Retirement planning for ill health

25 August 2015

Like it or not, retirement planning is a morbid business. However much you might be looking forward to holidays or more time on the golf course, working out how much you have to live on ultimately means giving some consideration to how long it needs to last.

For those lucky enough to be in rude health, the emphasis is on inflation-proofing and stretching your pot out for as long as possible. But if your health isn't 100%, it may mean squeezing as much out of your pension as you can while you are still around to enjoy it, or taking steps to protect the money for your loved ones.

Thankfully, the new reforms that allow you to do what you like with your pension savings, combined with changes to the taxation of pension benefits on death, make both these objectives at least a little bit easier for members of defined contribution schemes.

Your options will ultimately be the same as any other retiree: you can take the cash, leave it invested within a pension and go into income drawdown or buy an annuity. However, how you use them might be different.

Taking the cash may seem like an attractive option for those who are very seriously ill and may only have a year or two left to live. However, cashing in your pension could leave you with a hefty tax bill.

This is because only the first 25% is paid tax-free, so you have to pay tax at your highest rate on the remaining 75%. The taxman will regard this payment as income for the current year, which could see you bumped up into a higher tax bracket.

People who have always paid basic-rate tax could become higher-rate taxpayers overnight. You'll also lose some fantastic tax perks. Once you take money out of your pension, it will form part of your estate when you die and could be liable to inheritance tax (IHT) – currently charged at 40% on estates worth £325,000 or more. Likewise, thanks to the abolition of the 55% death tax, if your money is still in your pension when you die, you may be able to pass it on without paying any tax.

If you die before the age of 75, the money could be passed on tax-free to the beneficiary of your choice.

Alternatively, if you died at 75 years or older, your beneficiaries would only start paying tax on the money when they drew an income from it, and at their marginal rate. In either case, no IHT would be payable.

As such, Ray Chinn, head of pensions and investment at LV=, says drawdown has become a more viable option. "It has opened up a whole new set of benefits," he explains. "You can now leave your money to whoever you want; it's no longer just financial dependants."

Indeed, these benefits are so valuable that Chinn says if you can manage it, it's worth spending any other assets first. "The last place you want to take money from is your pension," he adds.

Of course, you can still buy an annuity. Although rates remain pretty dismal, poor health counts in your favour. Chinn adds: "Most of us feel conditioned to keep details of ill health to ourselves but it's the opposite in retirement – the more information you can give the underwriters the better." This is because if you can prove you have a lower life expectancy, the insurance company will pay you a higher income.

Analysing your health

Which option works best for you will very much depend on the nature of your health problems.

If you're in the unfortunate position of being very seriously, or indeed terminally, ill an annuity may not be a sensible option – even with enhancements based on your medical condition. This is because any unused funds will be returned to the insurance company unless you have extended guarantees or value protection.

"Why give away your pot to your pension company when you may only live a year or two?" says Jonathan Watts-Lay, a director at Wealth at Work.

But however bleak your outlook, bear in mind the tax perks you'll lose by taking the cash. Going into flexible drawdown will enable you to get your hands on your money when you need it and it will remain sheltered from tax both during your life and once you've died, and any remainder is passed on to your loved ones. "If you're really poorly, it's worth holding on to the money in your pension for as long as possible," says Danny Cox, head of communications at Hargreaves Lansdown.

The decision-making process is arguably more complex for those who have suffered serious health problems but could still live for many more years. In these cases, the flexibility of income drawdown – where you can vary your income according to your needs – coupled with the fact that it's easier to pass on all that money you've amassed in your lifetime to your loved ones when you do pass away – can be very appealing.

But, as Cox says, the risks associated with this option are the same whether you are ill or not. "With drawdown, if you take too much money in the early years your fund could dwindle, just as it would with a healthy person." With the risk of outliving your money to consider, experts agree that people shouldn't be too quick to dismiss annuities.

"Enhanced annuities work well and boost your income if you aren't sure how long you will live," says Cox. Just because you've been seriously ill, it doesn't necessarily follow that your life expectancy will be any less than someone who's as fit as a fiddle.

Jim Boyd, director of corporate affairs at Partnership, explains that while enhanced annuities will be individually underwritten, they will still be based on average life expectancies, albeit from people with similar issues. And, however much data an underwriter has, predicting life expectancy is not an exact science. "A significant number of people will live longer than expected."

He cites the example of a 63-year-old woman with stage three ovarian cancer. Although there is a 60% chance she will die in the next five years, if she overcomes that hurdle there's a 35% chance she'll live for another 25 years and a 5% chance she'll survive 40 years. "It's a classic kill or cure situation and an insight into the risks people can run," says Boyd.

But it's the risk that you'll die earlier than anticipated that puts many retirees off annuities. "One of the big problems people have had with annuities is that if you buy one, then die six months later, a lot of money goes back to the insurer, even with a 10-year guarantee," explains Andrew Tully, pensions technical director at Retirement Advantage.

To a certain extent, this problem has been tackled by the pension reforms. Under the new rules, insurers can now offer guarantees of up to 30 years, when previously they were capped at 10. Here, payments are guaranteed for your chosen period irrespective of whether you have died.

Alternatively, you can opt for value protection that ensures unspent funds are returned to your estate when you die. This option has always been available but, until April, a death tax of 55% made it less worthwhile. Currently, a 45% tax rate applies but from April 2016 it will be taxed in the same way as income drawdown.

This peace of mind comes at a cost but if it means you get a guaranteed income for life without the risk of waving goodbye to your capital if you die ahead of time; you may decide it's an 'insurance policy' worth buying.

According to Retirement Advantage, a £50,000 pot would pay an income of £2,752 at age 65; however, to guarantee for 20 years, it would drop by £163. By comparison, a 65-year-old smoker would get £3,054 a year without any protection or £2,785 with 100% of the remainder returned.

Form a strategy

What will work best for you will depend on your state of health and your life expectancy but it shouldn't be the only factor. Whether you're visiting the GP more often than you'd like or are seriously ill, you'll need to think about the income you'll need, tax that will need to paid during your life and once you've died, as well as provision for spouses and other loved ones you may want to leave money to. As Chinn says: "There are no 'yes you should' or 'no you shouldn't' answers."

The good news is that you don't need to commit to a strategy on day one. "You don't have to convert all of your pension in one go," notes Cox. You might, for example, start off in drawdown but buy an annuity further down the line or those with larger funds might slice off portions of their funds and guarantee income in tranches with a number of annuity purchases over their retirement.

Others might opt for a blended solution. "It's about insurance versus flexibility," Cox adds. This might mean annuitising part of your pot and leaving the rest in drawdown to get the best of both worlds. "You might use guaranteed income to ensure you have enough money to meet your everyday living needs and then be flexible with the rest."

But whichever route appeals to you, it's worth consulting an independent financial adviser. They'll work with you and your prognosis to come up with a plan that gives you the income to pay your bills today and provide for you and your family's future. It may seem like just another expense but one salient tip could quickly recoup your money. "Get some good advice," says Chinn. "£500 spent might save you £10,000 in cash."