As you approach retirement, you will have some big decisions to make which could have serious implications for your future financial stability. There is £5.3trn of private pension wealth in the UK, according to official figures. That’s a big pot of cash which needs to be handled carefully so that it generates the income pensioners will need over the whole of their lifetime.
What to consider when deciding what to do with your pension
As you start thinking about what to do with your pension pot when you retire, there are a few important factors which will affect any choice you make. Imagine you went to see a financial adviser, what sort of questions would they ask you to build up an accurate picture of your retirement needs? You’ll need to get into that same mindset and try to assess your whole financial situation dispassionately so you can decide on the best pension pot options (and ideally you will also speak to a financial adviser before doing anything). You should ask yourself:
How much money have I got?
All your assets and liabilities need to be taken into account, so that includes any small pension pots from old jobs you may have forgotten about (read our article on pensions consolidation for more on this), and any outstanding debts such as a mortgage.
What does this money need to do?
This includes not just the lifestyle you want and the income needed to support your day to day spending, but also any one-off bills like medical or care costs, financial gifts you may wish to give to family members, or big purchases like a property investment or holiday home. You also need to think about what you want your pension to do after you die: do you want to leave any of it to your children or grandchildren, or provide your spouse with an income, for example?
How long does it need to last?
None of us have a crystal ball so we don’t know how long we will live, but we can make an estimate based on our age and state of health. Hopefully you’ll stay hale and hearty for many years, but you should also plan for living long and being unhealthy – would your pension see you through to the age of 100 and cover your care needs?
Generating a guaranteed income from your pension
When the pension freedoms were introduced in 2015, the requirement to buy an annuity was abolished. Consequently, sales of annuities plunged as retirees started to consider other ways to extract an income from their pension pots. An annuity is a type of retirement product you can buy with some or all or your pension pot which gives you a guaranteed regular income in retirement either for life (a lifetime annuity) or a set period like five or ten years (a fixed term annuity). With a fixed term annuity, you may also get a maturity payment at the end of the term.
The main drawback of annuity products is arguably the poor rates on offer. Pension annuity rates are linked to gilt yields and they have fallen in recent years as these have remained low, but they may start to come back as interest rates begin to rise (see our article ‘ When will interest rates rise’ for more on this), which could lead to healthier payouts for pensioners. Generally speaking, the older you are when you take out an annuity, the better rate you’ll get. The financial regulator is keen for people to shop around to get a better annuity rate, as many don’t realise they can buy one from any provider, not just the company that administers their pension.
Sales of annuities are recovering as people realise the value of an annuity in guaranteeing an income over what could be a very long life. They don’t require management in the same way that an investment portfolio does, they simply pay out a set amount each year for as long as you live. This is their main advantage. With a lifetime annuity, you are locked in and can’t change your mind once you’ve bought one. You can choose a basic product which sets your regular income in advance, or an investment-linked one where your income changes in line with investment performance, but will not fall below a certain floor. A joint life annuity also lets you provide an income for life for a dependent or spouse. If you are unwell or you smoke, you could buy an enhanced or impaired life annuity to give you higher income payouts.
How to calculate how much your pension is worth
Now you’re probably wondering how much your pension pot is worth. To get an idea of how much annual income your pension might get you, try our free pension calculator.
Generating adjustable income from your pension pot
Pension income drawdown is when you use your defined contribution pension money to draw a regular income in retirement by investing it in funds designed and managed for this purpose. Income is variable and not guaranteed like an annuity because it depends on the performance of the underlying investments. All new income drawdown plans set up after 6 April 2015 are flexi-access drawdown, meaning there is no limit on the amount of income you can take from your pension pot. The first 25% is tax free. You can take the income regularly or at times to suit you, and you can move your pension into income drawdown gradually, you don’t have to move it all at once.
A recent FCA review found that, before pension freedoms, over 90% of pension savings were used to buy annuities, but now pension drawdown sales are twice that of annuity sales.
According to Zurich, almost half a million people have put their pension into income drawdown since 2015, with an average drawdown pension pot of £153,000. Around 41% of these have gone ahead without taking any advice.
The benefits of drawdown products are that you are still investing your pension pot in the stock market, so your money can keep growing, but this is also a risk as equally your investments could fall in value. Income drawdown gives you the flexibility to take money out when you like, and you can vary the amount and frequency of payments so this can help with tax planning.
Other risks are that you could end up in investments that are too volatile for you, or which don’t generate enough growth or income to fund your retirement, so you could run out of money as payments are not guaranteed. This can also happen if you draw too much income too early. You will have to pay income tax on your pension income, large withdrawals could push you into a higher tax band, and there may be charges attached to your drawdown plan. You will only get tax relief on £4,000 of future pension contributions if some of your pension is in drawdown, so this is something to bear in mind if you are still building up a pension pot.
Cashing in all or part of your pension
Since the introduction of pension freedoms, anyone aged 55 or over can withdraw all or part of their defined contribution pension in cash. If you have a defined benefit (DB) pension, you may need to transfer the money you want to cash out into a defined contribution (DC) scheme first. You are required to take financial advice before transferring if you have more than £30,000 in a DB scheme. Read our article on ‘How to transfer your pension’ for more information.
The main advantage of cashing in some of your pension is the freedom to enjoy some of your hard-earned cash in one big lump, whether it’s to pay off a mortgage, go on a cruise or even buy a Lamborghini (just kidding). If you have health issues, you might need to pay for healthcare, or you might simply prefer to spend some of your money now rather than getting a guaranteed income for life. You could withdraw cash from one of your smaller pension pots, while leaving your main one untouched, for example. Or you could withdraw to reinvest the money elsewhere. To calculate your ideal pension lump sum, try out our pension calculator.
The main drawbacks are that, although you can take 25% of your pension pot tax free, there are tax implications for any amount you withdraw above this. You may have to pay emergency tax which you will need to reclaim. Plus, once you withdraw some or all of your money, it is out of the market and loses its potential to grow further. This means you risk your pension fund not lasting the whole of your retirement. You should also bear in mind that any means-tested benefits you receive could be affected if you withdraw a lump sum from your pension.
Cashing in part of your pension to get a lump sum
You don’t have to be in an income drawdown plan, you can just take lump sums from your pension when you want to, from the age of 55. These are called ‘uncrystallised funds pension lump sums’ (UFPLS). Yes, it means you get easy access to your money, but using your pension pot like a cash machine might not be very tax efficient. You must pay income tax on 75% of your pot if you cash it out. You might be able to reduce your tax liability by spreading your withdrawals over a number of years. A financial adviser will be able to guide you in this. Bear in mind your pension provider may charge you for withdrawals, and some may not allow lump sum payouts so you may have to transfer to another product first.
Can you take all your pension pot in one go?
Yes, you can withdraw your whole pension pot in one go if that is what you want, but it’s probably not recommended. There are a few important reasons for this. You could be in line for a large tax bill for anything over 25% of your pot as it will count as income and will be subject to your highest tax rate. Some pension providers will not allow you to take the whole pot, and those that do may charge you to do so, and may require you to pay for financial advice before you can. Withdrawing all your money means it is no longer invested and growing, and this presents the very real risk that you could run out of money in retirement. To avoid this, it’s vital that you take financial advice before doing anything if you are considering withdrawing your whole pot.
Getting the right advice
Every individual will have different life circumstances and different needs in retirement, so there isn’t a ‘one size fits all’ solution. Many people will benefit from a combined approach which uses a combination of different strategies like income drawdown, annuities and lump sum withdrawals. A good financial adviser can give you pensions advice to help find the right strategy for you. This is important to help you maximise your pension pot so it will last as long as you need it to, getting the best returns you can without taking too much risk or paying over the odds. There are free services to help you, such as the government’s Pensions Advisory Service, or you could visit an independent financial adviser for professional advice. MoneytotheMasses.com has partnered with VouchedFor to offer readers a free pension healthcheck with a local IFA. We also suggest you read our article on how to choose a financial adviser you can trust.
Looking for a financial adviser near you?
Do you need financial advice? An independent financial adviser can show you how to make the most of your money.
Simply find your nearest qualified and regulated adviser using the UK’s largest adviser search.