In this article we briefly review the landscape before pension freedom, discuss three ways in which you can withdraw your pension savings and highlight some factors to consider when choosing between the three ways.
Prior to pension freedom most savers reaching minimum retirement age of 55 could take up to 25% of their pension savings as a cash lump sum. With the rest they had to purchase an annuity or leave the money in their pension while withdrawing variable income from invested funds. In most cases withdrawals were subject to maximum annual limit. The objective of this so called capped drawdown was reducing the risk of individuals depleting all their savings quickly and falling back on state benefits.
A minority of savers satisfying a minimum income requirement could enjoy uncapped flexible drawdown. They could withdraw unlimited income from their pension savings.
This all changed in April 2015. Savers now have three ways in which they can withdraw all their pension savings: (1) cash lump sum; (2) flexi-access drawdown; and (3) annuity. How and when you access your pension is entirely up to you.
The first way is cash lump sum – you simply withdraw your pension savings and do whatever you want with them. While it sounds attractive, there is a catch: taxes. All withdrawals from your pension are subject to income tax at normal marginal rates (visit www.gov.uk and search for income tax rates and personal allowances). Normally, up to 25% of the cash lump sum is tax-free. On anything above it you pay income tax. You do not need to take all your tax-free lump sum upon retirement. You can spread the lump sums, with 25% of each tax-free.
Income tax is levied on withdrawals in each tax year (running from April to April the next year). Therefore, spreading the amounts you withdraw across different tax years minimises your tax bill.
The second way to withdraw pension savings is flexi-access drawdown. Under this arrangement whatever is left after taking the cash lump sum remains in your pension. You withdraw as much as you need when you need it.
The advantage is that money in your pension can remain invested. It can continue growing tax-free, either through interest on cash deposits or income and gains on investing. You pay income tax only on what you take out, deferring tax to when taking money out.
The third and final way to access pension savings is buying an annuity. Annuity is a financial product offered by insurance companies, which promise to pay income for the rest of your life. For example, on every £100,000 you use to buy an annuity you can get an income of £5,000 per year.
Income from annuities depends on annuity rates (5% in the example above). Annuity rates are mainly a function of long-term gilt yields, the annuity’s features (such as guarantee period, during which payments continue to dependents even if the annuity holder dies, or indexing payments to inflation) and your personal circumstances (such as age and health).
When reaching retirement, shop around for the best annuity rates on the market. One good source which explains the details of annuities and other subjects on pensions is www.pensionwise.gov.uk. The Internet also has plenty of sources with current annuity rates and providers.
So, you have three choices to access your pension savings but which one should you choose?
The answer depends on your circumstances and needs. Each of the three ways plays a role, with its advantages and disadvantages. The best solution is probably blending all three.
Take up to 25% tax-free cash lump sum. Use it to pay off debt, purchase your home or a property and spend some (not all of it) on a red Ferrari. Ensure you have enough savings left to provide sufficient income for the rest of your life. One of the worst things that could happen is running out of money after retirement. You want a financially independent, comfortable life. This calls for discipline and prudence.
Consider using some savings to buy an annuity. Together with Sate Pension and other sources of guaranteed income, such as defined benefit (final salary) pension, annuity can provide for your minimum financial needs. Longevity risk is living longer than expected. Annuity is a way to mitigate this risk since it pays a lifetime income.
One disadvantage of annuities is the current depressed rates. The yields on gilts have hit an all-time low recently, following Brexit, and so are annuity rates. And if you want your annuity payments to keep pace with inflation, rates are even lower.
Another disadvantage of annuities is inflexibility – currently you cannot change your mind and sell your annuity to get back some of the money you used to purchase it. This may change with the introduction of a secondary market for annuities. But until then, annuities are rigid.
Use flexi-access drawdown arrangement with some of your savings. Your pension is a tax-efficient vehicle to wrap your investments. Withdraw income from your pension, topping up other sources of income, depending on your variable needs. You may live many years and prosper after retirement. You want your money to continue working for you, generating returns above inflation.
Flexi-access brings much needed flexibility. You can access the money if you need in case of an emergency or if your circumstances change. The disadvantage of flexi-access relative to annuity is that income is unsecured and you may need to take investment risk to generate an income surpassing that of annuities.
You have three ways to access your pension savings. Mix them to generate secured income for a lifetime to satisfy necessities, variable income to provide for discretionary spending, while minimising taxes, mitigating inflation risk and incorporating flexibility.
Yoram Lustig is the author of the new Financial Times Guide: Saving and Investing for Retirement. It is out now, priced £26.99 from FT Publishing, and available from Amazon.