know that!
We are not alone in our dash for cash
Writing a blog on linked in, Stefan Lundbergh cited Chile’s saver’s dash for cash.
Chile introduced their DC pension system in 1980 and was one of the early adopters of a fully funded mandatory DC system. For a long time, Chile was used as the role model for DC pensions by both OECD and the World Bank. The mandatory contribution is set at 10% of the salary, which is slightly higher than the minimum contribution level in the UK for auto-enrolment. The pension providers are highly regulated privately managed organisations known as AFPs (Administrado de Fondos de Pensiones). Today, the Chilean DC market is consolidated and dominated by six AFPs.
The pension savings were only accessible at retirement, but during 2021 it became possible to withdraw some of their pension savings in three different rounds tax-free. This was a policy measure to help people access some of their pension money during a period of particular hardship. It turned out that taking tax-free cash was popular across all income levels. In December 2020, the Chilean workplace pension system had 213 billion US. By September 2021, 49 billion US had been withdrawn. 35% of those with pension savings had depleted their pension account after the third round.
Stefan cites Chile as an example of a people’s trust deficit with its private pension providers.
Some of the distrust in the AFPs is related to how the transition to DC was “sold” to the public back in the 80s – a classic example of overpromising and underdelivering. It seems that people feel dissatisfied with their pensions, and think that it is unfair that the AFPs have been profitable with the people managing them doing very well. In this context, it was not helpful that the AFPs consistently and aggressively had lobbied for increasing the mandatory pension contributions. On the political side, the ideological fight between left and right is still alive in Chile; and those with a political leaning to the left, tend to distrust the financial markets in general.
As you can see from my earlier comments, I think people in the UK are only too trusting that tax free cash is a “no brainer”. Of course no one wants to (or should) pay unnecessary tax but the trustees of my pension scheme were only too happy to pay heavily for the tax opportunity, at the expense of my lifelong pension. That was an abuse of trust.
Stefan and I differ slightly as to why so many people strip out their tax free cash at their normal minimum retirement age (55). I don’t think it’s a sign of dissatisfaction with workplace pensions so much as confusion as to what they are saving for.
Tell someone they are saving for a pension , tell them they will never have to buy an annuity and 35 years later offer investment pathways and an hour of guidance with Pension Wise – does that make sense? I don’t trust a pension which says it is a pension and turns into an investment pathway!
No wonder people take their cash when they can – the DC pension system is currently broken. Some of us see CDC as the way forward but….
And finally, a word on property rights in CDC.
I will be writing a separate blog on this which will be published tomorrow, but in summary, I don’t think that CDC will work, if it doesn’t offer property rights that people can understand. Transfers and tax-free cash are two points at which property rights are tested.
So far, the CDC regulations don’t even acknowledge tax-free cash as a “CDC-thing”!
Stefan and I are as one in expressing concern that CDC is currently in the hands of people who seem to still be living in a world where actuaries are not questioned and we get what we are given. That world is done with.
Ever since we set up the original Annuity Direct 1994 it became an annual ritual just before April. People would call (a lot of lawyers) and say “the company which pays no commission have told us that the Government are going to take away tax-free cash – what do you think?”
My reply was always the same “unlikely because the people making the rules need their tax-free cash as well and are unlikely to vote for it”
Turning to tax-free cash at retirement. There is no doubt that unless TFC is need for a specific purpose e.g. paying off a mortgage or helping children with a deposit, the best way to take free cash is in slices. I call this salami slicing, others call it phased retirement.
If anybody is interested, I can find my PowerPoint on this subject.
However, behavioural biases come into play and most people want the TFC in one go.
This is best evidenced by my accountant clients; “yes i understand the tax advantages of salami / phased retirement but – JUST GIVE ME THE MONEY”
Henry. Interesting that you turned down the measly cash conversion rate for your DB TFLS. I did the same myself with pretty similar terms on offer to yours. One of my relatives with an NHS pension also did. So I think there are more rational people than you realise. But I agree too many people are blinkered by this. Of course it would have been different if trustees had been obliged to do market rates for TFLS conversions.
But when I went into income drawdown with a PP I did take the full cash because I wanted to build a house at the time. I know that if I hadn’t it would have been better to keep the gross investment return going and to follow Billy’s wise advice and take it in slices.
Thanks Peter and Billy for your wise comments. I have a lot of housing debt to pay off – so may well strip out some cash from my DC savings – a totally sensible thing to do – especially as you can’t take it with you when you go!
Doesn’t it depend what you’re going to do with the tax-free sum? I’m toying with the idea of moving enough into drawdown each year to fill up that years ISA allowance. That gets my investments more balanced between pension and ISA so if the governments screws with one hopefully the other will be left less attacked. Arguably I should have started doing this a few years ago when I reached 55. I can take payments from ISA and pension. I don’t really see how that’s less tax-efficient than slicing and seems it would be easier to calculate the percentage of my LTA I’ve used. As with many things there’s nothing intrinsically wrong with tax free money depending on how its used.