Drawing the most from your pension
After spending years building up a pension pot to fund retirement, it's important to invest some time into considering how you'll take income from it. Getting this right will not only boost your income but can also deliver tax benefits for you and your beneficiaries.
The earliest you can start taking pension benefits is age 55, and there are several options you can take.
"You can choose between taking an annuity, going into an unsecured pension (USP) or taking a phased approach," says Mike Morrison, head of pensions development at AXA Wealth. "Your choice will be determined by what you want to achieve, as well as your attitude to risk."
The most common and straightforward option is to take an annuity. With this you exchange your pension pot, minus up to 25% in tax-free cash, for a guaranteed income for life.
Rates are based on age, sex and health, as well as the yield on long-term gilts. Because the annuity you buy will affect your standard of living for the rest of your life, it's important to scour the market, rather than go with your pension provider's annuity offer.
"You can increase your income significantly by shopping around, especially if you have health problems that will mean you're entitled to an enhanced annuity," says Morrison.
"Also, think about whether you want your income to rise; a guarantee to return some of your fund if you die prematurely; and whether you want to provide a pension for your spouse. Once you've made the decision, you can't reverse it."
As well as the straightforward annuity, a number of 'third-way' annuities have come onto the market in the past few years.
Among these are variable annuities, where your pension pot is invested in the financial markets, offering the potential to grow your pot, as well as derivatives to give protection from market falls.
Temporary annuities, offered by the likes of Living Time, LV= and Canada Life, are also an option. These allow you to delay annuity purchase in the hope that your pot will grow or your health deteriorate, thereby earning you an enhanced rate.
These offer greater flexibility but as Tom McPhail, head of pensions research at Hargreaves Lansdown, explains, there can be potential pitfalls:
"Variable annuities are expensive, with running costs around 3% a year. With the temporary annuity, although it allows you to keep your options open, there is a risk that annuity rates will have fallen when you come to take one," he says.
Instead of handing over your pension pot for a guaranteed income, you could go for an unsecured pension. With this, you take your 25% tax-free cash and the remaining fund remains invested to provide an income.
The income you take can be varied between 0 and 120% of the rate set by the Government Actuary's Department (GAD). This rate is based on the 15-year UK government bond yield and, like annuities, varies with age and sex.
John Lawson, head of pensions policy at Standard Life, adds: "If you took 100% of the GAD rate you'd get roughly the same as if you'd taken an annuity."
Being able to flex the amount of income you receive can be a major benefit, especially from a tax perspective.
Lawson says: "If you were cashing in an investment or receiving income from a piece of consultancy work, you could turn the income off from your pension if it was going to push you into a higher tax bracket." He adds that this will become more important with the new higher rate of capital gains tax at 28%.
It's also important to consider the death benefits of a USP. Unlike an annuity, where you'll only get a refund if you paid for a guarantee or put a spouse's pension in place, a USP allows you to pass on a greater return to your beneficiaries.
If you die with a USP the remaining fund can pass to your spouse or other dependant, who can continue to draw down income from it or convert it into an annuity. Alternatively, they can take it as a lump sum, subject to a tax charge of 35%.
Although there's greater flexibility and the death benefits are better than on an annuity, there are risks. As your pension pot remains invested, you're subject to the whims of the stockmarket.
"You need to assess your investment profile carefully," says Morrison. "Too high risk and you could lose your retirement income; too cautious and you won't achieve sufficient investment growth to justify going into an USP instead of taking an annuity."
To counter this, many providers insist you have a fund of at least £50,000 and some advisers say more. Matt Pitcher, senior client partner at Towry, says: "I wouldn't recommend a USP unless someone had at least £100,000 in their pension. An annuity takes away the risk.'
It's also possible to take a phased approach to drawing your retirement income. With this, your pension is split into segments, allowing you to take tax-free cash and draw an income from some segments, either through a USP or by converting into an annuity, while others are left untouched.
This approach presents good opportunities for financial planning, as Pitcher explains: "Because you can take a mixture of tax-free and taxable income, you can adjust what you receive to complement other income sources."
For instance, if you took a part-time job, you could take more tax-free cash to keep your income within your personal tax allowance or below the higher-rate tax bands.
Another advantage of the phased approach is the position on death benefits.
Colin Batchelor, head of pensions technical services at Legal & General, says: "The death benefits for the segments where you have taken tax-free cash are the same as for a USP but the segments that are untouched receive preferential treatment. These can be paid tax-free to a beneficiary."
Because of this death benefit position there are advantages to moving into phased retirement, rather than taking the full 25% tax-free cash upfront and leaving the remaining fund invested.
Although the coalition shelved the requirement to take an annuity or switch to an alternatively secured pension (ASP) at age 75, effectively killing off this option, some over 75s are already in an ASP.
This allows you to remain invested in much the same way as a USP but there are two major differences – the income limits and the death benefits – which make it considerably less attractive.
In an ASP you can only take between 55% and 90% of the GAD rates. Additionally, the rates are set at age 75 throughout an ASP so your income levels aren't going to rise significantly.
The position on death benefits can be even harder to take. You can leave it to a charity or as a pension benefit to a spouse or dependant, but if these options aren't possible the remaining fund could face a tax charge of up to 82%.
But, if you don't want to benefit the taxman to this extent, you can switch to an annuity at any point.
This article was originally published in Money Observer - Moneywise's sister publication - in November 2010
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 familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
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.