Unlocking pension cash 'creates a risk'

Published on Friday 28 August 2009 14:33

INVESTORS in their fifties are increasingly putting their retirement funds at risk by prematurely unlocking tax-free cash from their pensions to help them through financial difficulties.

Financial advisers are reporting growing interest from people affected by the recession – particularly those made redundant – in taking advantage of tax-free cash rules to gain financial breathing space, but there are concerns that many investors doing this are jeopardising their pension plans and consequently risk greater financial difficulties in retirement.

Under pension rules introduced in 2006, up to 25 per cent can be taken from pension funds tax-free from the age of 50, although this age rule rises to 55 next April.

Not all of the 25 per cent has to be taken and pension holders can take out a smaller portion if that is all they need. Any money not taken out remains invested and contributions of up to 100 per cent of earnings can still be made to the scheme, regardless of whether some of the pension has been drawn.

Unemployment in particular has forced many people to resort to their pension to solve financial problems, according to Douglas Baillie, director of Perth IFA Douglas Baillie Ltd. Earlier this year Baillie launched www.comparemypension.com, which allows investors to track down their pensions and find out how much they are worth.

The company has now reviewed the details of more than 700 pension plans, with the average user having three different pensions worth a total 73,500.

In more than half of these cases, pension funds have been amalgamated into one lower cost plan with more accessibility and visibility, and the newly consolidated funds have allowed some over-50s – many of whom were unaware that they could access their benefits before retirement – to use their pension to address immediate problems.

Often, the decision to take tax-free cash has been driven by cashflow problems. Baillie said: "The fear factor is generally heightened following an increased awareness of a specific need or distress that has been prompted by sudden illness, reduced income, or unemployment." Add the shortage of credit into the equation – and consider the limited alternatives that are available, such as hugely expensive credit cards – and the consequences are "unthinkable", said Baillie. "Then the pension option may make some sense."

One case handled by the website comparemypension concerned a woman in her early fifties who was having problems keeping up with her mortgage payments having lost her job.

She had four workplace pensions, which the company consolidated into one larger pot, allowing her to access a decent amount of tax-free cash to help her out.

"This was used to reduce her mortgage, and having secured employment she could now afford to join her new employer's pension plan, and benefit from a 7 per cent of salary contribution paid by her employer," explained Baillie.

The combined effect of the employer's contribution, plus her 7 per cent and the income tax relief means that the 25 per cent withdrawn from her pension is gradually being replaced.

Similarly, Baillie helped a father use his pension benefits to help his son, who faced eviction as he was unable to maintain his mortgage payments after losing his job.

He said: "We simply amalgamated the father's four pension funds and arranged for an immediate tax-free lump sum to be paid for 25 per cent of the total fund value. This cash was then loaned to the son so that he could keep his home."

The father is continuing to contribute to his new pension plan and will soon replace the sum lent to his son, who will begin repaying his father when he is back in employment.

While these examples are positive, the risks of accessing pension benefits before retiring are significant. Advisers stress it is an option of last resort.

One problem with taking cash out of pension funds is that it crystallises losses incurred in the downturn. Where a pension fund value has experienced a significant fall in value, taking out too much money now can deplete the fund to a point from which recovery is unlikely.

Tom McPhail, head of pensions research at Hargreaves Lansdown, has also noticed increased interest in taking tax-free cash early, and he advised those considering the move to bear in mind the impact on death benefits and on any future annuity purchase.

He added: "There is also the basic point that pensions are designed to provide a retirement income, so a sum taken out prematurely eats into the income available in retirement."

Similarly, by taking it out earlier the tax-free cash sum is smaller. For example, a 55-year old taking all their tax-free cash from a fund of 100,000 gets 25,000. By 65, the remaining 75,000 has grown to, say, 150,000. If the tax-free cash hadn't been taken, the fund growth could have reached 200,000, giving a tax-free cash entitlement of 50,000.

"This isn't a panacea," warned Baillie. "Accessing pension funds early is a last resort and is only recommended after taking professional advice from a pension specialist who is authorised to give this advice."