5.1 Understanding your pension options
In this section you’ll learn more about the pension options you explored in the previous section.
First, watch this video where Emma Byron of Legal & General introduces these options.
Transcript: Video 3
So most people will receive from their pension provider an options pack as they approach retirement. And they'll set out four main options. The first being, you can stay invested. The second, you can take all of your cash. Thirdly, you can buy an annuity. Or finally, you can enter drawdown. So just to talk a little bit about what each of those mean.
So clearly, I think, we all know what taking cash would mean that you would take drawdown, the whole fund in one go. It's really important to think about the fact that only 25% of that would be tax free. The balance will be subject to income tax you. So you do need to make sure you're not going to push yourself into a higher income tax bracket than you would normally be paying.
You can also choose to leave your fund invested. If you don't need to access the money at the moment, then you absolutely don't need to take it. there's no obligation. You can choose when you want to access your pension fund nowadays. So that's definitely something to consider if you're worried about having sufficient funds in your retirement. The longer you can leave it invested, the longer you can keep contributing to it, and the shorter period you going to draw it down over, then clearly that's going to last you longer.
So an annuity is a product that provides you with a guaranteed income for life. So the insurance company-- you will pass the fund over to the insurance company and they will agree to pay you a set amount every month or every year, whatever you choose, for the rest of your life. So that insures that you won't run out of money.
But the important thing to be aware of with an annuity is it is a one time decision. You can't surrender annuity products. So you can't choose to take more money out of it than the company is paying you each month. So it is a one time decision. It's something you need to be sure about doing.
Finally drawdown, so drawdown, the fund is left invested. So you are subject to investment risk, but you have complete flexibility over how much money you take. The really important thing to note with that, though, is that your fund could be exhausted before you die if you take too much out, particularly in the early years. Or if there's a poor performance in terms of the funds, then you may exhaust them before you retire.
But with both annuities and drawdown, the really, really important thing that I can't emphasize enough is that people shop around. A lot of people stick with their existing provider, which is not always the best thing to do. Your existing provider won't necessarily provide you with the best annuity rate. And the fund charges and fees on a drawdown product will vary from provider to provider.
So it's really, really important to make the most out of your money in retirement that you really do your shopping around.
Now watch these three short videos which explain the options for using a pension pot. Then check your understanding by working through the activity below.
Transcript: Video 4
Before 2015 when pension rules were changed, most people converted their pension savings into a guaranteed income for life by buying an annuity with their pension pot. Now there are other options, but many people still choose an annuity as a way of protecting against financial uncertainty. Annuities can offer peace of mind as they provide a secure regular income.
You can split your pension pot. So if you want to, you can just use part of your retirement savings to buy an annuity so that you do get some secure income, perhaps to cover your basic expenses, like your bills. Remember, an annuity is a guaranteed income for life, no matter how long you live.
However, you need to be sure on the choices you make. You can't change your mind once your annuity has started, and you can't cash it in.
Unlike other financial products, with an annuity disclosing health conditions can help you get a better rate if these conditions may affect your expected lifespan. And this can apply to lifestyle choices too, such as drinking and smoking. Your pension provider may offer an annuity or another retirement product, but remember their rates might not be the best. So shop around and see who can offer you the highest income.
The income you're offered will depend on how much is in your pot, your age-- the younger you are, the lower the income offered will be. How much you decide to take as a tax free lump sum-- you can have up to 25%. Whether you include extras features, such as protection against inflation or providing an income for a partner or spouse after your death.
Your health, lifestyle, and occupational history-- this could help you get a better rate. Also current rates and the state of the economy.
An alternative to an annuity is to opt for a guaranteed income for a fixed time period. This option might be a tax efficient way to take retirement income. These products pay a regular amount for an agreed time, and some also offer a lump sum at the end. This can be useful as a bridge to a future date when another source of income starts.
Whichever option you choose, do you remember that your pension is liable to income tax. And do you bear in mind that when you opt for an annuity or another guaranteed income product, it's a one off decision that you can't change. So take your time to make sure it's the right decision for you.
Transcript: Video 5
Your pension pot is your money. So if you wanted to just take the whole lot right now you can, as long as you're 55 or over. But if you do, there are quite a few things to think about. Firstly, you'll lose a fair chunk of it in tax, because you can only take 25% tax free. You'll have to pay tax on the rest, and of course, the amount could easily put you in a higher tax bracket. It may be more tax efficient to take the money in smaller lump sums over a few years.
If you're claiming any means tested benefits such as pension credit, housing benefit, or council tax support, then a large lump sum could mean you're not entitled to them anymore. Also, if you withdraw more than the tax free part of your pension, there is a limit, currently 4,000 pounds per year on new contributions into your pension pot. Beyond this limit, you're liable to tax. And possibly the most important question of all, will you have enough money to last for the rest of your life, and what will you do if it runs out?
Transcript: Video 6
If you like keeping your options open and don't mind doing a bit of financial homework, then you might want to manage your pension income yourself. You could choose to move your pension pot into drawdown. You can then take your 25% tax free lump sum while leaving the rest of it invested where it can continue to grow, taking further money when you need to, either as a regular income or occasional lump sums.
With this approach, you're responsible for managing your own pension pot, and taking decisions to make sure that you have enough to live on while still leaving money invested so that you don't run out later in retirement. Ultimately, any money that's left in your pot becomes part of your estate.
Taking your pension this way means that you'll benefit if investments do well, but you'll also carry the risk if investment performance is poor. A significant concern with the drawdown approach is that predicting how long you'll live, and therefore how much money you'll need, is far from an exact science. Based on national averages, a woman of 68 today has a one in four chance of living to 94, and a 1 in 20 chance of reaching 100.
Unless the withdrawal of money from a pension pot has been very carefully managed, by that age, and potentially when her needs are greatest, the funds might have been long spent. Of course, you can combine approaches, and perhaps have the drawdown approach in the earlier years of your retirement. And then in later years, either buy an annuity or choose other approaches that require less ongoing financial management.
Activity 3 Exploring your pension options
Having looked at the options for using a pension pot, what do you think are the pros and cons of choosing:
- A guaranteed income for life (an ‘annuity’)?
- A guaranteed income for a set period?
- A mixture of these options?
A guaranteed income for life (an annuity)
Choosing a lifetime annuity provides certainty about your pension income as it pays out a regular fixed income until you die. This will mean you can check, with confidence, how far it will go to meet your spending in retirement.
There are additional features available on annuity products such as inflation-proofing the payments, protecting some or all of the money used to buy your annuity, or ensuring your spouse or dependant continues to receive some or all of the income should you die before they do. Having health issues could increase the return you can get, so disclosing your health and lifestyle details may mean you qualify for an enhanced annuity. And do shop around for the best annuity deal as what you can get varies between annuity providers.
As people are living longer and long-term interest rates have fallen, annuity rates have reduced in recent years, but they are guaranteed. Also, buying an annuity is a very important decision which can’t be reversed.
A guaranteed income for a set period
Taking your pension pot through a fixed term plan is a good way to provide certainty about your retirement income for a set period of time. This could be a tax-efficient way to use your pot – particularly if your total income each year is no more than your personal (tax-free) allowance. Some of these products pay a fixed amount through the term and others offer a lump sum at the end of the term as well as regular payments. This lump sum payment can then be used to purchase another retirement income product or taken as cash depending on your circumstances and the amount payable.
The downside is that these plans have a set term – and at the end your pot may be used up and you will get no more pension income from the plan. This could mean that you have less income than you need in later retirement.
Choosing drawdown provides more flexibility with how much cash you can take, and when, from your pension pot. This will help you manage those periods when your spending increases (for example, bills for home maintenance). This might also be useful if you’d like to access the tax-free cash amount from a pension pot. With drawdown your money is invested in your name and therefore you are responsible for managing the investment and the amount you withdraw. You would be susceptible to financial market lows as well as benefiting from the highs. If you spend money too quickly you could be short of money later on in retirement.
A mixture of these options
You may want to use different options if you have more than one pension pot. You may choose to take a larger lump sum at the start of your retirement to pay off debts, or to spend on major projects and plans (e.g. a world cruise or on renovations to your home). You could then use other pensions to provide that regular income you need to cover routine annual spending – perhaps using your state pension to cover your major essentials and your private pension to cover other spending.