Retirement isn’t just about pensions any more. Everyday expenses in retirement are increasingly being met using other financial products, such as Individual Savings Accounts (ISAs). And the new rules that came into force on 6 April look to reinforce this trend, by making pensions one of the most attractive ways to pass on savings to future generations (you can read more about what’s changing and why it’s so significant in our article entitled ‘New pension rules make it easier to pass on pension wealth’.
Nevertheless, pensions will remain the most significant contributor to retirement income for many people. And the question of how to turn your pension wealth into an income that will last the rest of your life remains one of the most important in personal finance – with many of the decisions involved being irreversible.
The new pension rules will make a variety of new retirement strategies possible. However, there are still just three methods that most people will use to turn their pension savings into retirement income: annuities, cash lump sums and income drawdown. Once you’re clear about how these work, you’ll be well on your way to working out which retirement strategy might be right for you.
Arranging a guaranteed income with annuities
You could use some or all of your pension to buy a ‘lifetime annuity’, a guaranteed stream of income that will last for as long as you do. You can take any tax-free cash available from your pension before using the rest to buy an annuity from whichever provider you choose. The regular payments you get from an annuity are subject to income tax.
In its simplest form, an annuity pays one person the same amount on a regular basis, for life – this is known as a ‘single life, level annuity’. The more you spend on a level annuity, the higher the income you’ll receive. However, there are many other types available, with varying levels of complexity and cost. For example:
- Inflation-linked annuities provide an income that rises in line with inflation – usually as measured by the Retail Prices Index (RPI). You’ll get a lower income initially than you would with a level annuity at the same purchase price, but the rising value over time could mean you end up receiving a higher amount back overall.
- Increasing annuities, also known as ‘escalating annuities’, provide an income that rises by a set amount each year – usually between zero and 8.5%, with higher increases adding more to the initial purchase price. As with inflation-linked annuities, you’ll get a lower income initially than you would with a level annuity at the same purchase price.
- Joint life annuities continue to provide an income for your spouse, civil partner and/or other dependants when you die.
- Investment-linked annuities pay a variable income that’s linked to the performance of an investment portfolio. If the investments perform well then your income will increase to match or beat the rate of inflation, but if not then you could get less than you expected.
- Enhanced annuities, also known as ‘impaired annuities’, pay higher incomes to those with lower life expectancies; you may be eligible for one even if you suffer from a very minor condition, so it’s worth exploring the many criteria with your annuity provider.
You’re not obliged to buy an annuity with your pension savings, but remember they’re still the only way to guarantee yourself an income regardless of how long you live.
Depending on your pension scheme, you may have the freedom to buy an annuity at any point after you retire, using as much or as little of your pension pot as you like. You could even buy a number of annuities over a period of time –perhaps to take advantage of rising rates or because your circumstances have changed and you want the peace of mind of a guaranteed income for the rest of your life. The new pension rules will give you more freedom than ever to buy annuities as and when required.
|A guaranteed income for life. You can chose for this to be paid for a guaranteed period of time even if you die before the end of that guaranteed period.
||Limited opportunities to control your level of income.
|You can choose to protect the capital you use to purchase the annuity. If you die and the total amount of annuity payments you have received is less than the capital you invested initially, the difference will be returned for the benefit of your beneficiaries.
||You will start with a lower annuity income and may outlive any capital repayment. This would reduce the level of income that you continue to receive compared with what you would have, had you not taken the capital protection option.
|You can opt for an annuity that also guarantees income for a surviving spouse, civil partner and/or dependant.
||Once an annuity is purchased it cannot be changed.
|You can opt for an annuity income that increases to offset the effects of inflation.
||Inflation may outstrip the value of the income, even if you take an increasing income option.
|In some cases, an annuity can be linked to the performance an investment portfolio, in order to provide potential for growth.
||Purchasing an annuity is an irreversible decision.
|Enhanced annuity rates are available for those with lower than average life expectancy or certain lifestyles.
For more information on the types of annuities available and how to buy them, visit the website of The Pensions Advisory Service.
Using cash lump sums to cover retirement expenses
Most pensions allow you to withdraw up to 25% of your pension pot tax-free when you reach the age of 55. This is known as the Pension Commencement Lump Sum (PCLS), and you can take it either as a single lump sum or in stages, before using the rest of your pot to generate a retirement income. Anything you withdraw from the remaining 75% of your pot will be taxed as income.
Most retirees choose to use the remainder of their pot to buy a lifetime annuity or go into income drawdown (see below). But you’re not obliged to do so. Under the new pension rules, you won’t have to take your tax-free money in one go at the start. It will be possible to take lump sums from your pension of varying amounts, whenever you like, with the first 25% of each withdrawal tax-free and the remainder taxed as income. The remainder of your pot will remain invested.
This type of withdrawal will be known as an ‘uncrystallised funds pension lump sum’ (UFPLS), and it could be useful for people who don’t want to take all of their tax-free entitlement up front, or who want a ‘phased retirement’ in which they gradually turn their pension wealth into an income while their work tapers off. Some pension schemes will not give you the option of transferring your pot into drawdown, and for these UFPLS may be the only way to make variable withdrawals.
Under the current rules, you may have further options to withdraw cash lump sums if your total pension savings are worth less than £30,000 or if you have any individual pots worth less than £10,000. To find our more, read our article entitled ‘Lump sums: new options and tax rates for large withdrawals’.
|A lump sum can be used to pay off any debts, e.g. your mortgage.
||Because you have taken capital from your pension pot the remaining amount available to provide you with an income during your retirement will be reduced.
|Most private pensions allow you to take a tax-free lump sum any time after you reach 55, worth up to 25% of your pot, with the remainder taxed as income no matter how you use it.
If you’re not going to use all of your tax-free lump sum immediately it could be disadvantageous to take it in one go. If you end up having to find somewhere else to invest it, it’s unlikely to perform as it would by remaining in your pension.
And don’t forget, once you have taken the whole of your tax-free cash, the remainder of your pension pot will all be taxable when you come to draw it down as income.
|Under the new pension rules, you may be able to take lump sums of varying amounts, whenever you like, with the first 25% of each lump sum being tax-free and the balance taxed as income.
Note: The rules of some pension schemes may require you to take your lump sum before the age of 75, so you should check with your pension provider to see what they allow.
Keeping your options open with income drawdown
Income drawdown enables you to withdraw cash from your pension pot while leaving the remainder invested.
Under the rules that applied up until 6 April 2015, it could take two forms: ‘capped’, which restricted how much you could withdraw, and ‘flexible’, which was only available to those who had a minimum level of retirement income guaranteed from another source. However, under the new pension rules, it’ll be available to most people over the age of 55 who have a defined contribution pension. You can read more about what’s changing in our article entitled ‘Drawdown: the most flexible pensions, now available to all’.
Under the new pension rules, all new drawdown products will be known as ‘flexi-access’, and they’ll give you complete control over how you access your pension savings. You could make withdrawals of any size, whenever you like, and even take your whole pot as a single lump sum (in which case you’d get no further income from the pension at all).
If you are already using capped drawdown you have the option to convert to flexi-access although you will need to check whether your existing plan will be able to do so. If you are already using flexible drawdown you will now automatically be in flexi-access.
The ability to make variable withdrawals gives you the freedom to cover big expenses in some years while lowering your income in others to avoid paying more income tax than necessary. It could help you to manage your income if you continue to work during retirement, so that you don’t move into a higher tax-band. And it will give you the freedom to buy an annuity whenever you feel it’s necessary to your retirement strategy – for example, you could buy a lifetime annuity to cover your basic expenses during retirement while leaving your options open about how to use the rest of your pot.
|You can take an income, or choose not to, as required – within limits for capped drawdown and without limits for flexible or new flexi-access drawdown.
||The remainder of your pension pot will remain invested, so its value could fall as well as rise.
|You have the freedom to vary your income, which could enable you to cover big expenses in some years while minimising the income tax you pay in others.
||Income drawdown makes you responsible for your own income during retirement – you’ll have to be careful that you don’t withdraw too much or you may run out of money and end up dependent on the state.
Building the right retirement strategy for you
You may find that a mixture of some or all the methods above gives you the best chance of achieving your retirement goals. You may also find that non-pension assets influence your decision about when to touch your pension savings and how. As mentioned above, the new pension rules make it easier to pass on pension wealth than ever before, meaning that you could reduce the tax paid by your beneficiaries on your estate when you die, if you use other assets to fund your everyday expenses before making any pension withdrawals.
What’s right for you will depend on your circumstances, needs and goals – and those of your family. So if you’re in any way unsure about how to build an effective strategy then you should consult a financial adviser. If you don’t yet have a financial adviser but are interested in finding one, you can do so using the free search tool here.