The days of being told what to do with your pension are long gone. Now you can make the most of your hard-earned savings with a plan that suits you and your lifestyle.
Prior to the pension freedoms – which were introduced in April 2015 – annuities were the default option for the vast majority of investors in personal pensions. Only those with very small pots were able to cash them in, while only those with sizeable pots were able to use flexible income drawdown.
Today, members of defined contribution pensions can do what they like with their pension once they turn 55. You can take the cash, leave your money invested and draw an income or stick with a traditional annuity.
These freedoms allow you to generate an income from your pension without surrendering your capital and increase or decrease that income as and when your circumstances change. If you have the money to spare, it will also be much easier to leave your loved ones an inheritance.
The difficulty is that you don’t know what the future holds in store so that means you need to think about the challenges you are likely to face before you dive in.
How long will you live?
A good starting point is to think about how long your pension savings need to last – or more bluntly how long you, and any partner, are likely to live. Unfortunately, this isn’t something we are very good at, as Alistair McQueen, pension policy manager at Aviva, explains: “These savings are designed to last us for life, but we tend to be very poor judges of our life expectancy. We make our judgements based on how long our parents or grandparents lived.”
Research from Aviva shows that men typically expect to live until they are 80, while women expect to reach 84. The reality, however, is that a newly retired man is likely to live until 88, compared to 89 for a woman.
While it’s impossible to work out when you will die with any accuracy, it is worth checking out online life expectancy calculators to enable you to make a more informed estimation.
Your health
During this process you will invariably think about your health, which should have a significant impact on your decisions. Poor health can relieve pressure on your pension if it is likely to reduce your life expectancy, but it could involve additional costs if you need to pay for care. Even if you are in rude health, it’s still wise to factor in care costs further down the line. (See box above for more information on the cost of care.)
Adrian Lowcock, investment director at investment company Architas, says: “You need to face up to things such as life expectancy, now and in the future. Care costs can destroy people’s savings and it’s something many people don’t think about.”
Rising costs
Like grey hair and ageing, inflation sneaks up on you slowly. You may not notice the effects of rising prices in the early years of your retirement, but as time goes on it may become increasingly apparent that your money doesn’t stretch as far as it used to.
Research from Retirement Advantage shows that paying the bills is a priority for 72% of over-50s and that 30% are concerned about the cost of living in retirement.
Andrew Tully, pensions technical director at Retirement Advantage, says: “People are worried about how their finances are being stretched and are clearly concerned about how they will be able to pay the bills. We’ve seen an increase in the number of people who say they will work part-time following retirement due to the pressures on household finances.”
He adds: “Inflation manifests itself in two ways. Not only can goods and services cost more, but people will also find the products they do buy won’t go as far due to ‘shrinkflation’. Both can have a significant effect on household budgets, especially for those who have fixed incomes in retirement.”
Although inflation hasn’t been a big concern in recent years, it has risen. When the pension freedoms were introduced in April 2015, inflation (consumer prices index) was hovering just above zero but it was 3% in December 2017 (the latest figure available at the time of writing). This was down from 3.11% the previous month. Although the Bank of England is forecasting inflation will fall in the coming years, it’s likely to remain ahead of the government’s 2% target until 2020.
Currently, the state pension is at least protected from inflation by the highly contentious ‘triple lock’ – this guarantees that it will rise by the higher of inflation, wage growth or 2.5%. However, its future is far from certain. In the run-up to the 2017 general election, the Conservatives said they would not guarantee its future beyond 2020, but they were forced to renege on this as part of their deal with the Democratic Unionist Party.
“The triple-lock will certainly be looked at,” says Jamie Clark, pensions business development manager at Royal London, “but when is not clear. Scrapping it certainly would not be a vote winner.”
This makes it even more important to think about how you manage other sources of income to ensure they have the capacity to increase over time.
Mr Tully says: “People need a financial plan that not only secures an income to pay the bills throughout retirement, but is flexible enough to cope with inflation. Only then can they start thinking about how other savings can be used to create the retirement they’ve worked so hard for.”
As part of this, you will also need to consider what your spending habits are likely to be and how these could change during your retirement (see box below).
Expect the unexpected
It’s important to remember that however well you’ve mapped out your retirement, life doesn’t always go as planned. This means it’s helpful if your plan is sufficiently flexible that you are able to cope with a change of circumstances.
This could be the end of a marriage or the start of a new one. You may enjoy a return to work, set up a new enterprise or find that poor health derails your plans. It may simply be that loved ones move overseas and you need to find cash for long-haul flights.
Only once you are aware of these challenges can you start to think about what you will do with your pension money.
Cashing in your pensions
When the pension freedoms were first announced, the option that garnered the most headlines was the new ability to cash in your pension from age 55. Previously, only people with very small pensions were able to take them as cash.
This new flexibility means you can now use your pension to pay off any niggling debts, start a new business or invest in property (see page 63 for more on this). Alternatively, you may plan to help children out with university fees or buying their first home.
There is, however, a very big catch and that is whether you are cashing in all or some of your pension, only the first 25% of any withdrawal is paid tax free. The remaining 75% is added to your income for that tax year and taxed at your marginal rate of income tax – that is the highest rate of income tax you pay. Depending on your income and the size of your withdrawal, it may be enough to bump you into a higher-rate tax band.
While there may be value in cashing in small pots if you have a specific need for the money – such as debts – the tax payable means cashing in bigger pots is unlikely to be a wise move.
Experts are particularly concerned about people taking money out of their pensions simply ‘to get their hands on it’. Research from the Financial Conduct Authority (FCA) shows that 32% of over-55s have withdrawn money from their pension and put it into an Isa or bank account, while 25% spent all or the largest part of their pot on items such as home repairs or a car. This is one of the worst things retirees can do with their cash.
Not only will you have a tax bill to pay, you will also give up the tax protection offered by pensions. Within the pension wrapper, your money grows tax-free and can be passed on to anyone you like, free of inheritance tax. If you die before your 75th birthday, no income tax will be paid on it either.
Likewise, you are also able to access the same investments without moving them out of your pension, or if you are worried about stock markets and want to hold some money in savings accounts, then cash-based accounts are available too.
“This is just moving your money from a tax-efficient wrapper into one that is not,” says Mr Clark. Even if you have considered the tax and have a specific plan for your money, Mr Clark says it still makes sense to think twice before dipping into your pension.
He cautions: “You have to question whether you can afford to be taking money out of your pension when you are still in your 50s if it needs to last you until you are in your 90s.”
Mr Lowcock adds that people also need to be cautious when it comes to dishing out lump sums to family – you shouldn’t let your desire to help them undermine your own financial security. “People can be over-generous, especially with children and grandchildren, so don’t splash out on gifts you can’t afford,” he adds.
Flexi access drawdown
Income drawdown offers the epitome of flexibility for retirees as it allows you to leave your money invested and take income or capital from it as and when required.
“It’s like a bank account linked to an investment account,” explains Jamie Smith-Thompson, managing director of pension adviser Portafina.
This means you are able to have total control over your money and have a flexible income, without giving up your capital or sacrificing valuable tax perks offered to savers in pensions. It could be an ideal option for the growing numbers of people who are taking a phased approach to retirement and reducing their hours or ‘downsizing’ their job before they fully retire.
Many people may only need their pension to top up their earnings in the early years of retirement or don’t feel ready to commit to products, such as annuities, that cannot be reversed.
The new tax perks also make drawdown more attractive to people who are in poor health and want to protect their savings for their family, as well as wealthier retirees who want to leave loved ones an inheritance.
For those who are concerned about longevity – the risk of living ‘too long’ – and the effect inflation could have on their finances, drawdown may also appear to be the answer. This is because your money remains invested and should provide some capital growth.
But while flexi-access drawdown might appear to be all things to all people, there is, once again, a significant catch. It may offer unparalleled flexibility and tempting tax breaks, but it cannot offer any guarantees.
A large stock market fall, for example, could wipe years off your savings and you may struggle to recoup your losses – especially if you are still drawing an income from your money.
Even if stock markets are on your side, you could still run out of money if you spend it too fast or live too long. (Turn to the feature on page 34 for more on managing your retirement investments).
“We always encourage people to try to live off the fund’s natural income,” says Mr Lowcock. “But, in reality, we know that isn’t always achievable for many people and they will need to dip into their capital at some point.”
For these reasons, it’s sensible to get a professional adviser to run your portfolio for you. This will reduce your risks substantially.
“The DIY route is a bit scary,” says Mr Smith-Thompson. “There is lots of data out there to show that a top-performing fund for three years won’t be top-performing over the next three. We use lots of trackers and make sure our portfolios are diversified across a wide variety of assets.”
In addition to recommending the right investments, a good independent financial adviser (IFA) will also help you manage your plan and offer advice on how much you can afford to withdraw.
Figures from the FCA show that 26% of investors have withdrawn income at a rate over 8%, 13% have taken between 6% and 7.99%, followed by another 13% who have taken between 4% and 5.99%.
“Any amount more than 5% is probably too much if you want to sustain the fund for the rest of your life,” says Mr Clark.
Finally, by taking the responsibility out of your hands, IFAs will be better placed to stop you getting burnt. When markets are volatile, novice investors will often panic and sell their investments through fear of losing more money.
“When markets dip, it is common for people to want to sell up. But cashing in your chips just crystallises your losses,” says Mr Smith-Thompson. An IFA could therefore also stop you making expensive mistakes.
Good advice does not come cheap, however. According to Unbiased.co.uk, the website that helps consumers find financial advisers, retirement advice on a £100,000 pot is likely to cost around £2,000, rising to £2,500 on £200,000 pot. For people with larger pots, this is likely to be a sensible investment – but for some, the costs will be too great.
Guaranteed income
As great as it is to have control over your money and the ability to manage it flexibly, this isn’t always the priority for retirees. Recent research from Retirement Advantage found that for 45% of retirees certainty of income is the most important factor, ahead of flexibility at 36%, instant access at 12% and income growth at 7%.
This means that for many people, an annuity that pays a guaranteed income for life will be a much less stressful option. Once you have purchased your annuity, you can be sure that your income will carry on being paid even if you live to 110. You won’t have the responsibility of managing your investments or suffer palpitations when markets wobble. As Mr Lowcock says: “It’s a personal decision, not a financial one. Some people just want the security.”
The downside is that the income you receive is likely to leave you disappointed. Today, a healthy 65-year-old with a £50,000 pension can expect an average annuity income of just £2,505 a year, according to figures from Retirement Advantage.
You may, however, be able to top that figure by shopping around for the best deal – something most buyers fail to do. According to research from Hargreaves Lansdown, over a 20-year retirement, somebody with a £100,000 annuity would miss out on £7,133 of lost income by sticking with their existing provider.
Retirees who aren’t in the greatest health stand to gain the most from shopping around. Enhanced annuities – which are only available from specialist providers – will pay a higher rate of income to people with health problems or lifestyles that mean they are likely to have a lower life expectancy. You don’t have to be seriously ill to benefit; people who are overweight, have high blood pressure, smoke or have raised cholesterol can also get a higher income.
Just because your health or lifestyle suggests that you are likely to have a reduced life expectancy, it does not necessarily follow that you will. For some people, enhanced annuities will offer exceptional value for money.
Mr Lowcock says: “You never know what will happen. An annuity could end up being very attractive if you live longer than expected.”
While the humble annuity cannot claim to be anywhere near as flexible as income drawdown, you can still make provisions for a spouse or any other dependants when you die – either by taking out a joint life plan or choosing one that guarantees payments for a fixed period of time, irrespective of when you die.
The rub, of course, is that these extra benefits come at a price and will reduce the level of income you receive.
You can also choose an index-linked annuity that starts off paying a lower level of income initially, but increases over time to help you cope with the rising costs of living. But it may be more effective to leave some money invested to grow on the stock market, as you may have to live for a sizeable length of time before you recoup the income you lost in the early years.
Mix and match
There are pros and cons to each option with none offering the perfect solution, but thankfully the pension freedoms don’t require you to make an either/or choice. Instead, you can use a combination of strategies to strike the right balance of flexibility and security for you.
Sean McCann, technical advice manager at insurance firm NFU Mutual, says: “People think they need to stay invested or buy an annuity, but you can mix and match. I might, for example, buy a small annuity and leave the rest invested if I am carrying on working part-time.”
Alternatively, you might start off in drawdown and then gradually start annuitising tranches of money once your circumstances are more settled, your health has deteriorated or you have simply lost the inclination to manage your finances yourself.
Another option might be to use an annuity to ensure your guaranteed expenditure – food, bills and so on – is covered and then invest the remainder. This will leave you with access to lump sums if you need them, shelter your wealth from tax and provide some protection from rising prices.
Whatever your circumstances, there are lots of considerations and you need to think carefully. “Take your time,” advises Mr McQueen. “There is no ticking clock. You’ll have been saving this money for 40 years or more, so don’t just take a few days to think about what you’ll do with it.”
How much does care cost?
AT HOME
Expect to pay £17 an hour, with two hours a day racking up to £12,500 a year. Round the clock live-in care is likely to cost around £50,000 a year.
RESIDENTIAL CARE
Costs vary across the country, but average fees for residential care are £30,000 a year, rising to £40,000 if nursing care is also required. Expect to pay more than this in London and the South East.
HOW MUCH CARE SHOULD I BUDGET FOR?
The average life expectancy for somebody going into a residential home is 2.5 years. However, there are sizeable variations, depending on how ill residents are when they fi rst move in. Of the 55% who survive the first year, seven in 10 will survive the second. A total of one in 10 will live in a care home for five years or more.
WHAT ARE THE CHANCES I’LL NEED A CARE HOME?
Close to 15% of those aged over 85 live in a residential care home, while 30% of people will use some form of local authority-funded social care in the final year of their life.
Sources: The Money Advice Service, Laing and Buisson, Just Retirement
What impact will inflation have on your savings?
At 2%, the value of your money will halve in 35 years.
At 3%, the value of your money will halve in 25 years.
At 5%, you’ll lose half its value in just 15 years.
PENSION WARNING
Since April 2017, the amount you are able to pay into your pension each year once you have started taking money from it (known as the ‘money purchase annual allowance’) has reduced from £10,000 a year to just £4,000. This will be an important consideration for those who want to take cash from their pension, but are still making contributions. It’s particularly important if you are expecting an inheritance or planning to pay bonuses into your pension.
Think holistically to pay less tax
When you think about income in retirement you probably just think about your pensions, but it’s worth taking a more holistic view.
“Considering your pension in isolation is a bit one-dimensional,” says Justin Blower, head of sales at investment platform Ascentric. “People need to think about taking their income in the most tax-efficient way.” Following a change of legislation that allows you to pass on money free of inheritance tax (and income tax if you die before age 75), it often makes sense to spend other assets first. “Take as little income as you can from your pension and think about taking tax-free income from Isas and on- and offshore bonds that potentially have a tax-free allowance. Make use of your capital gains tax allowance on other investments,” he adds.
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