A range of challenges face partners looking to plan effectively for their retirement in the current volatile marketplace. Mark Waddilove looks at the options, and which to choose at different stages of your retirement planning.
Historically, many partners have relied on traditional personal pension arrangements to meet the majority of their income needs during retirement. But the low levels of annuities currently provide questionable value to the retiree. Annuities have been affected by increasing longevity, Basel II, gender equalisation, quantitative easing during the financial crisis and the year-on-year low rates of interest. Some may be able to postpone their retirement date, but others may not wish to do so or not have the option, and so are forced to accept a lower level of retirement income than they had hoped for. Postponement may be achieved through extension of their partnership arrangements, consultancy arrangements with the firm or new opportunities by pursuing alternative careers in the autumn years of their professional careers.
In this article, Mark Waddilove looks at some of the options for partners who are unable to prolong the membership of their firm and for whom consultancy work is, for whatever reason, not a desirable choice. Needless to say, readers should seek specific advice before taking action.
Everybody should hold some money in cash. If nothing else, this can provide liquidity and cater for any shorter-term emergencies or requirements.
With interest rates at historic lows, the return from cash accounts doesn’t seem particularly attractive. However, cash should provide certainty in absolute terms, and so is an appropriate choice for those approaching retirement or who are very risk-averse. Those investing in cash must accept that, in the current environment, many accounts will be paying interest at less than the rate of inflation, so their money will be losing value in real terms.
Cash investors can help to protect themselves by using their annual ISA allowance – £15,240 for the current (2016/17) tax year – and ensure that all savings are kept below the Financial Services Compensation Scheme (FSCS) limit of £75,000 (reduced from £85,000 per person per provider).
The cap on ISAs used to be £6,000, increased in 2014 in two increments, to the current level. The cap is set by the UK government on an annual basis, and there are further plans to increase it to £20,000 – perhaps an indicator that the government also sees these as alternative retirement plans from the traditional personal pensions. While you can split your £15,240 allowance across multiple forms of ISAs investing (cash, stocks and shares, innovative finance, lifetime), the combined amount invested during the tax year must not exceed the limit for the year.
Of course, although not cash, National Savings & Investment (NS&I) premium bonds (capped at a maximum of £50,000 per person with effect from July 2016) and savings products also provide a risk-free environment for capital, along with the excitement of winning regular prizes of up £1m. However, the odds are not good – see Table 1
Table 1: National Savings & Investment premium bonds rates and returns
|Current rate|| New rate (from 6 June 2016)
| Prize fund
|| 1.35 per cent tax free
|| 1.25 per cent tax free
| Winning odds
|| 26,000 to one
|| 30,000 to one
|Total value of prizes|| £67.5m
|Number of prizes||2.3m||2m|
For those who are within two to three years of retirement, a cash fund of three years' anticipated income might be sensible. We look at different investment ideas in this article, although all other assets will have periods when they may produce poor or negative returns.
The ISA was launched by the government to encourage individuals to save for the future. It is a tax-efficient method by which someone can hold either stock market-based investments or cash in a traditional savings account.
As an incentive, any interest earned on savings or bonds, and any capital gains made on investments held within the ISA are tax-free. This is particularly advantageous for those partners who are taxed at the rate of 40 or 45 per cent on all their savings income and investment income, as well as those who have utilised their capital gains tax (CGT) annual exemption. It should be remembered that spouses are also able to invest in ISAs and therefore, for this tax year, £30,480 can be invested by a couple.
The ISA allowance is in addition to the new personal savings allowance (PSA), which came into effect on 6 April 2016. All basic rate taxpayers whose income is less than £43,000 can now earn £1,000 of savings interest a year without having to pay any tax on it. A higher rate taxpayer – who has an income between £43,001 and £150,000, is entitled to a lower PSA of £500 a year. An additional rate taxpayer who earns £150,001 or more will not get an allowance at all.
ISAs can, over time, build up to represent a significant capital sum, which can provide a flexible and tax-efficient income stream in retirement. The choice of asset held in an ISA is crucial: fixed interest returns are mainly from income, so an ISA wrapper is ideal. Equity investments, which rely more on capital appreciation, should often be a second choice. Importantly, ISA losses cannot be offset against other capital gains, so equity investments, which can show losses over the short term, could be held outside an ISA, especially if the equity is non or low-yielding.
The UK government introduced the innovative finance ISA from 6 April 2016. This new ISA allows individuals to use some (or all) of their annual ISA investment allowance to lend funds through the growing peer-to-peer lending market, while receiving tax-free interest and capital gains. The anticipated higher rates of interest which are expected under peer-to-peer loans do come with a higher risk profile, and crucially unlike a UK bank or building society account, peer-to-peer lending is not currently protected by the FSCS.
Since August 2013, investors can invest in companies listed on the Alternative Investment Market (AIM) in ISAs. This provides investors in shares with greater flexibility, and as AIM companies are typically growth companies with little or no dividends, an ISA could be a future shelter for capital gains that exceed the annual exemption, as well as being tax-efficient for inheritance tax purposes while the shares are held.
As announced in the 2016 budget, legislation will be introduced to create lifetime ISAs. This ISA will be available from April 2017 for those under the age of 40. They will be able to contribute up to £4,000 per year, and will receive 25 per cent bonus from the government. The funds from a lifetime ISA, including the government bonus, can be used to help the individual buy their first home, or can be withdrawn after their 60th birthday.
ISAs should usually be held in conjunction with pension planning, as the differing benefits of the two options mean it can be useful to blend the amount invested in each. Pensions are particularly beneficial for higher earners who may qualify for 40 or 45 per cent initial tax relief on their investments, whereas ISAs can be more suitable for those who require greater flexibility over how and when their assets are accessed.
Commercial property has historically provided consistent returns. Unfortunately, much of the return comes as income, and if the total return is viewed, the performance of commercial property has been more volatile and less rewarding in recent years. Income tax can be deferred and tax leakage reduced by gearing the property purchase and using efficient structures.
Commercial property is a valid part of an overall investment strategy, and therefore is applicable to most investment situations at various points in the accumulation and realisation phases of retirement. However, as property is illiquid, holding this asset may not be advisable if a short-term liquid position, such as annuity purchase, is needed.
Greater liquidity and diversification can be achieved through buying property investment funds rather than holding individual properties.
Residential property (UK and overseas) investments can also be a valuable addition to the overall investment strategy. It is not uncommon for partners to own more than one property as an investment and, as with commercial property, these can be structured tax-efficiently to ensure maximum returns in revenue and growth.
However, on 8 July 2015, George Osborne announced some changes to property taxation, some expected and some less so, which affect both homeowners and landlords. While some of the measures were good news to the investor, others were less favourable. The most significant change to landlords, particularly those with buy-to-let properties, was the restriction of tax relief on finance costs, to the basic rate – so instead of getting tax relief at 45 per cent, the maximum relief from 6 April 2020 will be 20 per cent. This has, in many cases, moved a buy-to-let arrangement from a tax loss to a taxable profit. These changes will be phased in over a four-year period, but landlords will first be impacted by these new measures from 6 April 2017. If you are caught by these new provisions, you are strongly recommended to review your property business and consider planning opportunities.
These recent changes to the tax legislation, plus the reduction in corporation tax, have led to an increase in the attractiveness of holding existing property and other investments in a personal investment company (PiC) or, where appropriate, incorporating the existing property portfolio. A PiC can provide significant tax planning opportunities and provide a very flexible vehicle to manage property and other taxable investments.
Hedge funds can give access to a large number of investment strategies, and can be used effectively to reduce volatility in a portfolio. However, high charges, including performance fees, can significantly reduce the expected returns.
In our experience, these investments are mainly used by the more experienced investor, and even then, the exposure to this type of fund, which can be illiquid, should be limited. Hedge funds are generally seen to be longer-term investments, so they can be used as part of an accumulation strategy, but much less so in the realisation phase of retirement planning.
Enterprise investment schemes (EISs)
EISs are designed to help small, high-risk trading companies to raise finance, by offering a range of attractive tax reliefs to investors who purchase new shares in those companies. A partner investing in a qualifying EIS company can obtain both income tax and capital gains tax (CGT) benefits.
If a capital gain is realised by a partner in any particular year, it is possible to defer the tax liability on that gain by claiming income tax relief, then reinvesting the gain and subscribing for shares in a qualifying EIS company (for gains realised up to one year before and/or three years after the investment). For every pound of the gain reinvested, a pound of the gain is deferred. It is worth noting that any gain on the disposal of shares in an EIS company which have been held for at least three years will be exempt from CGT. If the shares are sold at a loss after the three-year period, the loss will be allowable (income or gains), less any income tax relief given in the year of investment. However, the deferred gain will come back into charge when, for example, shares are sold, the company ceases to become a qualifying company, or the investor ceases to be UK-resident.
The income tax relief available is 30 per cent of the total investment against the individual's income tax liability. The investment is capped at a maximum of £1m per tax year (so, £300,000 of tax relief, provided there is sufficient tax liability to cover this). It is possible to carry back some, or all, of the relief against the previous year’s tax liability.
This year’s announcement of the reduced capital gains rate of taxation offers an 8 per cent benefit for those partners realising gains before 6 April 2016. Gains arising last tax year to higher rate UK taxpayers were chargeable at 28 per cent. From 6 April 2016, the rate is generally 20 per cent (but remains 28 per cent on certain assets, such as property). The EIS deferral could therefore move a gain from a 28 per cent tax regime into a 20 per cent regime.
Seed enterprise investment schemes (SEISs)
SEISs are similar to EISs, but to qualify, companies must be start-ups (that is, have been incorporated no more than two years prior to issuing the shares), and even smaller than EIS companies (with no more than 25 employees and gross assets of no more than £200,000).
As with EISs, income tax and CGT reliefs are available. If a partner realises gains during the current tax year and reinvests the proceeds into a qualifying SEIS company in the same year, half of those gains will be exempt from CGT liability (ie for a gain of £100,000 reinvested in an SEIS investment, £50,000 is exempt). The disposal of the asset realising the gain can be made before or after the reinvestment into the SEIS during the year. The maximum investment is £100,000 per tax year, and it is possible to carry back the investment to the previous tax year.
As with EISs, if shares in a SEIS company are held for three years or more, any gain arising on the subsequent disposal will be exempt from CGT liability.
A partner investing up to £100,000 per tax year in a qualifying SEIS company can receive tax relief of 50 per cent of their investment against their tax liability for the year.
It should be remembered that since these schemes invest in very small companies, the investment risks are significant.
Social investment tax relief (SITR)
The SITR was introduced in 2014 to encourage investment in social enterprises, and will be available for investments made in or capital gains arising for the period to 5 April 2019.
As with EISs and SEISs, there are income tax and CGT reliefs. If a partner realises gains during the tax year and reinvests the proceeds into a qualifying SITR company in the same year, all gains will be exempt from CGT liability. The disposal of the asset realising the gain can be made before or after the reinvestment into the SITR during the year.
As with EISs and SEISs, if shares in a SITR company are held for three years or more, any gain arising on the subsequent disposal will be exempt from CGT liability.
A partner investing up to £1m per tax year in a qualifying SITR company can receive tax relief of 30 per cent of their investment against their tax liability for the year.
As with EISs and SEISs, there are conditions and holding period requirements to meet before relief is available or relief clawed back by HM Revenue and Customs (HMRC).
Venture capital trusts (VCTs)
Rather than invest in one high-risk company such as an EIS and/or SEIS company, partners may consider investing directly into a range of small high-risk trading companies through a VCT. The companies qualify where shares or securities are not listed on a recognised stock exchange.
If a partner acquires shares in a qualifying VCT, any gain on the subsequent disposal will be exempt from CGT. The maximum amount of shares that can be acquired in a qualifying VCT in a year that will attract CGT relief is £200,000.
There are two types of tax relief that are available on VCT investments: investment relief and distribution relief.
Investment relief is available at 30 per cent of the amount that the partner subscribes in a qualifying VCT. This is capped at £200,000 and cannot be carried back to an earlier year in the same way as investments in EISs or SEISs. This tax relief is offset against the partner’s income tax liability in the year of investment. If the shares are sold within the first five years of ownership, tax relief may be clawed back from HMRC.
If a VCT declares qualifying dividends, distribution relief is available to exempt these dividends from income tax.
All EIS, VCT and SEIS investments have substantial and attractive initial tax reliefs. Caution is needed, though, as the tax relief may be the only benefit you will ever see from these investments, especially those at the higher-risk end of the spectrum. Needless to say, these are long-term investments, meaning that those nearing retirement and needing to rely on capital would be wise not to use them, unless there are other substantial assets to fall back on. However, for some partners, the tax-free dividends available to VCTs could provide a welcome boost to their retirement income.
Ordinary equity investment
Partners should not ignore their own and their spouse’s annual exemptions. It is worth considering paying income tax now and converting the income into capital first. By placing the money in a basic rate taxpayer’s name, the tax on the income will be the same as holding the same investment in a pension fund (although pensions provide tax relief on the way in). Wise use of CGT exemptions can reduce the tax on gains – the main advantage of this strategy is that the individual has total control of where and how their capital is invested.
Apart from those who look to take an annuity option on retirement, equities are a key component of an investment strategy. Equities therefore should be used in both phases of retirement, with growth stocks being used mainly for the accumulation phase, and stocks with a robust dividend stream used more in the realisation phase.
Notwithstanding the issues relating to traditional personal pensions outlined at the start of this article, these may continue to be the preferred means of saving for retirement. However, HMRC has made it clear from recent proposed consultations that further changes are likely in the future. The new Lifetime ISA is perhaps a clear indicator of the government’s direction of travel.
A personal pension plan is a UK tax investment vehicle, with the primary purpose of building up a capital sum to provide retirement benefits, although it may also be used to provide death benefits. Benefits can be taken from the age of 55, and a part of the fund (usually 25 per cent) may be taken as a tax-free lump sum.
Subject to earnings, the annual allowance attracting tax relief is currently £40,000, unless there is unused relief available to be brought forward from earlier years. Tax relief is available at a partner’s marginal rate of income tax, and almost all income and all capital growth in the fund are not subject to UK tax. As noted above, if a partner’s pension contributions in any of the last three years were less than the previous annual allowance, the unused relief brought forward can be augmented with the current year allowance. To use the relief brought forward, the partner must first maximise their current annual allowance of £40,000. This gives partners flexibility in arranging their affairs to ensure that they maximise the tax relief on their annual contributions. For partners with total income in the range of £100,000-120,000, the use of pension contributions can preserve personal income tax allowances and secure an effective rate of tax relief of 60 per cent.
However, from April 2016, the benefits for higher rate taxpayers (ie partners earning in excess of £150,000) will be restricted, by tapering away their annual allowance to a minimum of £10,000.
The lifetime allowance puts a top limit on the value of pension benefits that you can receive without having to pay a tax charge. Any amount above this is subject to a tax charge of 25 per cent if paid as pension, or 55 per cent if paid as a lump sum. The lifetime allowance has reduced, over a number of years, to £1m. From 6 April 2018, the government intends to index the standard lifetime allowance annually in line with the Consumer Prices Index (CPI).
A partner's pension strategy can, of course, be supplemented by a non-working spouse's taking advantage of a stakeholder pension, which allow individuals with no earnings to obtain tax relief on contributions up to £3,600 per year.
If you would like any further information, please contact Mark Waddilove or your usual RSM contact.