Poor choices under pension freedoms cost savers £2bn

LCP cited figures released by the Financial Conduct Authority showing just over 1.7m people withdrew their full pension pot in cash between April 2015 and March 2020.

The FCA’s Retirement Outcomes Review following the introduction of pension freedoms showed that 32 per cent of savers put the majority of their money into an Isa, savings or current account to either drawdown or keep as a safety net.

For those who have already used their freedom to take their pension pot in full, more needs to be done to alert them to the real losses they will suffer if they simply park their savings in a cash account

Sir Steve Webb, LCP

LCP claims that the majority of these will be cash accounts, rather than stocks and shares Isas, a conclusion drawn because the FCA identifies as a separate category those who invested the largest share of their money in “capital growth”. That category accounts for 20 per cent of the pots withdrawn.

An estimated 555,000 people took money from their pension and put it into a cash account or similar arrangement. The problem arises because, though interest rates payable on cash accounts vary, many savers will be earning interest of 0.5 per cent or less on money placed in a cash account.

Had that money been left in a pension invested in a mix of stocks and bonds, it would have yielded an expected return of 4.4 per cent based on official assumptions, meaning that savers placing their money in cash accounts are incurring a loss in returns of 3.9 per cent a year.

Even ignoring that, the fact that headline inflation is currently at 2.1 per cent means that savers are facing real losses of 1.6 per cent a year.

The FCA’s figures showed that more than three-quarters of full encashments are taken by those aged between 55 and 64. For simplicity, LCP assumed that the typical withdrawal is at age 59 and that the money stays in cash until the saver reaches the state pension age, 67, whereupon it is drawn in full.

Based on these assumptions, the consultancy estimated that the 555,000 people suffer losses averaging £3,500 each, for a collective loss of £2bn.

‘Decouple’ tax-free cash from the rest of the pension

To counter this, LCP argued that more must be done to alert consumers who are leaving the bulk of their withdrawn pension in cash accounts to the fact that they are suffering negative real returns.

It also recommended that savers who want to access cash from their pension be allowed to withdraw 25 per cent of it tax-free while leaving the rest of it behind. Though savers can put the remaining 75 per cent into a drawdown account, LCP argued that this process is complex and can incur additional charges.

As a result, many savers take “the line of least resistance”, withdrawing the full amount in cash despite having no plans for the 75 per cent of it that is not tax-free.

LCP partner Sir Steve Webb said: “For those who have already used their freedom to take their pension pot in full, more needs to be done to alert them to the real losses they will suffer if they simply park their savings in a cash account. And we need to ‘decouple’ the act of accessing tax-free cash from accessing the rest of your pension.

“Unless things change, hundreds of thousands more people could find they are not making the best use of their hard-earned savings.”

Other solutions proffered

John Yates, defined contribution proposition leader at Buck, told Pensions Expert that guided solutions “will help members understand the most efficient way to withdraw what they need today and avoid unnecessary taxes”. 

He said: “Investment pathways will invest the remainder of the fund appropriately given how and when the member intends to access the rest.

“Accessibility doesn’t need to be an issue either, with many of the DC providers now offering the full range of freedoms for all members, so an opportunity for employers and trustees to review the options and support available from their scheme.”

He added that reassurances from the government that any future change to the tax-free lump sum “wouldn’t be retrospective” might give members “the confidence not to unnecessarily withdraw this amount at the earliest opportunity”.

Jamie Jenkins, director of policy and external affairs at Royal London, noted that cash is an asset class of its own and “serves a purpose for those who want short-term protection against volatility while maintaining ready access to funds”, but he acknowledged that it carries “a significant inflation risk where it is held long term”.

“As such, it’s vital that people are supported with guidance or advice to understand that, and have options available to them to remove or reduce that risk,” he said.

“Many modern pension products already offer the option to take 25 per cent tax-free cash and leave the rest invested with no additional charge, but this option should be made much more widely available.”

LCP’s solution would require secondary legislation

Ian Neale, director at Aries Insight, told Pensions Expert that the flexible access reforms include three alternatives to annuity purchase from a money purchase pension pot.

The first is a partial uncrystallised funds pension lump sum, the second is a full UFPLS, and the third is a flexi-access drawdown.

“Where the pot contains a modest amount and the saver needs to maximise the cash they receive, the second option may be the only one which seems worthwhile,” Neale explained.

“Sometimes there’s a sting in the tail: up to 45 per cent might be deducted in tax from the balance after the 25 per cent tax-free amount. This is because [HM Revenue & Customs] requires the provider to apply [pay-as-you-earn tax] on the week 1/month 1 basis, which assumes a regular income of the same amount each pay period.

“Usually, this will result in an excessive tax deduction, which the individual can reclaim — if they know how.”

Some occupational DC schemes “insist that a member wishing to use flexible access takes their entire fund in this way, so to have other options they have to transfer out, typically to a personal pension”, he continued.

“In this way, they can obtain 25 per cent tax-free cash (a pension commencement lump sum) while designating the remainder of their fund as a flexi-access drawdown fund. Crucially, in this way the rest of the money stays in their pension pot, remaining invested. Investment gains are tax-free and the member retains their full annual allowance.”

Neale cautioned that the proposal advocated by LCP “might be a step too far in that it requires rupture of a fundamental principle of the FA 2004 pensions tax regime: a PCLS can only be taken in conjunction with an arising pension entitlement”.  

He added: “LCP’s radical proposal — which has been put forward before now — would break this nexus by allowing a PCLS to be taken without crystallising any further benefits. It would require significant amendments to primary legislation.”