Expert Pensions - R06

Question 1

What additional information do you need to ensure that Tom and Sara have a sustainable income in retirement?

Answer 1

• Is desired retirement age set in stone?
  -How much income and/or capital will they need in retirement in today’s terms?
• Views on inflation and willingness to take risk in this respect?
  -Any intention to work on a part time basis in retirement?
• There state pension forecasts and when it becomes payable?
• Are they aware State pension not payable straight away?
• Contribution history and willingness to meet any gaps?
• Willingness to make additional regular contributions?
• Willingness to make lumpsum contributions using carry forward?
• Availability of additional employer contributions?
• Affordability of extra contributions based on cashflow analysis?
• The extent to which they’d be prepared to rely on their other assets?
• Asset allocation within each pension fund (current and previous) and ISA’s
• Fund performance to date?
• Possibility of switching funds to ensure alignment with stated ATRs?
• Capacity for loss?
• Pension and ISA fund charges? Are the competitive?
• Projections of existing funds to desired retirement age?
• Options available at retirement under each scheme and how they intend to take benefits?
• Desire for Tom to transfer out of DB scheme?
• Likely tax position in retirement ?
• Willingness to downsize?
• Have they nominated each other as beneficiaries of death benefits?

Question 2

Identify the additional information you would need from Tom regarding his defined benefit scheme? (19)

Answer 2

• Pensionable service to date
• Scheme accrual rate
• Definition of pensionable salary
• Survivors benefits / Scheme Definition of dependants
• Normal Retirement Age
• Early retirement facotr
• AVC’s
• Options to boost benefits
• Pension Increase exchange options
• PCLS entitlement (separate / commutation)
• Commutation rate
• Whether it was previously contracted out and for what periods
• Revaluation rate GMP/non GMP
• Funding status
• GMP entitlement if applicable and revaluation basis
• Enhancement/reduction to TV
• Any state pension offset
• CETV offered
• Whether scheme allows partial transfers

Question 3

Identify the additional information which may be required when advising Tom on the possibility of transferring out of his DB scheme? (18)

Answer 3

• His willingness to give up the guarantees provided by the scheme
• Need for flexibility of income during retirement
• Expected expenditure during retirement
• His views on inflations and willingness to give up inflation proofing offered by the scheme
• The exact solvency position of the scheme
• Willingness to forego protection offered by the PPF
• Revaluation offered pre-retirement
• Escalation offered in retirement
• Any expected inheritances
• Requirements for any lump sums in retirement
• Likely tax position in retirement
• The CETV for his safeguarded benefits
• The Critical Yield
• Views on potential legislative changes in the future and his willingness to accept the uncertainty in this area
• Tom’s reasons for wanted to transfer out of the scheme
• Willingness/ unwillingness to pay ongoing monitoring and advice charges
• Any transitional protection
• State pension entitlement

Question 4

State the process an adviser should follow when advising Tom and Sara on their pension arrangements (9)

Answer 4

• fact find
• risk and capacity for loss profile assessed
• client agreement and documents presented and signed
  -obtain scheme details / analyse
• check for guaranteed benefits/ transitional protection
• carry out research
• formulate a recommendation
• present recommendation
• review

Question 5

Outline the key factors that an adviser should consider when advising Tom and Sara on their strategy for funding retirement (12)

Answer 5

• Planned target income
• state pension age
• asset allocation
• Use of annual allowance / salary sacrifice / matching
• Use of allowances - ISA, CGT
• Charges
• Budget
• Use of other assets
• Priority of objectives
• ATR
• Willingness to use trusts
• What they want to happen 1st death in terms of pension fund/ protecting surviving partner

Question 6

Identify any reasonable assumptions you might make in relation to Tom and Sara’s retirement planning (13)

Answer 6

• The earliest they will retire next year
• the will remain in employment until then
• they will receive the new state pension at the SPA
• their NI record will be adequate for the full new state pension
• they will continue to make regular contributions into pension schemes
• that ongoing contributions remain affordable
• they they will consider making additional lump sum contributions
• they they stay in good health
• they are willing to use other investments to generate retirement income
• they will be basic tax payers in retirement
• they will want to provide an income after 1st death
• they have nominated each other as recipients of death benefits from DB scheme and PP
• Tom wishes to discuss his DB scheme

Question 7

Describe the process an adviser would use to ensure there are sufficient assets to provide a sustainable income for Tom and Sara in retirement (13)

Answer 7

• Estimate the fund growth based on expected investment returns to retirement date in line with ATR
• Including planned future contributions
• Calculate estimated annual income requirements in retirement (cashflow modelling, stochastic modelling to determine sustainability of income for life)
• Allowing for inflation between forecast and retirement date
• deduct expected benefits from the DB scheme
• and from the DC schemes, using a reasonable annuity rate
• or sustainably withdrawal rate for FAD
• allowing for any PCLS which may be taken at outset
• obtain state pension forecast
• Deduct estimated value of state pension
• this will highlight if there is an expected shortfall
• calculate the funding requirement to achieve the target income amount
• ongoing reviews

Question 8

Explain to Tom and Sara how a lifetime cashflow model could be used to assist them in meeting their objectives of generating an adequate income in retirement (8)

Answer 8

• it can identify shortfalls
• based on their current and future income and expenditure
• returns required from their investments to supplement existing pension income
• stress-test existing investments
• apply range of growth rates based on ATRs
• Show impact of inflation
• show impact of withdrawals from investments
• can be adjusted as circumstances change over time

Question 9

Identify the main factors and assumptions that you should discuss with Tom and Sara when formulating a lifetime cashflow model (16)

Answer 9

• target amount required
• their ongoing health / life expectancy / potential LTC needs
• their ATR’s and CFL
• Any expected changes to their income
• Expectations of inflation
• any significant lump sum capital requirements
• pattern of expenditure throughout retirement
• current / likley tax rates
• any expected capital lump sums
• other non-pension assets, financial and non-financial
• provisions of their Wills / intended lifetime gifting
• affordability - now and in the future of lump sum investments
• expected growth rates for any investments
• use of tax efficient wrappers e.g. ISA’s
• Other potential sources of income / capital if downsized
• Assumptions for charges

Question 10

Explain to Tom and Sara the risks of relying solely on lifetime cash flow models (6)

Answer 10

• Assumptions can turn out to be wrong
• Figures are estimates only and will need regular reviews
• Their objectives or circumstances may change
• Availability of tax wrappers and allowances may be withdrawn
• It does not take into account market risk
• It does not take into account liquidity risk

Question 11

Evaluate the suitability and tax efficiency of Tom and Sara’s current assets for their retirement planning.

Answer 11

• Tom considers himself to be a low to medium-risk investor
• A range of equity trackers pension funds may not be in line with this, especially as he is due to retire next year
• However, they may provide some balance to his DB provision

• Retaining his DB scheme is likely to be in line with Tom’s ATR
• Although we do not know how much or when payable
• Or whether the scheme is in deficit or not
• However, he has significant other assets
• And has concerns about life expectancy
• Which may overcome this

• Tom makes regular pension contributions
• And so benefits from pound cost averaging

• And as a higher rate tax payer
• Benefits from higher rate tax relief

• He has not used his full annual allowance in the current tax year and probably hasn’t in previous tax years
• He can therefore make lump sum contributions
• And can benefit from carry forward

• Tom has used his ISA allowance for the current tax year
• Maximising the funds that can grow free from UK income tax and CGT

• Tom has £40,000 in his cash Isa
• Which seems a lot when taken with the funds in the current account
• Lacks protection from inflation
• And could be earning more in a S&S ISA

• Tom’s S&S ISA is in UK Commercial Property
• Which may be on the risky side for his ATR
• And the holding exceeds the FSCS limit so some of his capital is at risk in the event of default

• Tom’s OEIC is in UK Smaller Companies
• Which may be on the risky side for his ATR
-And the holding exceeds the FSCS limit so some of his capital is at risk in the event of default

• Sara considers herself to be a low to medium-risk investor
• A balanced managed fund may be in line with this

• Sara makes regular pension contributions
• And so benefits from pound cost averaging

• And as a higher rate tax payer
• Benefits from higher rate tax relief

• She has not used her full annual allowance in the current tax year and probably hasn’t in previous tax years
• She can therefore make lump sum contributions
• And can benefit from carry forward

• Sara has used her ISA allowance for the current tax year
• Maximising the funds that can grow free from UK income tax and CGT

• Sara has £40,000 in his cash Isa
• Which seems a lot when taken with the funds in the current account
• Lacks protection from inflation
• And could be earning more in a S&S ISA

• Sara’s S&S ISA is in UK Managed UT
• Which may match her ATR
• And the holding exceeds the FSCS limit so some of her capital is at risk in the event of default

• Sara’s OEIC is in a Global Equity Fund
• Which may be on the risky side for her ATR
• And the holding exceeds the FSCS limit so some of her capital is at risk in the event of default

• The have £112,000 in cash between them
• Which seems excessive
• Although they could use some of it to fund gifts to the grandchildren
• Rather than encashing the OEIC and creating a CGT liability

• Neither Tom nor Sara appears to be using their personal savings allowance
• Which could provide them with £500 of savings income each taxed at 0%

• Both should keep their pensions under review to confirm the likely future adequacy of their pension pots

• Both should keep topping up their ISAs
• Accessible tax-free income in retirement

Question 12

Identify the key benefits and drawbacks of the equity tracker funds in the couple’s pension portfolio:

Answer 12

Pro’s
Adds diversification to his overall portfolio Potential for growth / inflation protection
May be geographic spread for diversification May be in line with ATR
May be in line with need for sustainable income
Should be able to switch easily to income units to supplement income in retirement
With no tax implications as in pension wrapper
Won’t be included in estate on 1st death as pension fund
Can be kept out of 2nd estate if remains within pension wrapper Income and gains tax-free as in pension wrapper

Con’s
Not actively managed
No opportunity to outperform index
Will underperform index after charges May be some currency risk
May be political/regulatory risk May be too risky for his ATR
Miss out on actual dividend yield

Question 13

Identify the key benefits and drawbacks of the Balanced managed funds in the couple’s pension portfolio:

Answer 13

Pros
Adds diversification as invests in all asset classes
Potential for growth / inflation protection
May be geographic spread for diversification
May be in line with ATR
May be in line with need for sustainable income
Should be able to switch easily to income units to supplement income in retirement
With no tax implications as in pension wrapper
Won’t be included in estate on 1st death as pension fund
Can be kept out of 2nd estate if remains within pension wrapper
Income and gains tax-free as in pension wrapper
Actively managed

Cons
May be single geographic location – may lack diversification
May be some currency risk
May be some political/regulatory risk
May be too risky for her ATR

Question 14

Outline the rules relating to a personal recommendation for Tom for a transfer of his DB scheme. (7)

Answer 14

• If Tom has safeguarded benefits worth more than £30,000
• He must take financial advice before he transfers
• The transfer should only be recommended if it is in Tom’s best interests
• The starting point is that the transfer will not be suitable
• An appropriate pension transfer analysis must be conducted
• Including a prescribed comparator (transfer value comparator)
• To show the cost of providing the same benefits

Question 15

Outline the process to follow should Tom wish to transfer out of his DB scheme. (7)

Answer 15

• As the safeguarded benefits exceed £30,000
• Tom will need to receive financial advice
• If the advice is to go ahead, Tom returns the transfer form and adviser confirmation of receipt of financial advice to scheme administrator
• Scheme administrator will check Tom has received appropriate independent advice
• If not, the scheme administrator cannot process
• If so, but the transfer value is not actuarially sufficient to pay any revalued GMP entitlement from GMP age, then the scheme may not permit the transfer
• If it is, scheme administrator will process the transfer

Question 16

What documentation would you be required to retain on file as part of the process of advising Tom on transferring his safeguarded benefits? (7)

Answer 16

• Client fact-find
• Supplementary defined benefit transfer specific client questionnaire • Disclosure documentation
• TVC / APTA
• Statement of entitlement
• Ceding scheme information
• Recommended plan research, illustration and KFD • Suitability report
• Proof of Pension Transfer Specialist sign-off

Question 17

Tom is considering transferring his DB benefits to a personal pension. Explain to Tom the reasons he should remain in his defined benefit scheme (11)

Answer 17

• Guaranteed lifetime income
• Guaranteed spouse’s pension on death after retirement
• May be benefits on death pre-retirement
• Index-linking
• No advice costs or personal pension charges
• Simple to understand and no administration
• No investment risk
- May be in line with his ATR
• Protection from Pension Protection Fund
• May be entitled to more than 25% tax free cash
• Transfer may result in lifetime allowance charge

Question 18

Explain to Tom the reasons why he might wish to consider transferring the defined benefit into a personal pension. (10)

Answer 18

• May receive enhanced CETV
  • Financial strength of DB scheme not known
  • He cannot phase the benefits from a DB scheme
  • PP offers more flexible death benefits
  • IHT free / income tax free on death before 75
  • He has concerns over longevity
  • Potential for growth (though need to be mindful of LTA)
  • Income can be varied to suit expenditure needs
  • Income can be varied to suit income tax efficiency • May offer higher PCLS
  • Has substantial assets so does not necessarily need guaranteed income

Question 19

Explain to Tom and Sara how their State pension entitlement will be calculated and how to obtain a forecast of their benefits.

Answer 19

• Their foundation amount was calculated as of 5 April 2016
• This was the higher of their entitlement under the old multi-tier pension system and the new flat rate state pension system
• If an entitlement under the old system was greater than the starting level for the new state pension, this additional amount was added to the new state pension to make the foundation amount
• If it was less then more new state pension can be built up
• Contracted Out Pension Equivalent (COPE) from new state pension may be deducted if they spent any time contracted out prior to April 2016
• Under the new rules, they will need 35 qualifying years of NICs to get the full weekly rate
• i.e. years where they received or were treated as receiving earnings of at least 52 x the weekly lower earnings limit for the year
• Qualifying years can be accrued both pre and post 6 April 2016
• A minimum of 10 qualifying years are needed to have an entitlement to the new state pension
• They can complete a form BR19
• Or call the Future Pension Centre
• Or apply for a forecast online
• This will be provided in today’s money, but on the assumption that future qualifying years are added to entitlement prior to retirement

Question 20

Explain to Tom and Sara the benefits of increasing their pension contributions. (11)

Answer 20

• It would increase the amount paid into their pensions
• This would be subject to compound investment returns and growth over the period to their intended retirement date
• Therefore, it would increase the value of their retirement provision
• They would be entitled to a 25% PCLS from their pension funds
• This would mean that a quarter of the money paid could be withdrawn free of any tax liability
• This is likely to prove tax efficient over the long-term
• Pension contributions extend their basic rate tax bands
• Meaning they could earn more at the basic rate
• Pension funds are outside the estate for IHT purposes
• Meaning that any contributions reduce liability to IHT
• Potentially saving IHT on their estate in the future

Question 21

Explain how carry forward works and how it could help Tom and Sara with their retirement plans. (5)

Answer 21

• Can carry forward unused allowance from previous 3 tax years
• Up to £40,000 for 2019/20, 2020/21 and 2021/22
• The £40,000 could be less if individual is subject to a tapered annual allowance
• Overriding limit – total contributions paid in current tax year (even if they relate to a previous tax year) cannot be more than 100% relevant UK earnings in current tax year to obtain tax relief
• Neither Tom nor Sara appear to have used their full annual allowances in previous tax years and can therefore make up for that this year if they so wish / can afford to

Question 22

Outline the benefits to Tom and Sara of using a diversified investment strategy to meet their retirement needs. (7)

Answer 22

• Potential for growth
• Protection against inflation
• Non-correlation of assets
• Reduces risk / lower volatility
• Rebalance
• Match ATR
• Avoids over-exposure to single asset class

Question 23

Explain to Tom and Sara the difference between active and passive fund management (i.e. their trackers). (7,8)

Answer 23

Active Fund Management

• Objective is to achieve returns which exceed those of the market
• To achieve this the fund manager(s) select stocks or funds to either buy or sell, at a time that they feel is correct to make these selections
• This means there are constant changes to the portfolio
• In order to select stocks or funds that will achieve returns which exceed the market, high levels of information needs to be gathered to guide the selection process. This often involves the use of highly complex selection and trading systems
• This means the cost of running an active fund is often higher than that of a corresponding passive fund
• Active funds do not always produce returns in excess of the market
• There are many ways of running an actively managed fund.
Encompassing differing methods and including various types of analysis of both investments and the macroeconomic environment

Passive Fund Management

• Does not seek to outperform the market
• Fund invests in a selection of assets, which will produce the average returns for those asset classes
• Is periodically rebalanced to maintain the asset allocation over time
• Does not look to select stocks or funds that are deemed to be
attractive or otherwise, or to forecast the future price of any stock
• Therefore, fund management should not require active intervention
• Nor should it require large amounts of information gathering to drive
the selection process
• As a result, a passive fund is often less costly to run than a corresponding active fund
• Passive funds will often slightly under perform the average return, due to the deduction of fund management charges

Question 24

Explain briefly to Tom and Sara the following options available with DC schemes to provide them with an income in retirement, including any income tax and IHT implications for each of these options: (3)

Answer 24

• Option 1 – lifetime annuity
• Option 2 – flexi-access drawdown (FAD)
• Option 3 – uncrystallised fund pension lump sum (UFPLS)

Question 25

State 6 advantages and 6 disadvantages of Tom or Sara using flexi-access drawdown, rather than an annuity, to provide a retirement income. (12)

Answer 25

Advantages
• Potential for fund growth
• Flexible income
• Tax-efficient income
• IHT free
• Annuity rates may improve
• Flexible death benefits

Drawbacks
• Increased fees
• Investment risk
• Fund may run out before he dies
• Ongoing advice/reviews required
• Income not guaranteed
• Triggers money purchase annual allowance

Question 26

Identify the key factors you should consider when establishing a reasonable rate of withdrawal from Tom and Sara’s pensions in the future should they go for flexi-access drawdown in retirement? (10)

Answer 26

• Income / capital needs in retirement
• Income from other sources
• Future tax position
• Pension investment strategy
• Growth assumption
• Economic conditions / inflation
• Sequencing risk
• Charges
• Longevity
• Death benefits free from IHT

Question 27

Explain to Tom and Sara what sequencing risk is and reverse pound cost averaging. (5)

Answer 27

• Drawdown funds are exposed to sequencing risk
• It refers to the greater impact an early loss has on a client’s capacity to take withdrawals over the longer term
• Running down a fund amounts to pound cost averaging in reverse
• When the price of units is low, more of them are sold, when it is high, fewer are sold
• Taking regular withdrawals of capital exaggerates the impact of fluctuations rather than smoothing them

Question 28

Explain to Tom and Sara the factors to take into consideration when deciding whether to use a series of UFPLS to provide retirement benefits. (9)

Answer 28

• Flexible income
• Improved tax-efficiency (only take funds when needed)
• Personal circumstances may change
• Flexible death benefits
• Pension fund can be passed on IHT free
• Annuity rates low at present
• Potential for growth
• May not need guaranteed income
• State pension / other assets as back up

Question 29

Explain to Tom and Sara the benefits of using a portion of their pension funds to purchase a short term annuity to provide them with a source of guaranteed income. (9)

Answer 29

• Provides guaranteed income
• Retains some flexible income options within the pension
• Can benefit if annuity rates rise in future
• Potential for capital growth remains on residual fund
• IHT benefits remain on residual fund
• Less administration
• Can include spouse’s pension / value protection
• Escalation to protect against inflation
• No investment risk

Question 30

Explain to Tom and Sara how a discounted gift trust works and how it could be used to mitigate IHT and boost their retirement income. (10)

Answer 30

• Take out investment bond
• Ideally JL2D for most tax efficiency
• Tom and Sara to be trustees along with their children
• Assign bond to DGT (discretionary or bare)
• Calculate discount, meaning value for IHT is less than the amount gifted
• Up to 5% income can be taken to boost retirement income
• Can defer income to begin with (to provide additional income later)
• CLT if discretionary trust, no immediate charge to tax if below NRB
• PET if bare trust, no immediate charge to tax
• Fall out of estate completely if survive 7 years

Question 31

Outline to Tom and Sara the potential benefits and drawbacks of using a discounted gift trust. (10)

Answer 31

Pros
• Discount will reflect their good health
• Falls out of estate after 7 years
• Any growth outside their estate
• If use discretionary trust, no immediate charge to tax if keep under NRB, no periodic/exit charges if keep under NRB
• Can act as trustee to retain element of control
• But, income is fixed from outset

Cons
• Once cumulative 5% used, no further income came be taken
• Irrevocable
• Lose access to capital
• May incur set up costs

Question 32

Explain to Tom and Sara how a loan trust operates and the benefits of such an arrangement for them. (12)

Answer 32

• Establish discretionary trust
• Settlors should be trustees
• Retain control of capital
• Identify beneficiaries (surviving partner, children, grandchildren)
• Make capital loan to trustees
• Repayable on demand so remains in estate
• No immediate charge to IHT (as no IHT transfer has taken place)
• Growth immediately outside estate
• Can be held in Investment Bond
• Can take 5% withdrawals over 20 years
• Without immediate charge to tax
• Trust may suffer periodic / exit charge if value after deduction of loan exceeds NRB, but this is unlikely

Question 33

Recommend and justify the actions you would take to ensure Tom and Sara have a sustainable income in retirement. (31)

Answer 33

• Lifetime cash flow modelling
• To determine the amount required

• Both Tom and Sara to maximise pension contributions, using carry forward if necessary
• Up to 40% tax relief
• Maximising the potential for fund growth

• Tom to obtain scheme booklet for DB scheme and establish exact benefits
• Tom to decide whether to remain in scheme
• So as to benefit from guarantees provided
• Or transfer out
• So as to benefit from flexibility during lifetime and on death

• Tom and Sara to obtain State pension forecasts
• To ascertain how much they will both receive and from when
• Any gaps to be plugged with Class 3 NICs
• To maximise the amount of State pension that can be received

• Tom and Sara to use their ISA allowances each tax year
• Maximising the funds held in tax-free environment
• That can then be used to boost their investments
• No restrictions on access which may suit if their circumstances change

• Consider setting up a DGT/Loan trust
  • To create a regular income
  • While benefitting from discounted PET/CLT (DGT)
  • While pegging growth on amount loaned (Loan Trust)

• Tom and Sara to both review their fund choices across both their pension and investment portfolios
• To ensure in line with ATR and portfolio is appropriately diversified

• The couple should review the performance of their investment and pension funds
• To ensure competitiveness and ongoing suitability

Question 34

State the factors an adviser should take into account when reviewing Tom and Sara’s pensions at their next annual review. (17)

Answer 34

• Fund performance against benchmark;
• Whether rebalancing is necessary;
• Volatility of the funds;
• Any changes to their intended retirement date;
• Any new funds received or due which could be earmarked for this purpose;
• Any changes in willingness or capacity to make further contributions;
• Changes to allocation;
• New products available;
• Any changes to their residence/ domicile;
• Any changes to their mortgage repayment plans;
• Any changes to taxation rules/legislation/regulation;
• Any significant economic changes/changes to market conditions;
• Change in attitude to risk/ capacity for loss;
• Continued suitability of the current arrangements;
• Change in personal circumstances/health;
• Death benefit nominations;
• Cashflow analysis & stress testing;

Question 35

Why is it important to carry out regular reviews of Tom and Sara’s pension arrangements? (7)

Answer 35

• Changes in personal / financial circumstances / objectives/ATR
• Monitor performance / identify underperforming funds
• Rebalance / change funds
• Increase pension contributions / carry forward
• Costs / charges / cheaper products
• LTA/AA issues / protection available / tapering
• Economic / legislative / tax changes

Question 36

If Tom or Sara decides to use flexi-access drawdown / UFPLS to provide a pension income, identify 6 issues an adviser should discuss at the next review meeting in respect of this arrangement. (6)

Answer 36

• Income required
• Fund performance / ATR
• Changes in circumstances, e.g. State pension receipt
• Change in legislation/tax/new products
• Changes in annuity rates
• Review suitability of death benefit nominations