Today (April 6) marks the first anniversary of ‘pension freedom’ legislation coming into effect. Since then, over 55s have cashed in around £6 billion. Among these were small and medium-sized enterprise (SME) owners who used their pension pots to fund their businesses.
When the UK government introduced ‘pension freedoms’ in April 2015, the immediate, and natural, reaction of many eligible ‘olderpreneurs’ (business owners over 55), was to simply withdraw their accumulated pension pot and invest it directly into their company. We have estimated that around 100,000 UK olderpreneurs cashed in £400 million of their pensions to fund their new ventures in the last year alone.
Experience trumps youth?
It has been shown that ‘olderpreneurs’ can be more successful in business, with research from Age UK finding 70 per cent of businesses started by the over 50s surviving more than five years, compared to just 28 per cent founded by their younger counterparts. However, many of these ‘olderpreneurs’ have clearly not received realistic, or any, advice on how best to use their pension pots for business funding.
For some ‘olderpreneurs’, using the new freedoms has resulted in a large tax bill, significantly contributing to the £900 million in pension freedom tax receipts expected to be collected by the government. Taking this approach has even led to financial disaster, where a lack of expert advice has meant some owners invested in unsustainable businesses that could not provide a return on the pension investment. This ultimately resulted in the failure of the business and a loss of part, or all, of the pension.
Freedom, but not free
It’s no surprise that olderpreneurs have turned to their pension for business funding, as the pension freedoms allow anyone over the age of 55 to use their accumulated pension funds in any way they wish, including taking the entire pension pot as cash, subject to tax. While the average defined contribution pension for an individual in the UK aged between 55 and 64 is just £25,000, the average SME director has £117,000 in accumulated pensions, based on Clifton Asset Management’s client base of more than 2,000 businesses.
However, under existing pension regulation, only 25 per cent of the accumulated, untouched, pension fund is available tax free. Any further withdrawals are then subject to income tax in the year in which they are taken. For most directors that is likely to mean tax at the higher 40 per cent rate or indeed 45 per cent for the highest earners.
What are the options?
Close consideration needs to be taken by the business owner into how he or she wants to use their pension for business funding. Some may want a small, quick, cash injection; others may want tens of thousands of pounds in one lump sum for an expansion drive. Therefore dependent on personal circumstances and levels of funding required, the following four options should be considered:
1. Take a lump sum
If you take your pension out all in one go the first 25 per cent will be tax free, however, the rest will attract income tax – likely to be 40 per cent, but it could be as much as 45 per cent if your total income is more than £150,000. While this may be the easiest option for releasing money to put into a business, it may not be the most tax-efficient or personally beneficial in the long-term.
2. Multiple lump sums
This involves splitting the sum you need into multiple smaller parts allowing you, for instance, to release £30,000 from your pension by taking £10,000 to launch the business and drawing more later. However, the same drawback as the previous method remains, with the first 25 per cent being tax free and the rest being subject to income tax – likely to be 40 per cent or possibly higher – whenever it is taken and depending on future tax rates.
In fact, the timing itself can be important, depending on whether the sums are taken in the same tax year or spread across two or more years. Other downsides to this approach include the likelihood of incurring multiple sets of transaction charges for arranging each withdrawal and a potential loss in performance of investments.
3. Little and often
If you don’t expect your business to cost much to set up, an alternative would be to free up your pension money in small chunks, a few thousand here and there, to buy a new piece of equipment or help with cash flow when needed. The issue of attracting income tax still remains, but this approach makes sense for those with income closer to a higher bracket.
4. Pension-led funding
This form of finance is aimed specifically at business owners and directors who, in order to make it commercially viable, have accumulated pension funds greater than £50,000 and want to back their own business. They don’t need to be 55 or over, and should there be more than one owner director in the same firm, the pension funds can be amalgamated to invest in the business.
One of the reasons why PLF-funded businesses are so successful (97 per cent still successfully trading after five years) is that close attention is paid at the outset to whether the business owner’s pension fund and business model is appropriate for this form of finance. A PLF strategy therefore requires a detailed assessment of company accounts, track record and business plan, as well as an assessment of the business and the motivation of its owners and directors before it can be approved. Something that many business owners using the new freedoms to swiftly cash-in, part, or all of their pension pot for their business do not have.
We feel that this rigour – and extra pair of eyes – is hugely important when investing savings that have potentially taken over 30 years to build up.
The ABI figures and Nesta’s recent Alternative Finance Industry Report illustrated that, whether for business or personal use, the initial ‘dash for cash’ by the over-55s straight after the reforms came into force has now slowed considerably.
It’s reassuring that business owners aged of 55 are now taking a more considered approach, but it is still vital that all of the options are weighed up, so the right strategic decision is taken.
Adam Tavener is chairman of Alternative Business Funding.