The new pension rules: how will they affect you?
What will you do with your pension?
Until now savers have had very little choice. The vast majority had no option but to buy an annuity – which in return for your pension fund provides an income for life.
Only those with the biggest pensions would leave their funds invested and draw an income from it, while only those with the very smallest of funds could take the lot as cash.
As of April this year, savers in defined contribution schemes can do what they like with their money even if that means blowing the lot on sports cars or round the world cruises.
The message is clear. You worked hard to save it, now when you retire you can spend it as you wish. But while the new freedoms give you the opportunity to get a better deal, it puts that responsibility for finding it on to you.
Savers essentially have three key options: cash in their pension and take the money, leave it invested and use it to generate an income, or buy an annuity. Or a combination of the three.
Sadly, there is no one size fits all plan; what makes most sense for you will depend on a whole host of factors including your age, your state of health, the size of your pension, your attitude to risk, your desire to leave an inheritance, as well as your needs for flexibility and or security.
Here's our guide to the options open to you once the new rules kick in during April.
Taking the cash
You can now take all of your pension savings as cash and do what you want with it. But before you get carried away, there is a very significant catch and that is tax.
Only the first 25% of your pension is paid tax-free; you need to pay tax at your highest rate of tax on the remainder. And when you consider that the lump sum will be considered as income for that year, there is a very good chance it will bump you up into a higher-rate tax band.
As a result, if you pay a higher level of tax and have a large pension, taking the lot as cash could be prohibitive from a tax point of view. However, the tax impact could be reduced if you gradually stagger withdrawals over a number of years. The tax hit will not be so great for individuals with smaller pension savings and who pay a lower rate of tax.
Of course, you don't have to cash in your whole pension. From the age of 55, you can start taking money out of your pension - the government has given these withdrawals the catchy title 'uncrystallised pension fund lump sums'.
However, as only the first 25% of each withdrawal is paid tax free, if you want to take your full 25% tax- free cash - known as your pension commencement lump sum - you will have to cash in your whole pension and either stump up the tax on the remainder or move it into a retirement income vehicle which, at the moment, would need to be an annuity or income drawdown plan.
Until now, income drawdown has been the preserve of wealthier retirees but, following the relaxation of the pension rules, flexible drawdown is open to all. In a nutshell, this involves investing your money into a drawdown plan (your existing pension provider may offer this or you may need to open a new self-invested personal pension). You select where you want your money to be invested and start taking an income off it.
If you are in the fortunate position that you do not need an income, you can leave it to accumulate, taking lump sums as and when you need them.
The main advantage to income drawdown is control. You decide where your money is invested and how much or little income you take, allowing yourself to make changes as and when your spending needs change.
Another boon is that your money is invested. This means it should carry on growing, providing a useful hedge against inflation, which sees the value of your money reduce over time.
However the very significant downside is that because your money remains invested it could take a hit if stockmarkets fall. It also cannot guarantee to provide you with an income for life – take too much and you could run out of money.
Work means that most of us are used seeing to our bank balances replenished every month. However, the only way to carry on receiving a guaranteed income for life in retirement is with an annuity.
In return for a lump sum from your pension (be it all or some of your fund), insurance companies will pay you a guaranteed income for life. You can choose a level income or choose one that starts at a lower level but increases over time in line with inflation. The level of income you receive will depend on your life expectancy – so if you have any health problems – including issues such as obesity or high blood pressure – which could shorten your life, or you smoke, you could benefit from an enhanced rate.
However, the guarantees offered by annuities come at a price. When you die, any remaining funds that have not been paid out to you are returned to the insurer: effectively, those policyholders who die before their money has been spent subsidise those who outlive theirs.
You can protect yourself from this to a certain extent by purchasing an annuity with guarantees that ensure your payments will be maintained for a fixed number of years, irrespective of when you die. So if you died three years into a five-year guarantee, payments would be maintained for two years after your death.
Spouses can also be protected with joint- life annuities – enabling the policyholder to protect a portion of their income for their other half after they have died. Alternatively, some providers offer value-protected annuities, which return either all or a portion of your remaining capital if you die earlier than anticipated.
However, while these guarantees may increase your peace of mind they will reduce the level of income you receive. And this is the real nub of the problem of annuities for many people: the level of income they receive. For a variety of reasons (increased longevity, lower interest rates, falling gilt yields and quantitative easing, to name but a few), the level of income insurers are able to pay has plummeted in recent years.
According to figures from MGM Advantage, £100,000 would buy a 65-year old an income of £5,454 a year. However, 10 years ago that same figure would have secured an income of around £7,000, 15 years ago it would have paid £9,000 and 20 years ago it would have paid £12,000 – more than double todays figure.
These problems make it even more important for people seeking the security of an annuity to shop around for the best rate, rather than plumping for the first deal offered to them buy their pension provider, and to declare any health problems. Enhanced rates typically pay 30% more than standard annuity rates, according to MGM Advantage.
Find out everything you need to know about the new pension freedoms and how to plan ahead for the retirement you deserve with the new issue of How to Retire in Style. The magazine is available to buy now from all leading newsagents, priced at £4.99. It can also be ordered online here for £6 including postage and packing.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
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.