Your options at retirement

What you’ll learn:

• How annuities work.
• How drawdown can provide you with greater flexibility.
• How you can withdraw lump sums from your pension.

After all, you need to ensure it lasts and covers your needs for the rest of your life, as you could live several decades past retirement age.

Pension rules introduced in April 2015 mean that you can’t access your pension savings until you reach the age of 55. However, the Government have announced an intention to link this age to 10 years prior to the State Pension Age. If this passes into law, the minimum pension age will increase in the future. Under the rules, there’s more flexibility in how and when you can take money from your pension pot and can even take it all in cash if you want to.

Find out more about how pension freedoms affect you

However, although you can withdraw 25% from your pension tax-free, the rest is taxable when you take it. Remember that tax rules can and do change, and their impact on you will depend on your individual circumstances.

There are three main ways to take an income from your pension and many people use a combination of these. We take a look at the pros and cons of each and explain how they work.

Find out more about why it’s important to plan

Historically annuities have been the most popular income product amongst retirees in the UK. When you buy an annuity you’re essentially entering into a contract with an insurer whereby in exchange for your pension pot, it will provide you with a guaranteed income for the rest of your life, or for a defined period, depending on which type you buy.

If you plan to buy an annuity it’s vital you shop around and exercise what’s known as your ‘open market option’, as you don’t have to accept the quote offered by the provider you saved your pension pot through.

Under current rules, once you’ve bought your annuity, you have a short period during which you can change your mind, which is typically 30 days. After that you are unable to change your decision.

Annuity types

There are a number of annuity types with single-life products arguably the most common. This pays an income to just one person, and assuming that no minimum term is included when they die, the income ceases – it can’t be passed on to anyone else. Joint life annuities on the other hand will pay an income until you and your spouse or partner dies. In addition there are fixed increase or index-linked products, where the income rises in line with inflation. However, the initial income tends to be significantly lower than what a standard product would offer - and it could take years to catch-up. But, they do protect the spending power of the money you receive.

When it comes to shopping for an annuity at retirement it’s essential you’re completely open in regards to your health. Annuity rates are linked to average life expectancy, and if your provider believes your life expectancy is below average, you’re likely to qualify for an enhanced annuity, which pays a higher rate of income. To put it plainly, if your insurer believes you have less time to live than the average individual, it’s likely to offer you a higher income – smokers for example typically get better annuity rates because they’re considered to have a lower life expectancy.

How income drawdown works

Unlike an annuity, income drawdown, known as ‘Flexi-Access Drawdown’ (FAD) gives you greater control over your money in retirement. This route allows you to take an income from your pension, while keeping it invested. This option also gives you the opportunity to continue to grow the size of your pot and therefore tackle inflation. Unlike an annuity, you can even pass on any remaining money to your loved ones when you die.

But this extra flexibility comes with significant risk as your money remains at the mercy of markets and you could end up with less than you started with. If your investments fail to deliver and/or if the fund is eroded over time in the wake of hefty withdrawals, you run the risk of your fund disappearing altogether. It’s essential that you’re happy to take on not only the risks involved but also the responsibility of running your portfolio and reviewing it regularly. You can get a professional to run it for you but this will cost you more money.

Many income drawdown portfolios will typically have a bias towards income-yielding investments such as bonds and equity income funds, which invest in dividend paying firms. The ideal situation for an income drawdown investor, is that the yield delivered via their portfolio’s underlying investments covers their income needs. But given market volatility nobody is likely to enjoy such a backdrop on any long-term and consistent basis. And while you can take 25% of your pension pot tax-free, remember all subsequent withdrawals will be subject to income tax. You need to ensure you don’t unwittingly push yourself into a higher tax bracket as a result of hefty withdrawals.

Most personal and workplace pension plans offer an income drawdown option. If you’re in a workplace scheme, check what your choices are, as you may need to switch your pot into another form of pension, such as a self-invested personal pension, SIPP, a pension wrapper where you or your adviser can pick and choose which investments you want to hold.

Withdrawing all your pension savings

If you want to, you can withdraw one or more lump sums from one or all of your pension(s) without using the remainder to provide you with an income. The first 25% will be tax-free, with the rest taxed as income at your highest rate. While it gives you a great deal of flexibility, you need to consider the tax impact of taking this route. Since 75% is taxable, if you have a large pension pot you may find yourself paying the additional (top) rate of tax if you take it all in one go. If you draw the sums over a number of years, you may be able to minimise the amount subject to top-rate or even higher rate tax. This can make a big difference to the amount of tax you pay in total on your pension savings. Also don’t forget to consider how you’ will fund your living expenses in the future if you take your pension savings in this way.

Which route is right for you?

The way you draw an income from your pension is likely to be largely determined by your financial situation at retirement. Will you, for example, still be paying off your mortgage, or do you have any other significant debts? What other income sources, aside from the State Pension, will you have at your disposal?

While an annuity can offer you the security of a guaranteed regular income, a drawdown plan gives you the chance to grow your pension and overall wealth during retirement. The latter route is likely to suit those with a stronger appetite for risk, as any significant market swings could potentially cause serious damage to your pension savings.

Find out more about your attitude to risk

Bear in mind though, it isn’t a case of picking one or the other, as you could use part of your pension to purchase an annuity and invest the rest into an income drawdown plan, or you might decide to withdraw several lump sums. If you’re not sure which option is right for you, we recommend you ask for independent advice. We don’t offer financial or tax advice.