THE BLOG

Don't Blow Your Pension Pot on a Cruise

04/04/2015 23:27 BST | Updated 02/06/2015 10:59 BST

The phrase "unintended consequences" is often overused, but never more appropriate than what will happen on 6 April, when George Osborne's pension reforms come into effect.

The changes claim to provide people with "freedom and choice" which is laudable in every way, but for many it will create pressure, confusion and possibly even hardship for some.

The new rules affect people aged 55 and over who have some form of a pension pot. If you have saved into a defined contribution ("DC") scheme (also called a money purchase scheme), you can withdraw all of your pension pot in one go, with income tax to be paid on 75% of the pot, and the rest paid tax free. It all sounds appealing and for many they will feel as though Christmas has come early.

However, why on earth would you want to cash in your entire pension pot at age 55 when all the statistics point to you living well into your 80s? For many people, the answer is that you would be crazy to do so - you should leave the pot alone to let it grow and be thankful you will have a pension to fall back on when you reach 65.

For others with larger pots, these changes are attractive: they allow you to withdraw money from the pension pot over a period of years (called "drawdown") and pass on any unused pension to your children, tax free, when you die. Of course, to take this option you need to be financially savvy. You need to be sure your pot will last you well in to your retirement years and will not run out before you die.

However, these pension freedoms are only available to people with DC pots and this is where the danger lies. People with a defined benefit ("DB") scheme (also called a final salary scheme) are not allowed to access these flexibilities, so they will have to transfer their pension from a DB to a DC scheme in order to benefit from these new rights.

For most people with medium sized pots this will not be a good move. It will be hard, if not impossible, to achieve the same kind of growth in a DC pot to match a final salary scheme, which is also index linked and will in the majority of cases provide a spouse's pension. Thankfully the Government has recognised this danger and will require all DB members to take professional financial advice before making a decision to transfer. However, this requirement only applies to people with pots in excess of £30,000, so will not protect members with small pots.

If you have previously been thinking "I could use my pension to pay for a cruise or that bright red Lamborghini" please think carefully. You may want to be on that beach when you are 70 or 80 and who, other than you, is going to pay for that?