Securing an income for life
Maximising returns over the long term
The vast majority of funds available to the UK market are aimed at saving in the run-up to retirement, known as the ‘accumulation phase’. While diversification is a consideration, the primary aim is maximising returns over the long term and to increase the size of the eventual pension pot.
This situation has come about as previously funds were little used during retirement, known as the ‘decumulation phase’. Now, with pension freedoms, more investors can use funds as part of a decumulating portfolio. The government introduced on April 6, 2015 the most radical changes to pensions in almost a hundred years. For the first time, individuals from the age of 55 with a defined contribution pension were able to access their entire pension flexibly if they wished.
The pension freedoms, announced by then Chancellor, George Osborne, in Budget 2014 gave over-55s full control of their retirement savings. Instead of being required to buy an annuity with a money purchase pension pot, individuals aged 55 and over could take their money however they deemed appropriate. Generally, 25 per cent of the pension pot is tax-free, and the remainder subject to Income Tax at the individual’s current rate.
The decumulation phase is the process of converting pension savings into a retirement income. The decisions an individual makes during the decumulation process are crucial. Unlike the decisions people make whilst they are still saving, decisions made at retirement are often one-off and irreversible. The decumulation phase has become an increasingly important part of the journey to retirement as we move away from Defined Benefit and towards Defined Contribution pension contribution arrangements.
Defined Contribution arrangements require greater member engagement to ensure the best outcome. In addition, the nature of the retirement process is changing as our needs, demands and expectations change. Other relevant factors are the rise in life expectancies (we are living longer which makes securing the best possible retirement income more important than ever) and declining annuity rates, which mean that individuals may wish to explore alternatives to purchasing a traditional annuity when they come to retire.
Another key factor which is often overlooked is that expenditure during retirement is rarely even. There is generally an increase in expenditure immediately after retirement as people start doing the things they didn’t have the time to do when they were still working, which then declines before increasing later in life to pay for care needs and medical expenses.
How much you can save up depends on many factors. Working out how much to put into your pension will be determined by future investment returns, contributions and inflation, as well as consideration about your future holds – both in terms of your remaining working life and the increasingly long retirement that you can now expect.
Although pension rules have changed considerably in recent years, some things remain the same. The best way to build an appropriate-sized pension pot is always to start early, to take advantage of compounding. It’s essential not to make the expensive mistake that some pension savers make – putting off funding a pension until they’re closer to retirement.
Deciding what to do with your pension pot
On 6 April 2015, the Government introduced major changes to people’s private pension provision. Once you reach the age of 55 years, you have much more freedom to access your pension savings or pension pot and to decide what to do with this money.
Whether you plan to retire fully, to cut back your hours gradually or to carry on working for longer, you can now tailor when and how you use your pension – and when you stop saving into it – to fit with your particular retirement journey.
Under the new flexible rules, you can mix and match a number of different options, using different parts of one pension pot or using separate or combined pots. But not all pension schemes and providers will offer every option – even if yours does, be sure to shop around.
Options at retirement
Leave your pension pot untouched
You might be able to delay taking your pension until a later date. Your pot then continues to grow tax-free, potentially providing more income once you access it.
Use your pot to buy a guaranteed income for life – an annuity
You can normally withdraw up to a quarter (25%) of your pot as a one-off tax-free lump sum, then convert the rest into a taxable income for life called an annuity. Some older policies may allow you to take more than 25% as tax-free cash. There are different lifetime annuity options and features to choose from that affect how much income you would get.
You can also choose to provide an income for life for a dependent or other beneficiary after you die.
Use your pot to provide a flexible retirement income – flexi-access drawdown
With this option, you can normally take up to 25% (a quarter) of your pension pot or of the amount you allocate for drawdown as a tax-free lump sum, then re-invest the rest into funds designed to provide you with a regular taxable income.
You set the income you want, though this might be adjusted periodically depending on the performance of your investments.
Unlike with a lifetime annuity, your income isn’t guaranteed for life – so you need to manage your investments carefully.
Take small cash sums from your pot
You can use your existing pension pot to take cash as and when you need it and leave the rest untouched where it can continue to grow tax-free.
For each cash withdrawal, normally the first 25% (quarter) is tax-free, and the rest counts as taxable income.
There might be charges each time you make a cash withdrawal and/or limits on how many withdrawals you can make each year.
With this option, your pension pot isn’t re-invested into new funds specifically chosen to pay you a regular income, and it won’t provide for a dependant after you die.
There are also more tax implications to consider than with the previous two options.
Take your entire pension pot as cash
You could close your pension pot and take the entire amount as cash in one go if you wish. Normally, the first 25% (quarter) will be tax-free, and the rest will be taxed at your highest tax rate – by adding it to the rest of your income.
There are many risks associated with cashing in your whole pot. For example, you may be subjected to a significant tax bill, it won’t pay you or any dependant a regular income, and without very careful planning you could run out of money and have nothing to live on in retirement.
Mixing your options
You don’t have to choose one option when deciding how to access your pension – you can mix and match as you like, and take cash and income at different times to suit your needs.
You can also keep saving into a pension if you wish, and get tax relief up to age 75.
Which option or combination is right for you will depend on:
• Your age and health
• When you stop or reduce your work
• Whether you have financial dependents
• Your income objectives and attitude to risk
• The size of your pension pot and other savings
• Whether your circumstances are likely to change in the future
• Any pension or other savings your spouse or partners has, if relevant
Many of us will face big financial decisions during our lifetime, whether it’s deciding how best to invest for retirement or how to take our pension.
Working out which course of action to take can be difficult, which is why it is essential to obtain professional financial advice on the various options available.
Pros and cons of an annuity
Receiving a regular retirement income either for life or for a set period
If you’ve saved into a Defined Contribution pension scheme during your working life, you’ll have to decide what to do with the pension fund you’ve built up when you approach retirement age. One option is to buy an annuity. An annuity is a type of retirement income product that you purchase with some or all of your pension pot. It pays a regular retirement income either for life or for a set period.
They include Lifetime Annuities – which pay you an income for life, and will pay a nominated beneficiary an income for life after you die if you choose this option – and Fixed-Term Annuities – which pay an income for a set period, usually five or ten years, and then a ‘maturity amount’ at the end that you can use to buy another retirement income product or take as cash
Advantages of buying an annuity
The money you get from an annuity can never run out: the provider guarantees to pay you a certain amount every month, however long you live.
No falls in value
This income will remain at the same level, and it will not fall if there is a stock market correction.
Protection against inflation
Some annuities – known as ‘index-linked annuities’ or ‘rising annuities’ – pay a higher monthly amount every year in order to counter the effects of inflation. But this feature comes at a cost, and income in the early years will be lower than with a level annuity.
Income for your spouse
A joint-life annuity can continue paying an income to your husband or wife after you die.
Higher income for people with health problems
If you suffer from a medical condition, such as heart disease or diabetes, you could be entitled to a higher annuity income due to your lower life expectancy.
Disadvantages of buying an annuity
Annuities are irreversible
Once you have entered into an annuity contract, you generally cannot change your mind and cash it in (although there are plans to allow annuities to be sold in some circumstances – the Government is currently consulting on how such a system would work).
Rates are low
As a result of the financial crisis and rising life expectancy, annuity rates today are about as low as they have ever been.
No chance of growth
If you left your money invested in the stock market, you could make considerable gains if share values rise – this could help provide a more comfortable retirement. The opposite is also true, and you could lose money and see your income and savings diminish.
Inflation can eat away at your income
If you opt for a level annuity, your income can lose much of its spending power over time as a result of inflation.
Shop around for your annuity
You don’t have to purchase your annuity from your pension provider, and you should shop around. Start by checking what your pension provider is offering, because they may still offer a higher payment rate than those available elsewhere. But you don’t have to go with them, and you can shop around for the best deal – this is known as the ‘open market option’.