What are my options at retirement?
Maximising returns over the long term to secure an income for life
The vast majority of funds available to the UK market are aimed at saving in the run-up to retirement, known as the ‘accumulation phase’.
While diversification is a consideration, the primary aim is maximising returns over the long term and to increase the size of the eventual pension pot.
This situation has come about as previously funds were little used during retirement, known as the ‘decumulation phase’. Now, with pension freedoms, more investors can use funds as part of a decumulating portfolio.
Over-55s are now in full control of their retirement savings: they can draw on their pension funds however they deem appropriate and, usually, 25 per cent will be tax-free (with the remainder subject to income tax at your current rate).
The decumulation phase is the process of converting pension savings into a retirement income. The decisions an individual makes during the decumulation process are crucial. Unlike the decisions people make whilst they are still saving, decisions made at retirement are often one-off and irreversible. The decumulation phase has become an increasingly important part of the journey to retirement as we move away from Defined Benefit and towards Defined Contribution pension contribution arrangements. Defined Contribution arrangements require greater engagement to ensure the best outcome. In addition, the nature of the retirement process is changing as our needs, demands and expectations change.
Other relevant factors include:
- The rise in life expectancies – we are living longer which makes securing the best possible retirement income more important than ever
- Declining annuity rates – which mean you may wish to explore alternatives to purchasing a traditional annuity when you come to retire
- Expenditure during retirement – this is rarely even and is typified by an increase in expenditure immediately after retirement which declines before increasing later in life to pay for care needs and medical expenses.
How much you can save up for retirement depends on many factors.
Working out how much to put into your pension will be determined by future investment returns, contributions and inflation. In addition, there are considerations about what your future holds – both in terms of your remaining working life and the increasingly long retirement that you can now expect.
The best way to build an appropriate-sized pension pot is always to start early, thereby taking advantage of compounding. It’s essential not to make the expensive mistake that some pension savers make – putting off funding a pension until they’re closer to retirement.
Deciding what to do with your pension pot
Whether you plan to retire fully, to cut back your hours gradually or to carry on working for longer, you can now tailor when and how you use your pension – and when you stop saving into it – to fit with your particular retirement journey.
By mixing and matching a number of different options, using different parts of one pension pot or using separate or combined pots, you can tailor your funds available during (or before) retirement.
But not all pension schemes and providers will offer every option – even if yours does, be sure to shop around.
- Leave your pension pot untouched
You might be able to delay taking your pension until a later date. Your pot then continues to grow tax-free, potentially providing more income once you access it.
- Use your pot to buy a guaranteed income for life – an annuity
You can normally withdraw up to a quarter of your pot as a one-off tax-free lump sum, then convert the rest into a taxable income for life called an annuity.
Some older policies may allow you to take more than 25 per cent as tax-free cash. There are different lifetime annuity options and features to choose from that affect how much income you will receive. You can also choose to provide an income for life for a dependent or other beneficiary after you die.
- Use your pot to provide a flexible retirement income – flexi-access drawdown
With this option, you can normally take up to a quarter of your pension pot (or of the amount you allocate for drawdown as a tax-free lump sum), then re-invest the rest into funds designed to provide you with a regular taxable income.
You set the income you want, though this might be adjusted periodically depending on the performance of your investments.
Unlike with a lifetime annuity, your income isn’t guaranteed for life – so you need to manage your investments carefully.
- Take small cash sums from your pot
You can also use your existing pension pot to take cash as and when you need it and leave the rest untouched where it can continue to grow tax-free.
For each cash withdrawal, normally the first quarter is tax-free, and the rest counts as taxable income.
There might be charges each time you make a cash withdrawal and/or limits on how many withdrawals you can make each year.
With this option, your pension pot isn’t re-invested into new funds specifically chosen to pay you a regular income, and it won’t provide for a dependant after you die.
There are more tax implications to consider here than with the previous two options.
- Take your entire pension pot as cash
You can close your pension pot and take the entire amount as cash in one go if you wish. Normally, the first quarter will be tax-free, and the rest will be taxed at your highest tax rate – by adding it to the rest of your income.
There are many risks associated with cashing in your whole pot.
- You may be subject to a significant tax bill
- Your pension won’t pay you – or any dependant a regular income
- Without very careful planning you could run out of money and have nothing to live on in retirement
- Mixing your options
You don’t have to choose one option when deciding how to access your pension – you can mix and match as you like, and take cash and income at different times to suit your needs.
You can also keep saving into a pension if you wish, and get tax relief up to age 75.
Which option or combination is right for you will depend on:
- Your age and health
- When you stop or reduce your work
- Whether you have financial dependents
- Your income objectives and attitude to risk
- The size of your pension pot and other savings
- Whether your circumstances are likely to change in the future
- Any pension or other savings your spouse or partners has
Working out which course of action to take can be difficult, which is why it is essential to obtain professional financial advice on the various options available.
Pros and cons of an annuity
If you’ve saved into a Defined Contribution pension scheme during your working life, you’ll have to decide what to do with the pension fund you’ve built up when you approach retirement age.
One option is to buy an annuity. An annuity is a type of retirement income product that you purchase with some or all of your pension pot. It pays a regular retirement income either for life or for a set period.
- Lifetime Annuities pay you an income for life, and will pay a nominated beneficiary an income for life after you die if you choose this option.
- Fixed-Term Annuities pay an income for a set period, usually five or ten years, and then a ‘maturity amount’ at the end that you can use to buy another retirement income product or take as cash
Advantages of buying an annuity
- The money you get from an annuity can never run out: the provider guarantees to pay you a certain amount every month, however long you live
- This income will remain at the same level, and it will not fall if there is a stock market correction
- Some annuities – known as ‘index-linked annuities’ or ‘rising annuities’ – pay a higher monthly amount every year in order to counter the effects of inflation. But this feature comes at a cost, and income in the early years will be lower than with a level annuity
- A joint-life annuity can continue paying an income to your husband or wife after you die
- If you suffer from a medical condition, such as heart disease or diabetes, you could be entitled to a higher annuity income due to your lower life expectancy.
Disadvantages of buying an annuity
- Once you have entered into an annuity contract, you generally cannot change your mind and cash it in (although there are plans to allow annuities to be sold in some circumstances – the government is currently consulting on how such a system would work)
- As a result of the economic climate and rising life expectancy, annuity rates today are about as low as they have ever been
- If you left your money invested in the stock market, you could make considerable gains if share values rise – this could help provide a more comfortable retirement – but the opposite is also true, and you could lose money and see your income and savings diminish
- If you opt for a level annuity, your income can lose much of its spending power over time as a result of inflation
Shop around for your annuity
You don’t have to purchase your annuity from your pension provider, and you should shop around.
Start by checking what your pension provider is offering, because they may still offer a higher payment rate than those available elsewhere.
But remember: you don’t have to go with them, you always have the ‘open market option’.