Should you take a tax-free lump sum from your pension?
It's impossible to estimate how many conservatories, new cars and cruises have been bought with the tax-free cash investors can draw from their pension.
Most pension investors have, until now, considered this money - formally known as the pension commencement lump sum or PCLS - as an excuse to go shopping.
Laith Khalaf, pensions expert with independent financial adviser Hargreaves Lansdown, says: "Many people will mentally 'bank' their tax-free cash for a specific purpose - a round-the-world cruise or paying off the mortgage, for instance. There is nothing wrong with that, but you just need to make sure you hit retirement with enough savings to be able to use the tax-free cash for this purpose."
Low annuity rates, inadequate savings, increased longevity and now the threat that the government may drop the triple-lock guarantee (the promise that state pensions will increase each year by the lowest of inflation, earnings or 2.5%) after the next election, are forcing investors to reassess how they use their tax-free cash.
It's become vital to make the most of every part of your private pension savings, according to Chris Noon, partner at Hymans Robertson. "I think people will now use the tax-free cash to optimise their income. Fewer people will be able to take their cash and spend it: they won't be able to afford losing the income it could have generated."
The PCLS is cash you can withdraw from your pension fund any time from the age of 55. Provided you have not exceeded the pension lifetime allowance (currently £1.5 million, but due to drop to £1.25 million for the 2014/15 tax year) you can take up to 25% of the value of your fund free of tax, whether you have invested in a defined contribution (or money purchase scheme), or a defined benefit (final salary or career average scheme).
However, deciding whether to take the cash is not as straightforward as it sounds. The benefit varies considerably depending on what type of scheme you are invested in, and other factors such as the size of your fund and your state of health will also influence your final decision.
Always take advice
As with all issues to do with pensions, it is wise to seek independent financial advice when considering whether to take tax-free cash and what to do with it.
Taking your tax-free cash from a money purchase pension scheme is a fairly straightforward decision, even if you want to maximise the income you can generate from your savings. Noon says: "Provided you use tax-efficient wrappers like ISAs, it can continue growing and generating an income tax-free. But if instead you used this money to buy an annuity, the resulting income would be assessable for tax."
The income you generate by investing your tax-free lump sum might not be as high as that produced by an annuity. A £100,000 pension fund would buy a 65-year-old a level-term annuity of £5,800 a year, according to Hargreaves Lansdown. But the income generated by a £75,000 annuity combined with a £25,000 investment in an equity income multi-manager fund yielding 3.95% would produce a total of about £5,350.
There are still advantages to this route, says Khalaf: the investor has access to the £25,000, and there is potential for the investment and the income it generates to grow.
But he warns that such funds can fall in value too, adding: "An annuity gives you certainty and is paid for life, which shouldn't be underestimated."
Deciding whether to take tax-free cash from a defined benefit pension is much more complicated, as the impact on retirement income is potentially much greater.
Different pension schemes use different "commutation factors", the figures used to work out how much pension income you have to give up for a certain amount of tax-free cash. But Khalaf estimates that for a defined benefit scheme where the saver has a £10,000 annual income (before taking tax-free cash), the amount they could withdraw as cash would typically be £46,000, leaving them with a residual income of £6,900 a year.
"The important thing to bear in mind here is that the income from the final salary scheme is increased in line with inflation each year. This is a valuable benefit that needs to be considered," he says.
Many modern defined contribution schemes have been designed to enable you to take your pension in stages through income drawdown - where you leave the money invested and withdraw an income rather than buying an annuity.
This means you can "crystalise" or convert as much or as little as you like into tax-free cash and income drawdown as suits you at the time. If you are planning a phased retirement, gradually decreasing the amount you work, this offers considerable tax advantages, both during your lifetime and after.
Robert Graves, head of pension technical services at pension provider Rowanmoor Group, points out that if you are earning a salary and don't need to draw an income straightaway, you can still take tax-free cash by crystalising part of your fund without drawing an income.
"So if you would like £10,000 in tax-free cash, you could crystalise £40,000 into pension benefits, enabling you to take one quarter as cash and leaving the rest untouched but available to draw income from when you are ready," he explains.
This gradual conversion of a pension fund also helps the investor to reduce potential death duties on his or her pension fund. Hopkinson says: "If you take all your tax-free cash in one go, your estate could face a 55% tax bill on the remaining money if you die.
"However, if you have a pension that enables you to take tax-free cash from a portion at a time, it means you will only pay the 55% tax bill on that portion, not the whole of your pension fund. The remainder can be passed on to any beneficiary completely free of tax."
Deferring your state pension
You can build up a lump sum of cash by deferring your state pension for at least one year. The lump sum comprises the deferred payment plus interest at 2% above base rate, compounded.
Taking this cash cannot push you into a higher tax bracket, regardless of the amount, and once you've taken it, you will get the standard pension as normal.
Alternatively, you could choose to have a bigger weekly pension rather than a lump sum. For every five weeks you delay claiming, your future weekly allowance is increased by 1%. So after one year, you will get the full pension plus 10.4% extra, but this is not compounded.
Deferring could work well for those who plan to work on after state retirement age, but Khalaf says the benefits may be less generous for those who reach this age after 2016.
"Deferring state pension to get a lump sum is a reasonable, if not outstanding, deal, and it's probably a better deal to defer your state pension to get a higher income. However, the government is planning changes to the state pension and the terms of deferral are likely to become less generous from 2016 onwards. Indeed, the ability to defer and take a lump sum is planned to be abolished," he says.
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.
Money purchase pension
A pension plan where the level of benefit paid out in retirement is solely dependent on the accumulated value of the contributions. It’s another term for a defined contribution pension.
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 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.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
Defined benefit pension
Often referred to as a “final salary” pension, benefits paid in retirement are known in advance and are “defined” when the employee joins the scheme. Benefits are based on the employee’s salary history and length of service rather than on investment returns. The risk is with the employer because, as long as the employee contributes a fixed percentage of salary every month, all costs of meeting the defined benefits are the responsibility of the employer. (See also Final Salary).
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.