The penny has dropped.
Almost six years after originally laying out plans to increase the pension age, the UK government has finally confirmed that it will put the necessary legislation in place.
To be clear, we are not talking about the state pension age here. That’s a whole different (albeit related) story.
Instead, what’s being changed here is the age at which you can tap your private pension.
The way things stand at the moment, you can access the money you’ve been patiently putting away at the sprightly age of 55.
You get 25% of it as a tax-free lump sum (hurray!) – and get to withdraw the other 75% whenever your heart desires, although it does get taxed at your marginal tax rate.
Under the new rules, as of 2028, you’ll have to wait until you turn 57 before you can do any of the above.
A little less spring in your step? Sure. But as the government likes to remind us, life expectancy has gone up – and so it’s a sensible move to spend a few more years in the workforce.
The situation is different for those (lucky few) on defined benefit plans.
Withdrawals are governed by the specifics of their plan, but they usually kick in at the age of 65 (sometimes there’s an option to start taking reduced payments at 55).
Back To The Drawing Board
In a way, *only* being able to retire at 55 – or 57 – is a high-quality problem. Most people (and not just in the UK) simply won’t be able to afford to do so, thanks to the savings crisis across most of the developed world.
That, however, is beside the point – because for many people, tapping your pension pot has little to do with retirement.
The money can be used to finally pay off the mortgage. Take that trip you’ve been dreaming off for so long. Or to simply supplement your income – and allow you to take things just a little bit easier when it comes to your day job.
Then there are the people who are actually ready to pull the plug at 55 – or even earlier. As it happens, that includes a big chunk of the personal finance crowd, including many readers of this blog.
While the pension age increase certainly doesn’t come as a surprise to them, it does create a number of implications to think through.
A big one is the Lifetime Allowance (LTA). It currently stands just shy of £1.1m (to be precise, it’s £1,073,100 in the 2020/2021) – and will likely increase in line with inflation over the coming years.
It may seem like a massive number – and objectively, it is.
However, hitting a £1m pension pot is actually easier than most people seem to appreciate, especially if you start early enough.
Here’s what it takes to become a pension millionaire:
If you are trying to get the maximum juice out of your pension (as you should), the implications are two-fold.
One is that you’ve got to take a view on whether you will actually work the extra two years as the government is imploring all of us to do.
If that is the case, you’ve got to factor in the additional contributions, lest you want to miss out on the employer match and the tax break.
The other one is the extra two years of compound growth in your pension pot. This is a tricky one as it depends on both market performance and your asset allocation.
As enticing as it is to have a significant allocation to equities (given that at 55/57, you’ve still got a 20+ year investment horizon), it may make sense to shift your pension pot allocation towards bonds – and rebalance your ISAs towards equities instead.
Otherwise, you may be looking at a whopping 55% tax surcharge if you end up above the LTA.
Mind The Gap
The additional wrinkle in the works for those who want to retire early is “bridging” the gap between the age you retire and the age you get to tap your pension.
Nowadays, you’ve got two extra years to plan for. Once again, not critical – but does take some planning and finesse.
You may want to check out this post, where I’ve uploaded a spreadsheet that could help you run the numbers.
A few tweaks to your pension vs ISA allocation may well be in order.
More To Come
The biggest implication, however, is that we are far from end state when it comes to pension regulations.
It’s no secret that the state pension age is only going up from here onwards.
Life expectancy keeps going up, public finances are even more of a mess post-Covid, and so the government is clearly going to have to react.
The most straightforward way to do it is to raise taxes. However, no one wants to bear the political costs of that decision.
The other one is to reduce expenditures, which is what’s playing out today.
By increasing the pension age, the government is implicitly shifting the burden of supporting us in retirement towards retirees.
Work a few years longer – and don’t blow your tax-free lump sum on that Porsche seems to be the message here.
Finally, there’s the option of removing the tax breaks.
Mathematically, it’s the same as increasing taxes. But because most people have a highly rudimentary understanding of taxes, it’s usually the preferred way to go. The clued-in personal finance crowd doesn’t represent a big part of the electorate.
The UK workplace pension system is still one of the most generous savings vehicles in the world, leaving plans like the US 401(k) in the dust. It’s not very often you get to double your money on the spot:
It also costs the Treasury roundabouts of £40 billion per year. There is a perception that it mostly benefits the high earners, making it a convenient target.
When Sajid Javid first floated the idea of reducing the tax break on workplace pension contributions, it may well have cost him his job.
Just six weeks later, Covid came to the fore. And six months later, the idea may well be back on the table.
Sajid is going to be a-okay, and I’m sure JP Morgan is going to take good care of him.
For the rest of us, and notwithstanding the moving goalposts, saving into a workplace pension is still by far the most effective money move we can make.
Take advantage of it now, because it might not last.
Happy (tax-efficient) investing!
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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