Bond but not that one
by Doug Brodie
In this blog:
/1. The 5 ways to get income from your pension
/2. Bonds at that mythical 5%
/3. Never pay full rate 40% or 45% income tax again
/1. The 5 ways to get income from your pension.
There’s a permanent mismatch between the pension industry and consumers, being what a ‘pension’ is. For you and I, a pension is the income you receive in retirement, when you’ve stepped away from working for a pay cheque. Politicians don’t have this misunderstanding because they have final salary pensions which are…no confusion here…incomes paid when they stop working for the government. The same applies to our civil servants, local authority employees, Bank of England, pension companies (!) et al.
For the rest of us we are provided only with the raw ingredients of a pension – imagine buying a car and they deliver to your drive an engine, a set of wheels, some metal panels etc and tell you to work out yourself how to put it together.
If you’re reading this you’ll have a money purchase pension, i.e. a pot of money in a pension contract, not a pension income. Well, you’re in the right place, and we’ve provided an outline here of your five options.
Essentially before you delve into any consideration of investment you need to answer one binary question (and take your time over it) – if you need your income to be guaranteed then you need to select an annuity. End of your research.
If, however, you are happy with the concept of ‘probable’ rather than ‘guaranteed’, then you need to consider all the five alternatives.
An annuity.
Pros: guaranteed income for life.
Cons: irreversible single decision, gives all the pension money to the pension company outright, rates of income are low for your age.
Take out all the money from the pensions now and deposit as cash in the bank.
Pros: you can draw as much ‘income’ or capital as you wish.
Cons: you lose more than 43% in tax up front, cash in the bank will always be taxable, you lose the tax-free status of investments within your pensions. Pensions are IHT-free, bank savings are not. Growth in pensions is tax-free.
Hold cash in your pension instead of investments and draw out income as needed.
Pros: absolute stability of capital – it will not fluctuate from year to year. Simple, you can control the pension yourself. Pensions can be passed on to your kids without inheritance tax.
Cons: though interest rates have suddenly jumped, cash is poor for long-term returns, it historically has failed to handle inflation and current interest yields would not provide you with the income you need.
Invest the pensions in the general market using ‘asset allocation’ and sell assets each year in the pension to provide cash to draw out.
Pros: you can use ultra-low cost index trackers to keep the long-term costs to a minimum and you can direct the investment to any sector (country or industry) you think might rise. Pensions are IHT-free, growth within the pension is tax-free.
Cons: you have to sell capital to generate cash, then the remaining capital has to grow just to replace that capital, and then grow again to generate profit. This embeds sequence risk into your pensions. Your capital will be volatile and is likely to generate anxiety.
Invest the pensions in income-producing assets that themselves pay out sufficient income in cash for you to draw out.
Pros: stability and predictability of annual income, plus separation of income from capital volatility. Pensions are IHT-free, growth within the pension is tax-free.
Cons: growth of capital may be lower than pure growth assets, ultra-low cost contracts can’t be used.
The ‘pension freedoms’ introduced by George Osborne in 2015 changed the law on pensions for good reason, and during the period of peak ‘rubbish yields’, it saved millions of people from a lifetime of appallingly low incomes. Remember, annuities are irreversible, and before 2015 they were compulsory for all pension pots by the age of 75. (Paraphrasing pension law ever so slightly – Ed.)
Free money? Guess who got it.
At the end of December, the Guardian covered a story that the Treasury is to end ‘oversight of £425m scheme to help banks after RBS bailout’, written up by Kalyeena Makortoff.
Cast your memory back to 2008 – RBS received £45bn in state aid to stop it going bust. Due to the rules in place at the time (thanks Brussels) RBS money also had to be given to the smaller challenger banks to help them develop their services for business customers to prevent the market from being skewed by the money given to RBS.
Under so-called state aid rules, which applied when the UK was still a member of the European Union, RBS money was given to smaller challenger banks to spend…
The Guardian
It will leave no one to oversee the way lenders including Metro Bank, Virgin Money, the Cooperative Bank and specialist lenders like Atom Bank deliver their delayed projects, and spend any remaining funds.
The treasury withdrawal means there is nobody responsible for ensuring accountability in the projects for which the money was handed out. (‘Hand out’ being the relevant term to wee the taxpayer). Banks including Metro Bank, Virgin Money, the Coop and Atom Bank are amongst those who have yet to deliver on their obligations.
Metro bank was given £120m with the obligation to open seven branches – so far it has only opened four, and recently said they are planning to cut £30m of annual costs by next year. As it happened, it ended up handing back £50m of the money it was given as it couldn’t open sufficient new business accounts.
Co-op Bank had a target of cutting its account opening process from 15 days to 5 days – apparently it is now down to 7 days (even though Tim Peake could have breakfast 400 km up in space on the space station and then be in Kazakhstan for lunch – I guess it depends how important the task is: Ed.)
Not only is the oversight disappearing but there are no penalties for not delivering on those targets, so, no accountability at all, and one wonders why. Yahoo tells us that the CEO of Virgin Money received £2.3m in pay though Metro Bank was more reasonable with £770k.
Free money for banks?
(Details courtesy of Guardian News & Media Ltd)
/2. Bonds at that mythical 5%.
There are many financial products with the name ‘bond’ and the one we are talking about here is correctly known as an insurance bond; it is technically and legally a ‘single premium, non-qualifying insurance policy’. In practice it is a wrapper account much like an ISA, the key bonus being any income or gain generated by the investments inside the bond, stay there and the policyholder does not have any tax liability. This is because the assets in the bond are technically owned by the life insurer itself, not the investor.
Bonds should never be issued as single policies – they should always be issued in segments; this simply means that the investment sum is divided by (pick a number), say, 100, and the policy is then set up as 100 identical segmented (mini) policies. For example, if you invest, say £500k into a bond, you could have it arranged as 100 identical policies of £5k each.
The reason is simple: the investor is only assessed for tax on withdrawals (and it’s always income tax, never CGT). As the investment grows – let’s assume a simple 10% - then the bond will contain £500k of capital and £50k of profit. If the investor wants to have £6k of cash as a withdrawal, that can be done quite simply, by surrendering one whole segment – which pays out £5k of the original capital (not taxable) and £1k of profit (taxable). This is known as a full surrender (of that single policy).
The alternative would be to draw the £6k as 12% of the £50,000 gain that sits across ALL the policies. This is known as a partial surrender. Here’s where the 5% rule comes in: HMRC deem withdrawals to be a return of capital if they are capped at 5% of the original capital paid, per year. Naturally that allows for no increases in income at all, and if, say, it continues for 20 years then the 5% x 20yrs = 100% of the capital has now been withdrawn, meaning all the remaining money must be profit, so it must be taxable.
The 5% allowance is deferred tax, it is not tax-free – it is deemed a withdrawal of your original capital which is why there is no tax payable. It is cumulative, however, so if there are no withdrawals for three years, in year four the investor can draw 20%, being 5% for each of those four years.
/3. Never pay full rate 40% or 45% income tax again.
To save this blog being overly detailed I am only covering onshore bonds here, I’m leaving offshore bonds till another blog.
Onshore life companies account for insurance company tax for the gains on the policy, and that tax is deemed by HMRC to account for basic rate tax, so basic rate taxpayers have no further tax to pay on taxable withdrawals. The way the calculation is done for 40% taxpayers is very, very important to understand:
Assume a gross gain of £100 on an investment made for a 40% taxpayer. The life company accounts for 20% basic rate, so the investor then receives a net £80.
The investor still has the remaining 20% tax to pay (40% less 20% paid by the insurance company), however, the 20% is calculated on the £80 paid – it is not grossed back up to £100 in the way that cash at the bank would be.
This then means the 40% taxpayer has a liability of £80 x 20% = £16, so the whole tax paid on that £100 gross gain is 36%, not 40% - simply by virtue of the method of calculation.
A 45% taxpayer will only ever pay 40% income tax on the gain.
We are experts in this area, we have been working with insurers and their investment bonds since 1995 and when AIG imploded in 2008 I led the technical advice and consultancy for 1,250 UK policyholders who held £1.5bn in AIG bonds and didn’t have a clue about what they held. Bonds should never be mass-marketed and should never be punted to depositors by retail banks. Like antibiotics, they are brilliant used properly but dangerous if handled without due care and attention.
If you have long-term dormant cash – whether in cash or investments – and you’d like to know more then please contact us.