Unless you have a gold-plated final salary pension, chances are you will be amassing a lump sum in preparation for your retirement.
Once you reach 55 years old, it’s up to you what you do with it. However, there are basically four options:
- You can buy an annuity – which usually involves exchanging your pension pot for a regular income for life;
- You can take a lump sum as large as you like (and as many of them as you like until the pot is empty) and leave the rest invested;
- You can use income drawdown, which lets you take a tax-free lump sum, draw a regular income, and invest the rest;
- Or you can do a combination of these things – in any order.
Most people are keen to secure an income for life with at least part of their pension pot.
One sensible approach is to establish what your guaranteed income you can expect from things like your state pension and any defined benefit pension from your employer.
Then you can calculate your essential expenditure – like paying monthly bills – and use an annuity to close the gap.
Once you have covered the essentials, you then have the freedom to explore other options with the rest of the pension pot.
Annuities: pros and cons
Buying an annuity, with at least part of the pot, secures your income for life and also for your spouse should you die first.
Ten weeks before retirement, your pension provider will send you an annuity quote, but you don’t need to take the annuity from them.
Check whether your quote includes a guaranteed annuity rate – which will often beat anything else available.
Otherwise, you should shop around and compare quotes.
Before you compare providers, you need to know what you’re looking for. There are a number of different types of annuity.
Level vs rising
A level annuity will give you a higher payment to begin with, but will stay the same for the rest of your life, so will gradually be eroded by inflation.
The effect of this dramatic, and over the course of your retirement can easily halve the real value of your income.
A rising annuity, meanwhile, will offer a lower starting income but can rise by a fixed percentage or by inflation each year.
You can arrange for your spouse to receive an income after your death, but this comes at a cost.
These pay higher rates for people who have a shorter-than-average life expectancy, because of lifestyle or health issues.
It’s well worth considering because two in three people qualify – because of everything from smoking to high blood pressure and diabetes.
How to shop around
Comparison tables like those available on the Money Advice Service website, https://www.moneyadviceservice.org.uk/en/tools/annuities will give you a guide to the level of income an annuity might provide.
Because your annuity choice will have an impact on your income for the rest of your life, shopping around to get the best deal could make a big difference to your retirement.
At the same time check whether you are entitled to an enhanced rate. This is best done through an annuity broker or financial adviser who can help you with your choices and shop around on your behalf
Taking a lump sum from your pension
According to the Financial Conduct Authority, between the ages of 55 and 65, 72% of people take a lump sum from their pension.
If you plan to take this approach, it’s essential to understand the tax implications, because while the first 25% of every withdrawal you make will be tax-free, the rest is treated as income.
This can have a particularly striking impact when this pushes you into a higher tax bracket or affects any benefits you are entitled to.
If this approach is right for you, you simply get in touch with your pension provider and tell them you want to withdraw an uncrystallised fund pension lump sum (or UFPLS).
They will take you through a risk assessment process to check you understand the implications of withdrawal, and then send you the money you request.
They’ll take the tax out first, which has created some issues.
When you take a lump sum, they won’t know whether this is the first of many similar sums to be taken during that tax year, so they will apply an emergency tax code.
This essentially works on the basis that you’re going to take lump sums every month for the rest of the tax year, so instead of getting your entire 25% tax-free allowance, you’ll get a proportion of it (depending on how far through the tax year you are).
It means you’ll need to complete a form and claim the extra tax back.
The other thing to bear in mind is that if you take a payment this way, 75% of each lump sum is considered as income.
As soon as you are taking income, you trigger something known as the money purchase annual allowance.
This means that if you are working and want to continue contributing to a pension, instead of being able to put £40,000 a year into your pension, you can only put in £4,000.
Using income drawdown in your retirement
This involves taking a tax-free lump sum, of up to 25% of your pension pot, and then moving the rest into a flexi-drawdown product, which invests your money into one or more funds.
You can then take a taxable income at times that suit you from this pot: many people use this to draw a regular income. Some people take the full 25% and move the whole pot into drawdown.
Others will only want to take a chunk of their tax-free cash, so will move a corresponding proportion of their pension pot into drawdown – leaving the rest invested within the pension.
The tax on drawdown differs from UFPLS because the first chunk of cash is entirely tax-free, whereas each UFPLS payment will be 25% tax-free and the rest taxed as income.
In addition, because within drawdown you are initially simply taking your tax-free cash, until you start taking a regular income from the pot, you won’t trigger your money purchase annual allowance, and can still contribute up to £40,000 a year into your pension if you are still working.
The Financial Conduct Authority found that 94% of people who went into drawdown without taking advice just took the product from their pension provider, but it’s well worth checking what else is on offer.
Providers differ in the amounts they charge, the investments available, and the services they provide, so it’s essential to find one that matches your needs.
Once you have found a provider, you can get in touch and complete the relevant application form. The company will then contact your pension firm and arrange the transfer of cash.
You will be able to set the level of income you want to take.
The challenge is ensuring that you produce an income for life which rises each year to offset the rising cost of living, and don’t withdraw too much too soon.
Spend too much too soon and your pension income could decrease over time.
One option is only to withdraw the income generated from the investments in your drawdown plan, so you aren’t spending the capital portion at all.
As a rule of thumb, this is no more than £4,000 for every £100,000 in your drawdown plan.
Whatever level of income you choose, it’s important to revisit it regularly to ensure your investments are performing as expected, and you’re not taking more of your pension pot than you intended.
How much to draw down, where to leave the rest of the money invested and how to minimise the tax you will pay both on the income and on your pensions and investments when you die, is a relatively complex decision, with far-reaching consequences, so you may want to consider taking advice.
This article has been specifically designed and written for use by loveMONEY and its content partners. This is not intended for investors: it is not personal advice or a recommendation to either invest or to refrain from investing.