Call for MPs to change rules to allow access to 25% tax free cash while leaving the balance in a pension

In a response to the Work and Pensions Select Committee inquiry on pension freedoms, LCP partners Laura Myers and Steve Webb have submitted proposals to reduce ‘consumer harm’ by allowing savers to access tax free cash (at normal minimum pension age) from their pension fund whilst leaving the balance behind.

This is to overcome the losses to consumers who either take 100% of their pension (and put the balance in a cash account, earning little or no interest) or take their 25% lump sum and move the rest to a higher cost and worse-performing drawdown product.

In their response to the Committee, Myers and Webb point out that the most common choice made by savers when accessing their pension pot for the first time is to take the whole amount out in cash. In the period October 2019 to March 2020, 55% of policies were cashed out in full, 35% went into drawdown (most taking their full tax free cash) and around 10% were used to buy an annuity. Over 174,000 pots were cashed out in full in this six month period.

As the chart shows, those with small pots were overwhelmingly likely to cash them out in full:

Source: FCA Retirement Market statistics

The LCP response points out that the large majority of people are not taking advice or guidance about what to do with their pension pot, especially at lower pot sizes.

In terms of what people do with the money, separate FCA research shows that just 6% spent the whole pot in one go, and a further 19% spent the largest part of the pot. Around 1 in 7 (14%) used the money mainly to pay off debts, around 1 in 5 (20%) invested it, but nearly 1 in 3 (32%) but the money mainly into a current account, savings account or cash ISA.

The concern is that those who put the balance in a cash account are moving from a low cost environment where their money is carefully managed for growth (such as a workplace pension run by a Master Trust) to a deposit account earning next to no return. If money is accessed at age 55, unused balances can sit in such accounts for many years, missing out on years of investment growth.

With research showing that accessing tax free cash is the biggest single motivator for people accessing their pension for the first time, LCP propose changing the rules so that people can get their 25% tax free lump sum whilst leaving the rest invested in their pension. This recommendation mirrors an FCA proposal along similar lines in the conclusion to their Retirement Outcomes Review.

Although in theory savers can already access tax free cash and move the rest to a drawdown account. The big problems with the current system are:

Most people simply take the whole lot out, presumably finding it the simplest thing to do;
Those who take 25% tax free cash and move the rest into a drawdown product are moving from an ‘institutional’ environment where their money is invested at low cost and overseen by trustees or others, to a ‘retail’ environment where product charges are likely to be higher and where the individual has to choose a provider and investment mix;
If individuals could access their tax free cash, meeting their desire for a lump sum, but leave the balance *invested in their original pension scheme*, this could be the best of both worlds.

Laura Myers, partner at LCP and chair of the PLSA’s Defined Contribution committee said:

“Pension freedoms give savers welcome new choices but there is a risk that current rules for accessing tax free cash are leading to poor consumer outcomes. Many people who want to access their tax free cash find it easiest to cash out in full, but then put the balance in a cash account, losing out on vital investment growth on the balance of their funds. Even those who put the balance into drawdown risk moving into a higher cost environment with lower returns and poorer governance. Changing the rules to allow people to access their tax free cash and leave the rest in their pension fund could be the best of both worlds”.