Before the pension freedoms of April 2015, the practical reality, for most people with pension savings, was that they had to take an annuity. For those with benefits entitlements that was often a pretty poor bargain. The annuity was taken penny for penny from any means tested benefit entitlement that they had, whether Pension Credit for older people or Jobseeker’s Allowance, Employment and Support Allowance or Income Support for those of working age.
For a single healthy person with a basic state retirement pension and no other income then that meant the first £35.25 of an annuity was just handed straight back to the state. There was, for some, a small offset from Savings Pension Credit but that has been reducing for several years and will disappear completely for those receiving the new state pension after April 2016.
With the pension freedoms, things have changed. People are now able to exercise many more options, take capital in one lump sum or in multiple drawdowns or just leave their pension savings where they are.
Leaving the pension savings where they are, once somebody is able to make use of them, does not mean that they are ignored for benefits assessments. Somewhat unusually they are not treated as a capital lump sum but they are treated as producing a notional annuity value.
This notional income only applies to those claiming Pension Credit. For those getting working age benefits, there is no effect from untaken pension savings, even if they can be accessed. Only actual sums taken from those savings have an effect on the benefits assessment.
The notional value for Pension Credit claimants is calculated using tables produced by the Government Actuary’s Department, and depends upon the amount of money in their pot, their age and the current yield from 15 year Gilts. The tables and Gilt yields produce a notional annuity value for each thousand pounds in the pension pot and this is used to determine the notional income for benefit purposes.
No notional capital value is applied to the pension pot.
In many cases this might be seen as a relatively straightforward calculation. It can however become quite complicated when people start to make use of the money in the pension pot, because then the notional annuity value changes.
The chart below shows the, initially rather puzzling, situation where someone can take capital out of their pension pot and
- increase the amount of their benefits
- gain access to passported benefits
- have a higher overall income
- have a substantial capital sum in the bank
This is because of a number of factors. In this example the pot size starts at £35,000 and the new capital axis shows the amount withdrawn from that.
At first, the capital withdrawn is disregarded, as the amount taken is below the £10,000 level that is ignored for Pension Credit.
The reduction in the pot size also reduces the notional income which is used in the benefits assessment.
Benefits increase as there is less income taken into account.
When somebody has more than the disregarded £10,000 of capital then a notional income, called deemed or tariff income, begins to be taken into account. In Pension Credit that is calculated on the basis of £1 a week for every £500, or part, above £10,000.
When deemed income begins to be taken into account the increase in that income at each step is higher than the reduction in notional income because of the reduction in the pot size. That means that benefit entitlement begins to fall.
In the chart, it can be seen that the reduction in the notional annuity figure, as the value of the pension pot reduces, actually produces an entitlement to Guarantee Pension Credit with the passported entitlements which accompany it.
When taking increasing amounts of income from a pension pot then, for benefits purposes, there can be a steep initial rise in net income, which later becomes more gradual. An example of this is shown in the chart above.
The steep gain in net income initially happens because while the income taken is less than the notional income level, the calculated notional income is used in the assessment of benefits.
The actual amount of income taken is ignored for benefits purposes but produces an increase in real net income.
Once the real income taken is higher than the notional income level for the pot, the real income is used in the calculation and the benefits level reduces with the income increases rather than having been constant with a fixed level of notional income.
The notional value of the pot reduces by the amount by which the real income is greater than the notional income.
The table above shows the result and the way in which the switch from notional to real income occurs in the benefits assessment.
The charts and tables are produced by Ferret’s pensionForward advice system which calculates the tax and benefits impact of the pensions options open under the new freedoms.
The new pension freedoms have opened up options which can allow those on benefits to see less impact from their pension savings than was previously the case.
The new options introduce more complexity into the assessment of benefit entitlement and into the advice needs of clients. In order to provide an accurate picture of the effects and impacts of the different options, complex calculations are needed. This is particularly the case where notional income from untaken pots needs to be considered.