By Steven Cameron

WHEN it comes to decisions about retirement it is clear that the pension freedoms introduced for defined contribution or money purchase pensions five years ago have had a dramatic impact on consumer behaviour.

There were concerns that rather than using their savings to finance their later life, people would splurge their pension on a luxury Italian sports car.

Happily, these extreme concerns have proved unfounded, although there are ongoing worries that some people may be taking more than may be sustainable to provide an income for life.

Unshackled from what many felt was a compulsion to buy an annuity, the over 55s have been far from shy about embracing the new choices they have.

In fact, this transfer of power to the people has proved so popular that a record number of people - 1.3 million - are now utilising it by taking flexible payments from their defined contribution pensions.

Enabled by pension freedoms, one of the new trends we’re seeing is people transitioning into retirement by continuing to work with reduced hours beyond traditional retirement age. Around half of people now say this appeals to them rather than stopping working all at once.

However, it is not generally appreciated that the ability to access part or all of a pension while still working comes with a sting in the tail.

Coinciding with the launch of the 2015 pension freedoms, then Chancellor George Osborne brought in another new measure known as the money purchase annual allowance (MPAA).

The reason for this is that pension contributions get valuable tax relief at the individual’s highest marginal rate of income tax. In Scotland, this means someone paying tax at 21 per cent will have £79 topped up to £100 by the Government. For someone paying 41% income tax, the top-up is even more valuable, with £59 made up to £100.

When you start drawing your pension, you can typically take 25% of the whole fund tax free and you pay income tax at your highest marginal rate on the balance. The Government was concerned people would take money out and then pay it back into their pension, to get a second round of these valuable tax reliefs, something called recycling.

The MPAA rule means that once someone has accessed any of their pensions flexibly, they and their employer can only contribute £4,000 in total to all defined contribution pensions every year.

It is an important warning for the increasing numbers of workers over 55 years of age who want to blend reduced working patterns with partial retirement and dip into their pension savings flexibly to supplement their reduced earnings. And it is something people need to have their eyes opened to.

You do not need to be a super-high earner to get hit by this rule either. The MPAA limits pension contributions to less than £350 a month without the individual receiving a penal tax charge. That means someone earning £33,333 with an employer/employee pension contribution of 12% would exceed the current limit and face a tax charge.

This could severely derail an individual’s ability to continue saving for retirement and does not seem compatible with the modern way half of people now view retirement, as a transition that takes place over a number of years.

Given the lack of awareness, the current arrangement not only puts thousands of older workers at risk of finding out too late that they have damaged their future pension potential, it may also lead to them having to turn down their employer’s pension contribution.

To avoid risking this little-known rule undermining one of the really good aspects of pension freedoms, we would like to see it returned to at least a £10,000 limit. At that level, far fewer people would be affected or accidentally fall into this MPAA tax trap.

With the prospect of a new administration on the horizon we would urge the Government, whatever its persuasion, to increase the limit substantially, so people can have the freedom to use flexible pensions to transition into retirement at their own pace without it curtailing their future retirement savings.

It is also a timely reminder that the wider pension choices bring greater personal responsibility. People need to be aware of the risks. This underlines the benefit of seeking advice before making any decision that could impact the amount of money you have in retirement.

Steven Cameron is pensions director at Aegon.