Drawing your pension: what you need to know
Once you're retired, there are two main ways you can draw an income from your pension.
The most common option – an annuity – pays guaranteed income for life that will depend on factors such as your life expectancy.
Annuity types include:
LEVEL - This pays the same amount of income year in, year out.
JOINT LIFE - Your partner will be paid an income after you die. The more you choose to be paid out after your death, the smaller the income you receive while you are alive.
INFLATION-LINKED - The payouts rise and fall in line with the annual rate of inflation, as measured by the retail prices index. Over the long term, this can be beneficial as income will keep pace with living costs, but initial rates will be far lower than level annuity rates.
SHORT-TERM - This pays income for no longer than five years. It may be attractive to someone who wishes to defer buying a lifetime annuity.
You can choose to take regular taxable income. This increased flexibility, however, may lead to increased administration costs. And the income you receive isn't guaranteed, as the value of investments can fall as well as rise.
But with annuity rates at an all-time low, it's becoming a more popular option.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.