Retirement is a big decision and one we all start to think about at some point or another. There are so many options on how to take retirement income, for the uninitiated it is a minefield. Making the right decisions can mean the difference between a comfortable retirement and one where you watch every penny.
People come to see us for one of two reasons.
They have had a windfall, from an inheritance or property sale and they have a sum of money that they would like to invest. They want to preserve the spending power of their capital over inflation and use the money later. Or the more frequent reason is that they have pensions and do not understand them. What they really mean is “Am I own track to be able to retire?” The answer to the question, “How much is enough?” is the key to an enjoyable retirement. A good financial planner will help craft a financial plan by estimating your retirement income needs and then work backwards to calculate what pot you need.
They normally fit a profile, in their late 40s or early 50s, children ending their education and the mortgage either paid off or close to being finished. They can see the next stage of life looming and their thoughts turn to taking their foot off the gas. If that sounds like you, there is a link to book a free initial consultation at the end of this blog.
Types of Pension
Broadly speaking pensions can be divided into two types. Money Purchase or Defined contribution schemes. This is when you have a pot of money and how much income you receive depends on several factors e.g. the contributions you make, this risk you take and the growth. It is likely that you will see the value of the pension rise and fall over the years because of the impact of market volatility, but all being well your pot should increase in value over the long-term.
The second type are called defined benefit or final salary schemes. Instead of a pot of money, you accrue a yearly income at retirement for each year you have been employed. This income is guaranteed and usually increases in line with inflation. Each defined benefit pension has its own accrual rates so how much you will get depends on the scheme rules. Fewer firms are offering defined benefit pensions because of the cost of providing them, they are extremely valuable and nicknamed “Gold-plated pensions”
In this blog when we use the word pension, we are referring to money purchase rather than defined benefit schemes.
Traditionally income was taken from pensions by purchasing an annuity. In fact, it was only in 2011 that the compulsory purchase of an annuity at aged 75 was abolished. Most of the people reading this will be aware of what an annuity is, but for the ones that need a refresher.
In exchange for some or all your pension pot an annuity provider will pay you a guaranteed income for life. There are several options available depending on your needs. You can choose to build in a spousal benefit, to provide an income for your partner should you predecease them. They offer guarantees that make sure that even if you die quite quickly after setting it up you get a certain amount of money back. And yearly increases in line with inflation are available.
The downside to annuities is their lack of flexibility. Once they are set up, they cannot be altered. If you don’t reach a reasonable age it is possible you won’t get as much back as you’ve paid in and they don’t allow you to vary the income to suit your needs or income tax position. However, if you do not have other guaranteed income you should always consider an annuity to cover your subsistence expenditure.
Pension drawdown in the new kid on the block. If you have some other secure income and appetite to take some risk it’s worth considering pension drawdown as an option for your retirement income.
Instead of giving away your pension, it is retained and controlled by you. This potentially allows you to benefit from further investment growth. As with money purchase schemes, it is likely you will see the value of your plan rise and fall due to market volatility. It is important to manage the investment risk you take.
You can access the tax-free cash without having to take a taxable income and most plans will allow you to phase your tax-free cash withdrawal, rather than withdrawing the whole 25% in one go.
The flexibility allows you to plan and minimise tax by only taking the income you need. It is well known that people are living longer but they are not healthier in old age, a drawdown allows you to withdraw more income in the early years and reduce it as you become less active. Please be aware that the tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.
The other major benefit is a recent addition called beneficiary drawdown, which allows any remaining pension fund on death to be inherited by your loved ones and retained as a pension. There will be another article on pension death benefits soon.
The major risk involved with drawdown is running out of money. None of us know how long we are going to live and calculating a sustainable level of income is critical. A good financial planner will put together a withdrawal strategy to avoid this happening.
If you are approaching retirement and would like to understand your options for income better, we offer a free pension review and initial consultation. You can book an appointment instantly using this link here.