Question: Do contractor pensions differ compared to private pensions?
Well, they don’t differ in terms of the structure of the investments per se, but where they do differ is how the pension will actually be funded. What a permanent employee would do is he’d fund his pension, from their own personal bank account. And, then he’d claim back the tax relief via self assessment.
That’s fine if you’re on £40,000-50,000 a year. You’ve got a lot of scope to do that as a permanent employee because what the HMRC rule will allow you to do is invest 100% of salary. So, somebody on 50 grand could if they had means to do so, invest £50,000.
Obviously it doesn’t take Einstein to work out that 100% of salary issue poses problems for contractors because if they’re working through a one man limited company what they’ll do is invariably pay a very low salary, maybe up to the NI threshold and then take the rest of their income as dividends. So you could be looking at a maximum investment that a contractor could make, personally, of £6000-£7000.
Crucially where the contractor then has some flexibility is to use the limited company to fund a personal pension as a corporate investment and as an employer’s contribution. So whilst the pension’s structure is the same, how you actually go about getting the money into the pension pot is very much different.
And also for a limited company contractor there are a number of other pension vehicles that are open to the individual. He can fund an executive pension via the limited company or a small self administered scheme, a SAS, through the limited company as well.
And, there are various advantages to some of those other structures all funded via the limited company and all basically invested in the same manner, but just a wee bit more flexibility as to how benefits are taken and what you can do with the money when it’s in the pension.
Question: So the direct tax benefits of contributing to a pension for a contractor?
As an individual if you were funding the pension from your own personal bank account, what you’d do is you’d get income tax at your highest marginal rate. So for most contractors that will equate to 40 or even maybe 50% tax relief. And that would be from you own personal bank account and you’d claim back.
Firstly you’d automatically get basic rate tax relief, so 20% when you make the contribution. So a £10,000 contribution you’d actually write a check for £8000, but then you’d also claw back the higher rate tax relief via your self assessment.
There’s very recently been some flexibility that HMRC give you to alter your tax code and to actually get that higher rate tax relief that source as well. But, most people will pay net a basic rate and then claw back the higher rate via their self assessment.
The other alternative is if you’re working through a limited company is to get the company to pay that contribution on your behalf and as I’ve already covered, because the company is making the contribution that link with salary is broken and there’s far more scope for the individual to actually invest making an employer contribution via the limited company.
The way that the tax breaks work on a company contribution is that the contribution would be allowable as a business expense against corporation tax. So in effect you get corporation tax relief on any money that goes into a pension on behalf of what in effect could be the sole employee.
And that represents a really efficient way of getting money from contract into personal hands because there’s no income tax, you get the corporation tax relief, and crucially there’s no benefit in kind that the individual has to pay on a company pension contribution.
You could argue that it’s marginally more efficient from a tax point of view to have the contribution made personally up to 100% of salary. And as I’ve already said, in most cases that’s limited to £6,000 or £7,000 salary. So that’s going to restrict contractors from making a more substantial investment.
Then over and above that 6/7K really sort of the company can make a very substantial contribution on your behalf. Typically what we do is we work on the basis that the company will invest up to the level of its net profits, and that on an average contractors income can make for a very substantial investment.
There are annual limits in theory as to what you can invest. HMRC say that across the board an individual can only have £50,000 invested on their behalf. However, what we do is we have a work around for many of our clients that enables us to use the past three years unused allowance. In effect and in the right circumstances an individual would be able to invest as much as £200,000 in any one trading year. So, there’s an enormous amount of scope.
Question: Are there any problems if contractor moves from contracting to a permanent position?
No, because what would happen would be that any money built up in the pension, be it personally funded or funded for one man limited company, would remain invested. The beauty of modern day pensions is that back in the dark old days of high charges and inflexible contracts unfortunately a lot individuals would have taken out a pension expecting to have to fund it for 20/30 years. And would have been penalised had they stop to suspended payments for any amount of time.
Thankfully those days have gone and now you can actually turn your contributions into a pension on an off like a tap, as and when circumstances dictate. So if a contractor is going back permanent then they would just stop the contributions. If they were working maybe via a different structure they could suspend the pension, stop them all together without any penalties.
Question: You mentioned before about HMRC saying you’re allowed to add 50,000 a year. Could you just go into a little more detail about this work around that you were talking about that you can take the last three years back? content goes here.
Yeah, sure. We used to be in the admirable position of having annual allowance of £255,000. And I know that sounds like a colossal figure, but certain individuals maybe they’ve deferred putting money into a pension for years and want to now make up for some lost time, or by virtue of being contractors… I mean a lot of our clients will have something of a patchwork quilt to a very small pension pots from maybe two years working for Shell, three years working for BP, two years working for Totel and this money doesn’t really amount to very much at all.
So, they’re contracting and they really want to make up for some lost time. So, HMRC in 2006 allowed for far greater contributions on an annual basis. And, unfortunately in his first austerity budget the chancellors and this goes for Alistair Darling and George Osborne have reigned back in that scope to make very substantial annual contributions. So they now cap the annual allowance at £50,000 which is still not an insubstantial amount of money. But it has rather restricted certain individuals.
However, what the authorities have given us is the ability to carry forward unused allowances over the past three years. And so we’ve got the ability to bring forward £150,000 worth or annual allowances into the current year at that 2012/2013 allowance. And so an individual could invest £200,000 in this year. As I’ve said, it represents a very effective piece of tax planning.
Question: Does IR35 impact how much a contractor can invest?
Answer from John Yerou: Well, that’s an interesting question actually. Not in itself because as I’ve said, the company should be able to make a very substantial investment either way. But, where IR35 does become very interesting is if an individual deems himself to be outside of the tax rule now and is subsequently found to be inside IR35. Obviously then the employers and employees National Insurance is due on the bulk of their income.
But crucially when IR35 came out in 1999/2000, HMRC did allow pensions to be funded over and above that 5% that was allowable for expenses. And, so you could argue that the pensions are almost the solution to some contractors IR35 issues because actually it does represent quite an effective way of getting money from company into personal hands.
And certainly where IR35 is concerned, that contribution is allowable irrespective of size of salary, irrespective of the amount you’ve already earmarked for expense. So the there is some scope to invest even if your subsequently found to have been caught by R-35, and they can’t touch the money that’s been put into the pension.
If you are caught by IR35 and you’re obviously already paying the employer and employees NI, then the drive to put a more substantial amount into pension is even greater because it is a very effective way of reducing the employers and employees NI.
We work very closely with a lot of the large umbrella companies in the UK. And we do a hell of a lot around issues of salary sacrifice where those individuals are obviously paying employees and employers NI on the bulk of their contract income. But what we’ll do is they’ll exchange salary for a pension contribution made by the umbrella and that represents a very, very cunning way of getting money into your personal hand with out HMRC seeing any the action.
Mentally you need to bear in mind the fact that this money isn’t available until you get age 55 minimum. But it is coming to you without George Osborn seeing any of the action.
Question: As far as investing you pension goes, what would you suggest?
Answer from John Yerou: Far to often when we’re talking to clients that have got a preexisting pension be part of the house services that we’ll review what a contractor’s already built up, that patchwork quilt of existing benefits or maybe a pension that they’ve taken out on their own back.
And far too often unfortunately, when we’re having these conversations we notice that the individual maybe had taken a pension via his bank and have quite literally all of his eggs in one basket, in one particular fund. It will be a managed fund with a banker or insurance company. And in effect, that s like going to the casino and putting everything on black.
Really, I can’t stress enough that the key to getting the biggest bang for your buck in terms of any money that you put into the pension is to carry out a proper allocation of different assets, asset classes. So, yes, have some money in the stock market, but if the past five years has shown us anything is that the markets can ebb and flow and so you’ll have good times and bad times in any stock market and investment.
So, what the sensible thing to do is to spread your risks across a number of different asset classes. Typically when we’re constructing a portfolio for a client we’ll look at some equity exposure as money in bonds, commercial property, fixed interest, gilts. And by doing that you really are insuring that as one area goes down in value the smart money is properly transferring into an area that actually you’re in as well. So, over the long term you can really begin to develop some momentum and ride out some of those shock waves that can hit any one particular investment market.
For instance at the moment you could argue that the stock market is actually doing quite well, but it’s come from a very dark place when the credit crunch hit. And, so obviously if anybody was at 100% invested in an equity fund in 2007/2008, they got a serious shock to the system when they looked at their valuation on the anniversary of a pension.
However, if we spread the assets properly, then what you’re doing is you’re cushioning the blow of some of those shocks because the smart money moved from equities into government stocks and government gilts.
And so there have been some very healthy profits even in the depths of the credit crunch. Gilt funds (gilt-edged securities) were doing very well as there was this flight to safety. And if your client’s already in those areas as well then they profit in one area even if another is not doing so well.
Question: Is it easy to shift Pensions to different investment portfolios?
Answer From John Yerou: Yeah, very much so, What we do when we talk to a client initially is we’ll always try and make use of their existing pension as a foundation of what they then do going forward. Sometimes we can make good use of what they have already. Other times what we’ll do is we’ll look to consolidate it into an are that makes more sense, that gives more flexibility in terms of investment choice and hopefully lower charges as well.
But, once we’ve actually constructed a portfolio for a client we really do keep an eye on it and carry out a quarterly review with an annual shift in terms of the different assets to make sure that they’re not completely out so sync with where that client’s appetite for investment risk actually lay.
We do that as advisors. But, actually individuals should be doing that. If they don’t have an advisor, they really should be revisiting their pension at least on an annual basis to make sure that it’s still doing what you thought it was going to be doing 12 months previous because a hell of a lot can happen at a relatively short period of time in the investment markets and this is such an important part of your future as a contractor.
It’s not really something that can just be stuck in a cupboard and revisited maybe when you come up to retirement because it does need a bit of nurturing and a little bit of TLC that few pensions can deliver when you come to hang up your keyboard or move away from your engineering contracts to do something a little bit more enjoyable.
Question: What age can we start accessing the pensions?
Answer from John Yerou: Well, pension simplification moved the goal post somewhat. You used to be able to take your benefits at age 50, and now it’s at age 55. And that really represents a realisation on the part of HMRC. But also the population as whole because of changes in longevity we can all expect to hopefully see a longer retirement. They’ve been keen to have people defer for an extra five years the ability to actually gain access to pension.
But, 55 is still a relatively young age to be able to see the benefits of all your hard work and investment.
At 55 what you can do is you can draw out of a personal pension a quarter of the fund as tax free cash. And then you can either buy an annuity which is a relatively rigid income producing vehicle that an insurer would provide for you. And that pays you a monthly or an annual income for the rest of your life.
What you can do is you can build in a widow’s pension so that your other half gets the benefit of your pension as well. But increasingly what we’re finding with contractors is they’re quite a independent bunch. And we’ve been working with freelance contractors for over 12 years now.
And something that’s always struck me is that as an independent bunch they’re not too keen on the idea that a government or an insurance company would have control over their future living standards in retirement. So they’re quite attracted to the notion of income draw down. What income draw down allows is for the money to remain invested.
And so rather than buy that rigid annuity that is going to pay a set income each month, and you leave money invested to grow and you simply skim some of the growth each year as and when you need to. And that’s quite an effective way of maybe allowing your pension to bubble away quite nicely until the day when you really do need to call on the income without necessarily tying up the money in an insurance fund.
There’s also, relatively recently actually, been some moves around being able to pass on that unsecured pension. So that non-annuitised pension to your dependents and to your next of kin. So pensions actually from being quite a dull and gray subject, the whole area is now becoming a little bit sexier in terms of estate planning and actually being able to have a lasting legacy of an individuals time contracting because far too often I think pensions have been looked on as something that were great news for maybe a salesman that has set up the pension for you, great news for the insurance company, not tremendously good news for the individual.
And I’m very happy to say the tables have turned on that and because of the greater flexibility as to how and when you take pension benefits and who benefits, the pensioners can now probably go back their rightful position which was center stage in somebody’s financial planning.
Question: Do you think the UK will follow the Australian model and introduce a self managed pension?
Answer from John Yerou: Yeah, you can currently by yourself via a self-invested personal pension. A SAS is a small self administered scheme as I said. And, that gives you a huge amount of investment flexibility as an individual. So gone are the days when you needed to slavishly invest in an insurance company fund as such. And I have to say that contractors and freelancers have actually bought into the whole notion of SIPP’s (self-invested personal pension) in particular because it does give them a degree of control.
A cautionary note though is that what we found in our conversations with clients that have self-invested personal pension is that invariably you actually look under the bonnet and look at how that money is invested, invariably they’re not keeping an eye on how well the different funds are doing. They’re not looking at asset allocation.
I think far too often contractors will be drawn by the allure of the top of a best buy table fund that’s performed well in the past 12 months without maybe monitoring it on at least an annual basis to make sure that it’s still delivering the goods.
And, so our work with contractors actually, ironical lead to a number moving away from self investment to a situation where we do properly keep an eye on how the money is invested and more importantly manage some of that downside risk.
Self investment sounds like a fantastic idea, it does actually give an individual a real sense that they’re in control of their own destiny certainly. But I do think there’s some pitfalls involved unless the funds are properly managed, and it does take a fair bit of time and commitment on the part of the individual to self invest effectively.
John Yerou is a pioneer of contractor mortgages and owner and founder of Freelancer Financials, Contractor Mortgages®, C&F Mortgages and Self Employed Mortgages, trading styles and brands of the award-winning Mortgage Quest Ltd.