In April 2015, the Government finalised a major change in the rules surrounding pension options for income in retirement. This is known as Pension Freedoms and has ensured that you have much more control over how you utilise your pension to work for you. Whilst generally being a very positive change, it has meant that the options available to you in retirement are more complex than before. Understanding your choices is key to making sure your pension pot is maximised and allows you to complete all of your retirement goals.
Retirement presents an exciting opportunity to live the life you have always dreamed of. You have spent your entire life working – first towards your education and followed by your career, and now you have earned the right to kick back and do all the things that bring you happiness. During this time, the last thing you want to do is worry about money. With the steady decline of final salary pension schemes, more and more retirees are left with a large sum of money at retirement to try and use to their advantage.
Before 2015, pension annuities were the most popular form of income in retirement. After Pension Freedoms, however, savers have generally preferred to use their newly offered flexibility. Purchasing an annuity generally involves taking 25% of your pension pot as a tax-free lump sum and exchanging the remaining 75% for a guaranteed income until you die. The benefits from an annuity are taxable as income.
The amount you receive depends on the choices you make, along with your age and health. Someone who is 55 and healthy will receive lower each year than someone aged 70 in poor health. This is because the provider will most likely need to pay the income to the 55-year old for a longer period. Annuity rates are also closely linked to interest rates, which is another reason why annuities’ popularity has dropped in recent years. An extended period of very low-interest rates has drastically reduced the amount received when purchasing a pension annuity.
There is still a degree of flexibility involved due to the range of pension options available. Annuities can be set to increase each year, either at a fixed rate or in line with inflation. This is important as it means that the purchasing power of your income remains the same as the years go by. You can also choose to include a survivor’s annuity, which provides an income to a dependent or beneficiary after you die. The survivor’s annuity is often less than the income you receive during your lifetime, but it is still a valuable benefit for many families.
Annuities are well suited to those who are not comfortable with the various risks of investing. If you are anxious about the fluctuations of your pension when invested, then receiving a guaranteed income can put your mind at ease. For many people, it can be a sensible strategy to explore the idea of an annuity at age 75 so that the annuity rate received is more favourable. Alternatively, some choose to purchase an annuity that covers their essential expenses whilst using the remainder of the pension for discretionary expenditure.
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The greatest level of flexibility comes when using Flexi-Access Drawdown to provide an income in retirement. Like with annuities, you can take 25% of your pot free of tax, but this does not have to be taken all at once. The general idea is that any funds not taken as income are left invested so that they can continue to grow throughout your retirement. Any funds taken over and above the 25%, the tax-free amount is considered income and taxed accordingly. Flexible-Access Drawdown has emerged as the most popular pension options for retirees as it allows full control to be had over how much income is taken and when it is taken.
One strategy frequently used is to take the full 25% tax-free lump sum at the beginning of retirement and use it to fund large one-off expenses such as outstanding mortgage payments, a new car or a dream holiday. In this scenario, the remaining 75% stays invested, and any income is taken from that pot each year, depending on how much additional income is needed. The full amount of this income taken will be taxable. For example, if you have a pension pot valued at £500,000, you may decide to take your tax-free cash of £125,000 to pay off the remainder of your mortgage and then leave £375,000 invested in the stock market. In year one, you estimate that you need £20,000 income from your pension this year, so you withdraw that from your fund, and it is all taxed as income.
Another popular Drawdown method is to take no lump sum at the beginning but draw the income you require each year. Compared to the first strategy, the advantage of this is that your full 25% tax-free cash remains intact so that 25% of your income each year is tax-free. This is well suited to those who have no use for a tax-free lump sum and would rather save their tax-free cash to use as and when they take an income. We will use the same example as before, starting with a £500,000 pension pot. You again decide that you require an income of £20,000 in year 1, but this time £5,000 of that is tax-free, and only £15,000 is taxable as income.
Under a Flex-Access Drawdown arrangement, funds can be left to a chosen beneficiary when you die and are outside your estate for inheritance tax purposes. You can also nominate more than one beneficiary, and the flexible aspect of your pot is also transferred. The nominees can choose to continue a phased drawdown or take the remainder of the fund as a lump sum. From a tax perspective, the death benefits can be taken free of tax if you pass away before the age of 75 but are taxable if you pass away at age 75 or later.
Whilst being more popular, there are more risks involved with Flexi-Access Drawdown compared to purchasing an annuity. One major risk is called longevity risk, and this is the danger that your money runs out before you die. Careful planning is required to avoid this situation, and often with many factors at play, it can be extremely difficult to plan accurately.
At Consilium Asset Management, we are highly experienced in assisting clients using a strategy of income drawdown. We have many tools available to ensure you do not outlive your pension pot. Please get in touch if you would like further information about our services.
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Increased flexibility has been a huge advantage for retirees since the introduction of pension freedoms. However, this brings increased complexity due to the large array of pension options available. With the average life expectancy getting bigger year on year, it is more important now more than ever that sufficient planning is in place to make sure pension pots last a lifetime. No two situations are the same, and there is often no right or wrong solution, but there is always an optimal strategy. We can help you find that strategy using cash flow planning, expenditure analysis and estimating your sustainable spending rate. Get in touch today to learn more about how we can help you make the most of your retirement. Consilium Asset Management are based in Bristol and provide advice on retirement.