Receiving an income from your pension used to be pretty simple.
You’d pay into your pension every month, retire and then either receive an income from your ex-employer based on your salary or buy an annuity that would pay out a fixed amount every month. There were some exceptions, but for most people, that’s how it worked. However, things aren’t simple anymore. Your retirement options are now much more complicated.
Following the introduction of a whole raft of pension freedoms in 2015, people at retirement now need to think about:
Which assets they’ll use to create an income
When they should take this income, and
How they should take that income
Navigating the various options on your own can be daunting. There are so many factors to take into account.
Many factors influence your retirement options
The Size of Your Fund – The amount of money you’ve built up in your pension pot will clearly influence your decision. But it’s not just your pension pot that needs to be taken into account. Other assets like ISAs, rental properties, even your own home could be a good source of cash in retirement. It might be more tax efficient to leave your pension untouched in order to limit any inheritance tax payable on your estate.
Tax Liabilities – Accessing your investments the wrong way can create substantial tax bills that would have a material impact on your income. It’s important to think about how to create an income in a way that minimises your tax bill.
Surety of income – Are you in a position to accept any risk to your retirement income? If your finances are going to be quite tight you might prefer to know you’ve got a guaranteed income. You probably won’t like the idea of having a retirement income that might vary depending on whether investments rise or fall as markets change.
How Much Money You Need – Most people want to have enough money to enjoy retirement without worrying too much about the cost of things. And understandably so. After all, you’ve worked damn hard for a great many years to get to this point. However, others may envision a quieter, simpler life in retirement.
Your Health – As a nation, generally we’re all living longer. If you have any health issues that might affect your longevity, it’s important to factor these into your decisions.
Do You Want to Have Anything Left Over – Our children’s generation has it easy in many respects, but very tough in others. Getting a foot on the housing ladder and clearing university debt can be a real challenge for many in their 20’s and 30’s. Whilst most are happy to leave their family home to the kids, if you want them to inherit a slice of your investment portfolio to help with these issues, this clearly needs to be brought into your planning.
[Note: Getting a retirement professional to help you evaluate your retirement options can make your planning quicker and easier.
Some Sources of Income Might Not be so Obvious
Individuals reaching retirement frequently look only to their pension schemes for an income. That could be the wrong thing to do. Why? Because you might be able to use your other assets to provide an income much more cost effectively or with less risk.
So what assets can create an income in retirement? Here are six that you may be able to use:
1. State Pension – Your state pension provides an iron-clad guarantee of a basic level of income ONCE you reach state pension age. The way the pension is “triple locked” provides protection against inflation and you can rest easy in the knowledge that you’ll continue to receive the benefit as long as you live. The only problem is WHEN you can start claiming it. The idea of working to 67 or even older is not particularly palatable and most people want to retire well before this.
2. Paid Work – The concept of moving into a part-time role once you retire, and working as a consultant, non-executive director or the like, is attractive for many people. Not only does this soften the mental blow of stopping work abruptly, but the income can provide a very useful subsidy until your state pension kicks in.
3. Investments and Savings – If you’ve amassed £40,000, £50,000 or even more in ISAs and other investments outside your pension they can be used to provide a useful tax-free income at a time when most needed.
4. Property – You may have investment property that provides an income to support your retirement. But your family home can also provide an income. Taking advantage of historically low interest rates and borrowing money against your home, whether by delaying repayment of your existing mortgage or by equity release can provide a low-cost income whilst your pension fund remains invested. Landlords are also being faced with some major changes which make property as an investment less attractive. Take a look at my recent blog about this for more detail.
5. Defined Benefit Schemes – Traditional occupational final salary or Career Average Revalued Earnings (CARE) schemes can provide a secure income akin to the state pension, except you’re likely to be able to access the fund much sooner. However, depending on your individual circumstances, it might be relevant to transfer your scheme benefits out to a private pension so that you can enjoy a higher level of tax free cash and more flexible income, and pass on any remaining fund to your family upon your death. A benefit not generally available by taking benefits direct from this type of scheme.
6. Money Purchase Pension – The mainstay of many people’s pensions, money purchase (a.k.a Defined Contribution) schemes provide you with flexibility to withdraw all or some of your cash from age 55, or sooner if you’re in a protected occupation or are suffering from certain health conditions. There are a number of options for creating an income from your money purchase scheme which are considered next.
Withdrawing Money From Your Money Purchase Pension
Once you reach age 55, you now have total flexibility in terms of accessing the money you’ve built up in a money purchase scheme. This is where the number of retirement options available have increased the most following the new pension freedoms introduced in 2015.
There are pros and cons of each of these options:
Leave your money untouched – Leaving your defined contribution pension untouched, and keeping it invested in the market means that your fund can continue to grow throughout the 20-30 years that you’ll likely live in retirement. If for example you’d accumulated a pot of £100,000 by age 60, and assuming a real growth rate of 5% pa, your fund would be worth £271,264 by the time you were age 80. That’s money that you can pass to your children free from inheritance tax.
Tax-Free Lump sum – You can withdraw up to 25 percent of your pension fund as a tax-free lump sum and not pay any income tax on that amount. Doing so is clearly tax efficient but also provides a good tranche of money for spending when you have the ability and desire to enjoy it. Taking a big lump sum may not be appropriate for some people as doing so decreases the income available in the longer term.
Drawdown – “crystallising” your pension allows you to start taking withdrawals from the fund (known as pension drawdown) in regular payments or as a series of smaller lump sums. You can keep the balance of your fund invested in the market so that it can continue to grow whilst you’re taking an income.
Purchase an Annuity – for some people it would be appropriate to buy an annuity, but there are major pros and cons of doing so. On the plus side, you would be in receipt of a guaranteed income throughout your retirement. But, annuity rates are very low due to increased life expectancy which can make them poor value. You may be better off in the long term leaving your funds invested and accessing your pension via “drawdown”. Additionally, when you die, either the income stops altogether or is reduced and paid to a spouse, as opposed to the remaining fund passing to family in full.
Take the whole lot as cash – You can withdraw your whole pension as cash, although you will need to pay income tax on everything over and above your 25 percent tax-free allowance.
A mixture of the above – You’re not limited to using only one tactic for creating an income from your money purchase pension. The new pension rules allow you to mix and match different options to best suit your individual needs.
Getting advice
Assessing each of these options for creating an income in your retirement is a complex task. Some of the decisions you make are irreversible and the amount of tax you pay can vary dramatically, depending how your income is structured. Getting advice on your retirement options from a pension specialist is therefore highly recommended.
Are you retiring soon? Or have you already taken advantage of the retirement options made possible by the new pension freedoms? Tell us how you intend to create an income from your pension. We’d be delighted to hear your story.
The content of these articles are for information only and should not be seen as advice or recommendation to act. If you do wish to take action, seek independent advice first as your circumstances may be different to what has been discussed in these articles.
When investing, your capital is at risk and it may go down as well as up. You may not get back the original capital invested. Pension investment should be seen as a long term investment. Please note that pension legislation can and may change in the future.