I’VE covered the key psychological plans for retirement and what income you may need in retirement, so here, in my third column covering retirement, I’ll look at some of the options available to those with a personal pension.
In years gone by, as you neared retirement you had only one option which was to prepare yourself to buy an annuity - as much flexibility as uncooked spaghetti.
You had built up a fund, and, at retirement age, you were at the mercy of the financial markets moving your fund’s value around, because you then had to buy an income with that amount of money.
A fall in the last two years before retirement of, say, 20 per cent meant you would then buy an income of 20 per cent less for the rest of your retirement days. Spaghetti.
Further still, if annuity rates fell during those two years, you could be hit with a double whammy of a lower fund and a lower rate.
Say rates had dropped by 10 per cent, your retirement income would then sit at 30 per cent less.
Of course, the reverse is also true, but gambling at retirement age isn’t normally most people’s bag of crisps.
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So we might move our funds out of the market over the last five years and into more protected funds (cash and bonds for example) so we could lock in values. For some, that meant missing out on stock market gains.
And so, the government created flexibilities.
Today, a retiree can:
- Leave their whole fund invested until a later date;
- buy an annuity;
- take lump sums;
- put their money into drawdown.
Because of these options, it isn’t therefore so urgent to start moving your funds into safe or protected funds, as there are options other than – ‘you have to buy an annuity’.
Indeed, if you were doing anything other than an annuity, the capital will remain invested, potentially benefitting from any upward growth in the markets.
Leaving your whole fund invested means you can benefit from any upside growth in the market, the tax-free cash could increase, plus the fund will be growing free of tax.
Moreover, your pension doesn’t form part of your estate for Inheritance Tax, and you could appoint a beneficiary inside your pension who would then take over that pension pot with no Inheritance Tax, potentially passing it down generations.
This tax break applies to pension drawdown as well. The real benefit is the ability at a future stage to decide when you might want to do either of the other three options.
With an annuity, you take your 25 per cent tax free cash, your income is guaranteed, you can build in protection for that income to beneficiaries, and also you can build in inflation proofing.
Downside: You can’t encash your annuity. It’s a product, and the money (your cash) is gone. If annuity rates rise later, you won’t benefit, as you have already purchased the rate. If your circumstances change, there is no flexibility to alter it.
You can take lump sums: Let’s say you took a £10,000 lump sum. £2,500 would be tax-free as its 25 per cent of the lump sum and the remainder is added to your income and taxed accordingly. This is useful in that you can choose what taxable income you would like, but also leaving the total tax-free cash to potentially increase over time. If the markets rose over the next 15 years, you would receive a greater tax-free cash than all the other options.
The main pros and cons of lump sums are very similar to drawdown which I’ll cover briefly now and then in detail next week.
With drawdown, you take 25 per cent tax free cash at the beginning and then decide your income level that you would like to take. It could be more or less than the market is returning, and so you could put your remaining funds under pressure.
The key benefits are the same as the lump sums option: Deciding when and what you want whilst keeping all options open; maintaining buying power with your capital against inflation by leaving the capital invested; passing on your money to your generations free of Inheritance Tax.
The disadvantages: The fund might fall and might grow less than your withdrawals and inflation. The income isn’t income per se, it’s just withdrawals of your money, so it isn’t guaranteed, and it could fall. Drinking water from a bucket with a leak in it isn’t a great strategy.
I’ll cover drawdown in more detail next week, but please see an Independent Financial Adviser (IFA) for retirement advice.
Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a retirement question, call 028 6863 2692, email firstname.lastname@example.org or visit www.wwfp.net