How will you fund your retirement? A guide to planning your income
Gone are the days when you were obliged to buy an annuity as soon as you retired. Following the introduction of new rules in April 2015, you can now take the cash to spend as you wish, leave it invested and draw an income from it, or take out an annuity. And you don’t have to choose one option and stick to it. Instead, you can mix and match– using a combination of all three – and give yourself the opportunity to change your strategy as and when your circumstances change.
Here, we explain the pros and cons of each of the three key options so you can start planning a strategy to suit you.
Take the cash
Prior to the reforms, only those with the smallest pensions could cash them in. Now, whether you have £10,000 or £500,000, you can take some or all of your cash from age 55. Yet, however tempting this might seem, you should think long and hard before cashing in your pension.
Tax: Only the first 25% of every withdrawal is paid tax-free; the remainder is added to your income for the year and taxed at your highest rate of income tax. You may even be bumped into a higher tax bracket for the year. Complicating matters further is the fact that your pension company won’t know anything about any other sources of income you might have, meaning emergency tax will be applied in the first instance.
Although you’ll be able to reclaim any overpayment, it could take a long time. In addition to a hefty income tax bill when you take cash out of your pension, you will also lose other valuable tax benefits. Money within a pension grows free of tax and, when you die, it falls outside your estate – meaning no inheritance tax will be payable on it either. If you die before the age of 75, your money can also be passed on to your chosen beneficiaries free of income tax.
Further saving: If you’re still working, it’s important to understand that if you make an ‘uncyrstalised fund pension lump sum’ withdrawal from your pension – that is you take a lump sum out without putting the rest into drawdown or buying an annuity – the amount of money you are able to save into your pension each year (your annual allowance) will fall from £40,000 to £10,000.
Can you afford it? The more money you take out, the less you’ll have to turn into an income. So before you cash in a penny, check you will still have enough pension to generate sufficient income, or are confident that you will have income from other sources.
Will your provider stand in the way? Although new rules permit you to access your pension from the age of 55, they don’t oblige providers to play ball. Even when you can get your money, you may find you have to pay a charge or find withdrawals are restricted. However, some providers are more flexible than others so it may make sense to transfer to a plan that will let you access it. This is set to become easier following confirmation the Treasury will curb excessive fees with a cap from March 2017, but is not yet known what it will be.
Is it right for me? If you urgently need the money, it can make sense to cash in all or some of a pension – for example, if you have debts to repay, or the pot is so small it won't generate a meaningful income. You can also cut your tax bill by spreading withdrawals across a number of tax years. It rarely makes sense to cash in larger pots.
You don’t have to cash in your pension to get control over your money. Income drawdown allows you to leave your money invested and take a regular income as well as lump sums as and when you need them. And, as you don’t have to take your money out of the stock market, it should carry on growing.
There are no restrictions to the amount of money you can withdraw and when you die any remaining funds can be passed on to your beneficiaries free of inheritance tax. If you die before age 75, everything can also be paid to your loved ones free of income tax. However, while drawdown offers investors maximum control and flexibility, it’s not without substantial risks.
Your income is not guaranteed: This is the key message for anyone relying on income drawdown to fund their retirement. If you live longer than you expect, spend too much, or a stock market tumble hits your capital, there is a very real risk you will run out of money. For this reason, experts suggest you start off only taking the ‘natural yield’ of your investments to ensure you don’t run down your capital too quickly.
You need to manage your investments: Going into drawdown is just the start of the process. You also need to select your own investments and be prepared to review them on a regular basis. Likewise, you’ll have to work out how much money you can realistically afford to take without putting your financial security at risk. There are numerous online resources to help, but if you are a novice investor and haven’t managed investments before it makes sense to pay an independent financial adviser to make those decisions on your behalf.
Is it right for me? Prior to the new rules, flexible income drawdown was restricted to the very wealthiest investors. Others could use income drawdown, but would see their income capped to the equivalent annuity payment. Although these restrictions no longer apply it’s worth bearing in mind the reason they existed was to prevent retirees from running out of money. As such, just because you can use income drawdown only wealthy investors should rely on
it to deliver their retirement income. If your savings are more modest but you still want the flexibility it offers, it may make sense to use some of your savings to purchase some guaranteed income with an annuity to ensure you can always pay your bills.
Have you done your research?
Don’t take money out of your pension, set up a drawdown plan or buy an annuity without ensuring you fully understand the implications of the choices you make. Ask yourself the following questions to find out whether you’re ready to make an informed choice:
- How much income tax will I need to pay?
- Is my income guaranteed?
- Could my income fall?
- Is my capital at risk?
- Could I run out of money?
- Will my spouse or partner have enough money if I die first?
- Will I be able to leave an inheritance?
- How much tax will my beneficiaries need to pay when I die?
Before the new rules, annuities were the default option for most retirees. In return for a lump sum, an annuity will provide you with an income that is guaranteed for life. You can opt for one that pays a level income, or one that starts lower and increases with inflation. Alternatively, you can select an investment-linked plan that leaves your money in the stock market in the hope it will deliver a rising income over time.
Any remaining funds are returned to your insurer when you die, but you can get around this by selecting guarantees that ensure payments are made for a fixed period of time (up to 30 years), irrespective of when you die or you can choose value protection that ensures unspent capital is returned when you die with the same tax perks as money still held within a pension. However, any protection you select reduces the level of income you get.
How much will an annuity pay me? This is the bugbear for most people. Thanks to increasing longevity and low interest rates, annuity rates have tumbled – meaning the incomes they pay are shrinking. In the last quarter of 2015 alone, the average annuity rate fell by 3.24%. So while a £100,000 pot would have bought you an average income of £9,090 a year at age 65 back in 2001, today the same retiree would get just £5,120 today, according to figures from Retirement Advantage.
Can I get a better deal? These numbers will disappoint many, but it is important to stress they are market averages and by shopping around it is possible to get more for your money. According the latest data from the Financial Conduct Authority, the difference between the best and worst rates at any one time is a typical 17% and, despite the fact that 80% of people will get a better rate by shopping around, a whopping 64% stay with their existing provider.
If you have any health problems, you may be able to get an even higher rate with an enhanced annuity from a specialist provider. The more serious your health problems, the higher the rate you will get (as your life expectancy will be less), but you don’t actually have to be ill to benefit. Factors including smoking, high blood pressure and being overweight will all boost your income.
According to Retirement Advantage, 60% to 70% of retirees could be eligible for an enhanced annuity, which, when compared with the worst standard deals, could boost your income by as much as 36%.
Is an annuity right for me? Annuities may be the product we love to hate – rates are poor and they are notoriously inflexible. However, they provide the one thing no other policy can match and that’s an income that’s guaranteed for life. And – what can be a big plus for many – is that once you’ve arranged your annuity, it’s done: there’s no need to keep reviewing it or panicking after every stock market crisis.
So while a super-wealthy retiree might not be advised to tie their money up in an annuity, the rest of us shouldn’t be too quick to write them off altogether. Whether you use all or part of your pension to buy an annuity, the key is to buy sensibly – by shopping around, arranging the protection you need for your family and taking advantage of an enhanced rate if you can.
Consider a ‘pick and mix’ approach
You can choose a combination of cash withdrawals, annuities and income drawdown to build a strategy to suit you. This might mean using an annuity to ensure you can always pay the bills and leave the rest invested.
This gives you access to lump sums as and when required and – with a good wind – some capital growth to help you cope with inflation as your retirement progresses. Alternatively, you may start your retirement in drawdown – perhaps using it to supplement part-time earnings – before annuitising further down the line.
Later on in your retirement you may lose the desire to manage your investments yourself and, especially if your health has deteriorated, find you can get better annuity rates than were available when you first retired. This is the real benefit of the pension freedoms: they allow you to keep your options open and make changes as and when your circumstances change.
In recognition of these changes, more insurers are now developing accounts that enable you to hold investments and an annuity in one account.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
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).
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
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.
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.