Thanks to the pension freedoms, you can now do what you like with your pension from age 55. Whether you want a phased retirement, to simply relax, or embark on ventures new, you can structure your income to suit you
Prior to the pension freedoms – introduced in April 2015 – annuities were the default option for the vast majority of people. Only those with very small pots were able to cash them in, while only those with sizeable pots were able to use flexible drawdown.
Today, members of defined contribution pensions (so not final salary) can do what they like with their pension once they turn 55. You can take the cash, leave your money invested and draw an income, or stick with a traditional annuity.
These freedoms allow you to generate an income from your pension without surrendering your capital and increase or decrease that income as and when your circumstances change. If you have money to spare, it will also be easier to leave your loved ones an inheritance.
The difficulty is that you don’t know what the future holds, so that means you need to think about the challenges you are likely to face before you dive in.
How long will you live?
A good starting point is to think about how long your pension needs to last, or more bluntly, how long you, and any partner, are likely to live. This isn’t something we’re very good at, as Alistair McQueen, head of savings and retirement at Aviva, explains: “These savings are designed to last us for life, but we tend to be poor judges of our life expectancy. We make our judgements based on how long our parents or grandparents lived.”
Worryingly, lots of us also don’t want to think about our mortality. The results of the Great British Retirement Survey found 16% of men wouldn’t speculate on their life expectancy, compared to a fairly significant 25% of women.
Ironically, the survey also found that men were the most optimistic about their life expectancy – despite the fact that women tend to live longer. Some 40% of men think they will live between 20 and 29 years more, while 16% think they will live for another 30 years or more. This compares to 33% and 14% of women respectively.
The ONS online life-expectancy calculator shows that a woman aged 65 will on average live until she is 87, while a man can expect to live until roughly age 85
However, as Fiona Tait, technical director at Intelligent Pensions says, online calculators should be treated with caution. “They are just averages. Unless there is a known problem, we plan income to age 100 – the number of centenarians is increasing massively. Where you live, how much money you have – as wealthier people tend to be healthier – can all make a difference.”
During this process you will invariably think about your health, which should have a significant impact on your decisions. Poor health can relieve pressure on your pension if it is likely to reduce your life expectancy, but it could involve additional costs if you need to pay for care. Even if you are in rude health, it is still wise to factor in care costs further down the line.
Adrian Lowcock, head of personal investing at Willis Owen, says: “You need to face up to things such as life expectancy, now and in the future. Care costs can destroy people’s savings and it’s something many people don’t think about.”
Since April 2017, the amount you can pay into your pension once you have started taking taxable money from it has reduced from £10,000 a year to just £4,000 (known as the ‘money purchase annual allowance’). The exception is pots of less than £10,000.
This will be an important consideration for those who want to take cash from their pension, but are still making contributions. It is particularly important if you are expecting an inheritance or planning to pay bonuses into your pension.
Like grey hair and weight gain, inflation sneaks up on you slowly. You may not notice the effects of rising prices in the early years of your retirement, but as time goes on it may become apparent that your money doesn’t stretch as far as it used to.
Research from Canada Life shows that paying the bills is a priority for 65% of over-50s and that 33% are concerned about the cost of living in retirement.
Andrew Tully, technical director at Canada Life, says: “People are worried about how their finances are being stretched and are concerned about how they will be able to pay the bills. We continue to see an increase in the number of people who say they will work part-time following retirement due to the pressures on household finances.”
He adds: “Inflation manifests itself in two ways. Not only can goods and services cost more, but people will also find that the products they do buy won’t go as far due to ‘shrinkflation’. Both can have a significant effect on household budgets, especially for those who have fixed incomes in retirement.”
Although inflation has not been a big concern in recent years, it should not be dismissed. When the pension freedoms were introduced in April 2015, inflation was hovering just above zero, but by November 2017 it hit a five-year high of 3.1%. At the start of 2019 it was around the government’s 2% target, and as we entered 2020 it was at 1.4%. The Bank of England did predict it would dip below target at the end of 2019 – as a result of lower gas and electricity prices – but it does not expect this to last.
Currently, the state pension is at least protected from inflation by the highly contentious ‘triple lock’ – this guarantees it will rise by a minimum of either inflation, wage growth or 2.5%.
“The Conservatives pledged to retain the triple lock for the life of the next parliament, but, in the long term, it is an expensive promise and I’ve no doubt it will come under scrutiny,” says Tully.
This makes it even more important to think about how you manage other sources of income to ensure they have the capacity to increase over time.
Tully says: “People need a financial plan that not only secures an income to pay the bills throughout retirement, but is flexible enough to cope with inflation. Only then can you know how other savings can be used to create the retirement you’ve worked so hard for.”
As part of this, you will also need to consider what your spending habits are likely to be and how these could change during your retirement
Expect the unexpected
It’s important to remember that, however well you’ve mapped out your retirement, life doesn’t always go as planned. This means your plan needs to be sufficiently flexible to cope with a change of circumstances.
This could be the end of a marriage or start of a new one. You may enjoy a return to work, set up a new enterprise or find that poor health derails your plans. It may simply be that loved ones move overseas and you need to find cash for regular long-haul flights.
Only once you are aware of these challenges can you start to think about how you will spend your retirement savings.
Cashing in your pensions
When the pension freedoms were first announced, the option that garnered the most headlines was the new ability to cash in your pension from age 55.
This new flexibility means you can now use your pension to pay off any niggling debts, start a new business or invest in property. Alternatively, you may plan to help children out with university fees or buying their first home.
There is, however, a very big catch and that is, whether you are cashing in all or some of your pension, only the first 25% of any withdrawal is paid tax-free. The remaining 75% is added to your income for that year and taxed at your marginal rate – that is, the highest rate of income tax you pay. Depending on your income and the size of your withdrawal, it may be enough to bump you into a higher-rate tax band.
While there may be value in cashing in small pots if you have a specific need for the money – such as debts – the tax payable means cashing in bigger pots is unlikely to make sense. Experts are particularly concerned about people taking money out of their pensions simply ‘to get their hands on it’. The Financial Conduct Authority, for example, claims that 72% of people who have taken cash out of their pensions are under 65. More than half of pots (55%) were fully withdrawn and in 52% of those cases money was not spent but transferred into a savings account or other investment. It blamed a ‘mistrust’ in pensions.
However, taking money out of your pension just to put it in another savings plan is one of the worst things retirees can do with their cash. Not only will you have a tax bill to pay, you will also give up the tax protection offered by pensions. Within the pension wrapper, your money grows tax-free and can be passed on to anyone you like, free of inheritance tax. If you die before your 75th birthday, no income tax will be paid on it either. With interest rates remaining so low, you may also lose money in real terms if it sits in a cash account.
Whether you prefer cash or stocks and shares, you can also access the same types of investment without moving money out of your pension.
Even if you plan to spend the money, it’s important to consider the impact that this will have on your wealth long term. The more you spend now, the less income you will have in later life. Lowcock says this is particularly important when it comes to dishing out lump sums to help family – you shouldn’t let your desire to help them undermine your own financial security. “People can be over-generous, especially when it comes to children and grandchildren, so don’t splash out on gifts you can’t afford,” he says.
Income drawdown offers the epitome of flexibility for retirees as it allows you to leave your money invested and take income or capital from it as and when required.
“It’s like a bank account linked to an investment account,” explains Jamie Smith-Thompson, managing director of the pension adviser Portafina.
This means you are able to have total control over your money and have a flexible income, without giving up your capital or sacrificing valuable tax perks offered to savers in pensions.
It could be an ideal option for the growing numbers of people taking a phased approach to retirement and reducing their hours or ‘downsizing’ their job before they fully retire.
Many people may only need their pension to top up their earnings in the early years of retirement or don’t feel ready to commit to products, such as annuities, which cannot be reversed. The tax perks also make drawdown more attractive to those who are in poor health and want to protect their savings for their family, as well as wealthier retirees who want to leave loved ones an inheritance.
For those who are concerned about longevity – the risk of living ‘too long’ – and the effect that inflation could have on their finances, drawdown may also appear to be the answer. This is because your money can remain invested to provide capital growth.
But while flexi-access drawdown might appear to be all things to all people, there is, once again, a significant catch. It may offer unparalleled flexibility and tempting tax breaks, but it cannot offer any guarantees. A large stock market fall, for example, could wipe years off your savings and you may struggle to recoup your losses – especially if you are still drawing an income from your money.
At the opposite end of the spectrum, if you are too conservative with your investments you may miss out on vital returns. The FCA has expressed concern that a third of non-advised investors in drawdown were holding all their money in cash. However, by holding their money in a mix of assets, it says they could increase their annual income by 37% over a 20-year retirement. As a result, in 2019 it proposed that drawdown customers must make an active decision to invest predominantly in cash (rather than by default) and those customers that do should be given a ‘wealth warning’ of the risks of investing so heavily in cash by their provider.
Even if you invest wisely and stock markets are on your side, you could run out of money if you spend it too fast or live too long. “We always encourage people to try to live off the fund’s natural income,” says Lowcock. “But, in reality, we know that isn’t always achievable for many people and they will need to dip into their capital at some point.”
This complexity means it is sensible to get a professional adviser to run your portfolio for you. This will reduce your risks substantially.
“The DIY route is a bit scary,” says Smith-Thompson. “There is lots of data out there to show that a top-performing fund for three years won’t be top-performing over the next three. We use lots of trackers and make sure our portfolios are diversified across a wide variety of assets.”
But advice isn’t just about recommending investments – it will also help you manage your pot and offer guidance on how much you can afford to withdraw. “The most practical thing we can do is prepare a cash-flow model for you, illustrating your ongoing lifetime income, year-on-year, until you are 100,” explains Fiona Tait, technical director at Intelligent Pensions.
Research from Canada Life says that the average estimate of a ‘safe’ rate of withdrawal is 5.3% a year, but a worrying one in six over-50s think they can take 10% a year without running out of money.
Historically, people have talked about 4% a year as being a sustainable rate, while more recently Morningstar put it at just over 3%. But Tully says there is no such thing as a ‘safe’ rate – much will depend on your circumstances and the direction that your retirement takes.
“Five per cent could be sustainable: it just depends on your returns, when you die, and so on. It will also be different for investors who have other sources of income to fall back on. If it is your sole source of income you might need to be much more conservative.” He adds: “It also needs constant review. You can’t just pick a number and stick to it.”
By taking the responsibility out of your hands, IFAs will be better placed to stop you getting burnt. When markets are volatile, novice investors will often panic and sell their investments through fear of losing more money.
“When markets dip, it is common for people to want to sell up. But cashing in your chips just crystallises your losses,” says Smith-Thompson. An IFA could therefore also stop you making expensive mistakes.
Good advice doesn’t come cheap, however. According to Unbiased.co.uk, a website that helps consumers find financial advisers, retirement advice on a £100,000 pot will cost around £2,000, rising to £2,500 on a £200,000 pot. For people with larger pensions, this is likely to be a sensible investment – but for others the costs could be too great.
As great as it is to have control over your money and the ability to manage it flexibly, this isn’t always a priority for retirees. Research from Canada Life found that for 45% of retirees, certainty of income is the most important factor, ahead of flexibility at 28%, instant access at 18% and income growth at 9%. This means, for many, an annuity that pays a guaranteed income for life will be a much less stressful option. Once you have bought your annuity, you can be sure your income will carry on being paid, even if you live to 110.
You won’t have the responsibility of managing your investments or suffer palpitations when markets wobble. As Lowcock says: “It’s a personal decision, not a financial one. Some people just want the security.”
The downside is that the income you receive is likely to leave you disappointed. Today, a healthy 65-year-old with a £50,000 pension can expect an average annuity income of just £2,342 a year, according to figures from Canada Life.
You may, however, be able to top that figure by shopping around for the best deal – something most buyers fail to do. According to research from Hargreaves Lansdown, somebody with a £100,000 annuity could miss out on £592 every year by sticking with their existing provider. That works out as a loss of £11,845 over a 20-year retirement.
Retirees who are not in the greatest health stand to gain the most from shopping around. Enhanced annuities – which are only available from specialist providers – pay a higher rate of income to people with health problems or lifestyles that mean they are likely to have a lower life expectancy. You don’t have to be seriously ill to benefit; people who are overweight, have high blood pressure, smoke or have raised cholesterol can also get a higher income.
Just because your health or lifestyle suggests you are likely to have a reduced life expectancy, it doesn’t necessarily follow that you will. For some, enhanced annuities will offer exceptional value for money.
Lowcock says: “You never know what will happen. An annuity could end up being very attractive if you live longer than expected.”
While the humble annuity cannot claim to be anywhere near as flexible as income drawdown, you can still make provisions for a spouse or any other dependents when you die – by taking out a joint life plan or choosing one that guarantees payments for a fixed period of time, irrespective of when you die.
The rub is that these extra benefits come at a price and will reduce the level of income you receive.
You can also choose an index-linked annuity that starts off paying a lower level of income initially, but increases over time to help you cope with rising costs of living.
It may be more effective to leave some money invested to grow in the stock market, as you may have to live for a sizeable length of time before you recoup the income you lost in the early years.
Mix and match
There are pros and cons to each option, with none offering the perfect solution. Thankfully, you don’t need to make an either/or choice. Instead, you can use a combination of strategies to strike the right balance of flexibility and security for you.
Sean McCann, technical advice manager at insurance firm NFU Mutual, says: “People think they need to stay invested or buy an annuity, but you can mix and match. I might, for example, buy a small annuity and leave the rest invested if I am carrying on working part-time.”
Alternatively, you might start off in drawdown and then gradually start annuitising tranches of money once your circumstances are more settled, your health has deteriorated or you have simply lost the inclination to manage your finances yourself.
Another option might be to use an annuity to ensure your guaranteed expenditure – food, bills and so on – is covered and then invest the remainder. This will leave you with access to lump sums if you need them, shelter your wealth from tax and provide some protection from rising prices.
Whatever your circumstances, there is a lot to consider and you need to think carefully.
“Take your time,” advises Mr McQueen. “There is no ticking clock. You’ll have been saving this money for 40 years or more, so don’t just take a few days to think about what you’ll do with it.”
Care: how much does it cost?
Expect to pay an average of £15 an hour, with two hours a day racking up to £11,000 a year. For full-time care during the day, costs are likely to start at £30,000 a year, rising to £150,000 for round-the-clock live-in care.
Costs vary across the country, but the average yearly cost for care in a residential home is £32,344, rising to £44,512 with nursing care included. Expect to pay more than this in
London and the South East, or if more specialist care is required.
How much care should I budget for?
Life expectancy in care homes varies substantially, depending on how unwell residents are when they move in. The typical care-home resident will live 18 months, but for 25% of residents the typical stay is 4.25 years.
What are the chances I’ll need a care home?
Approximately 15% of those aged over 85 live in a residential care home, while 30% of people will use some form of local authority-funded social care in the final year of their life.
Sources: The Money Advice Service, Killik & Co, Laing and Buisson
Think holistically to pay less tax
When you think about income in retirement you probably just think about your pensions, but it is worth taking a more holistic view.
“Considering your pension in isolation is a bit one-dimensional,” says Justin Blower, head of sales at investment platform Ascentric. “People need to think about taking their income in the most tax-efficient way.”
Following a change of legislation that allows you to pass on money free of inheritance tax, it often makes sense to spend other assets first.
“Take as little income as you can from your pension and think about taking tax-free income from Isas, and onshore and offshore bonds that potentially have a tax-free allowance. Make use of your capital gains tax allowance on other investments,” Blower adds.
This article was first published in our sister publication How To Retire In Style.
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