From tax-free cash to allowances, transfers and annuities, we tackle your top 10 questions on the current pension rules and what they mean for your income options in retirement.
1. Should I take my tax-free cash?
Whether you are eyeing up a cruise, a new car, or have a nagging mortgage to pay off, the ability to take a quarter of your pension as a tax-free lump sum can give the early years of your retirement a real boost. However, before you get swayed by what the money could buy you, our experts all agree that you shouldn’t take it just because you can. There’s a barrage of issues you need to tackle first.
“When and why? What will you do with it? Have you considered the alternatives? What impact will it have on your life right now? What impact will it have on your future lifestyle? What will it cost you to do it? Will you be giving up any guarantees by taking it?” asks Jamie Smith-Thompson, managing director of financial planner Portafina. “These are all the sorts of questions to ask yourself, and some of the questions that we would be asking you should we be advising you professionally. There has to be a good reason to do it.”
When you take money out of your pension, you don’t just lose the initial value of your withdrawal – you also lose the growth that money would have generated had it remained invested.
Take a 55-year-old with a £100,000 pension pot. According to figures from investment firm Fidelity, if they took £25,000 tax free cash and made no further contributions, in 10 years they would have a remaining pension worth £122,167. However, if they left their pension alone at age 55 and kept the whole £100,000 invested by age 65 they would have a much more impressive £162,888, of which £40,722 would be available as tax-free cash, should it be required (assumes 5% return a year).
Carolyn Jones, head of pension products at Fidelity, says: “Lots of people view their tax-free cash as their rainyday fund, but you can still maintain that within a pension and if you don’t spend it and leave it in cash it will just be sitting there getting eroded by inflation.”
2. Could the government abolish tax-free cash?
“We hear from a lot of people, who are worried that the rules on tax-free cash will change and that if they have the money, the government cannot take it back,” says Ms Jones. However, while you can never say never, our experts reckon it’s unlikely to get the axe: tax-free cash has survived the Second World War, plus a handful of deep recessions, and it has escaped the chop so far.
Patrick Connolly, chartered financial planner at IFA Chase De Vere, says: “Abolishing tax-free cash would be a big money-spinner for the government. However, politically it would be a terrible move. When you think of how many people are saving into a pension and would be upset if tax-free cash was abolished or reduced, it would take a very brave or foolish government to push this through.”
3. Will the lifetime and annual allowances see further cuts?
These allowances refer to the amount of money you are able to pay into a pension over your lifetime, as well as the amount you can pay in each year and still receive tax relief on contributions. These stand at £1 million for the lifetime allowance (rising in line with inflation to £1.03 million in April 2018) and 100% of your earnings for the annual allowance, subject to a cap of £40,000.
While it is unlikely the government will abolish the right for savers to take 25% of their pension tax-free, it is a well-known fact that pensions are an easy target for politicians and, over the years, these allowances have been slashed. The lifetime allowance is down from a high of £1.8 million in 2008, while the annual allowance has collapsed from a peak of £255,000 in 2010.
Ms Jones says: “These allowances are easy for ministers to tinker with, and they will carry on tinkering, particularly until a time after Brexit when there is a bigger majority in parliament. Then they can make more fundamental changes to pension policy.”
So where does this leave savers? Mr Connolly says: “Nobody knows what changes to pension rules will happen in the future. We can only make decisions based on what we know today. That being the case, it makes sense for most people to invest in pensions, especially if they’re also benefiting from payments from their employer.”
Ms Jones also points out that if savers will breach the annual allowance, they can take advantage of unused allowances from previous years, explaining: “Carry forward rules allow you to maintain your allowance from the previous three years.”
4. Should I transfer my defined benefit pension?
With some pension scheme members being offered 20 or 30 times their promised income to trade in their policy for a cash lump sum, it is hardly surprising that many are rushing to transfer. But it’s not a decision to take lightly.
Mr Smith-Thompson says: “Many people are surprised at just how big the transfer value of their final salary scheme looks, but it is only that big because it takes a very large pot of cash to provide a decent ongoing income – and that is true of drawdown as well. You need to remember what the pension is there for in the first place, which is to provide you with a hopefully decent standard of living throughout retirement.”
This means it’s essential to get advice; indeed, if your transfer value is £30,000 or more it is a legal requirement.
Ms Jones adds: “There are times when it can work, but we always work from the basis that it probably won’t.”
Exceptions when it may make sense would include people who aren’t married – who wouldn’t get the benefit of a spouse’s pension, as well as those who are ill or unhealthy and unlikely to a have a long retirement. The move would also be less risky if you had other sources of retirement income.
5. Should I still buy an annuity?
According to figures from annuity provider Retirement Advantage, drawdown sales now outstrip annuity sales by two to one. The former is regarded as flexible and giving savers control while the latter is considered the very opposite, with tumbling rates leaving many savers disappointed with the income they receive.
Mr Smith-Thompson says: “It would be very rare for us to recommend an annuity with the current rates and products available, given the evidence available to support the case for a sustainable drawdown level with the right investments.”
However, while annuities may be regarded as outdated by some, they offer something no other product can – an income that is guaranteed for life.
Ms Jones says: “There is still a place for annuities, but it’s no longer an all-or-nothing decision.”
This might mean using an annuity to cover basic expenses and maintaining a pot to invest flexibly, or using drawdown in the early years and buying annuitised income in tranches as you get older. At this point your age and health may mean you can get better rates.
Andrew Tully, pensions technical director at Retirement Advantage, says that plans may also not be that inflexible.
“Many people are still drawn to the peace of mind provided by a guaranteed lifetime income. And with the longer guarantees now available, the concern that the pension provider will keep the money if you die early no longer applies. You can make sure your family receives the full value from your savings.”
He adds: “Never accept the offer from your pension provider for an annuity. Shopping around for the right annuity and the best rate can improve your income by 30% or more.”
6. How much can I take from my pension?
Unless you buy an annuity, you will have to carefully manage how much money you can take out of your pot to ensure it doesn’t run out.
“Our research shows people think they can safely withdraw around 7% from their retirement fund without fear of running out of money, although the reality is likely to be significantly less than 7%,” explains Mr Tully.
“We’ve completed some modelling work on drawdown strategies which concludes a sustainable rate of withdrawal is nearer 3.5%, and in all cases fell short of the 4% rule often quoted. This is based on the assumption that each strategy would provide a 95% level of certainty of the income lasting 25 years to age 90.”
Before looking at the numbers, you’ll also need to think about what you want to do with your retirement and what your financial priorities are – for example whether you want to really make the most of your early years while you’re fit and well, or whether you want to stockpile cash for care later in life or an inheritance for loved ones.
Mr Smith-Thompson adds: “This is one of those areas where ongoing management and advice is really key. You can’t predict the future, and the answer to this question will depend on so many factors, from your health and life expectancy through to world events and the underlying performance of your funds.”
It is also important to consider that your spending needs will change during your retirement. The early years of your retirement are likely to be the most expensive, but costs can be high in the latter stages too.
Jonathan Watts Lay, a director at financial education firm Wealth at Work, explains: “Income requirements are widely believed to follow a ‘U-shape’ in retirement with the first ‘active’ phase being the most expensive. Spending seems to fall after a while in what is known as the ‘passive’ phase, as people become a little less active and perhaps cut back on areas such as travelling. But costs then may go up later in retirement in the ‘supported’ phase, if extra care and support is required.”
7. Can I take my whole pension as a lump sum?
Since the introduction of the pension freedoms in April 2015, you can now take all of your pension as cash. But just because you can, it doesn’t mean you should.
Mr Connolly explains: “This is rarely a sensible move unless you have a small pension. This is because, after your 25% tax-free cash, any further pension withdrawals are added to your income and taxed at your marginal rate of income tax. This could mean that you find yourself with a very large and unwelcome tax bill.”
If, however, it is only a small pot and you have other sources of retirement income, it may not always be a bad move. The key is doing it because you have a specific need or use for the cash, rather than just sticking it in the bank where you’ll get pitiful returns and lose all the tax benefits of keeping it in a pension (see point 8 below). “In these cases you’ll still need to consider the most tax-effective way and it may make sense to phase your withdrawal over several tax years. You don’t want to go into a higher-rate tax band just to get the money,” adds Ms Jones.
8. Must I take an income from my pension?
The simple answer to this question is no. It may be that you’re still working or have other sources of income, in which case there are many sensible reasons for leaving your pension untouched, as Mr Connolly explains: “If you don’t need the money there can be advantages in leaving it within a pension, including tax-efficient growth, the ability to pass the money tax free to your beneficiaries if you die before age 75 and pension money being outside of your estate for inheritance tax purposes.”
9. Will I be taxed if I take an income from my pension?
“Any withdrawal from your pension (after tax-free cash has been taken) will be treated as income and taxed accordingly,” explains Mr Tully. “However, if your total income for the year, including the state pension, private pension any earnings, falls below the annual tax allowance then you don’t need to pay any tax.”
Although the issue of tax on pension income can come as a surprise to savers who have enjoyed tax relief on pension contributions and tax-free growth, thanks to the pension freedoms it is now easier for savvy retirees to keep their tax bill under control.
Jonathan Watts Lay, director at Wealth at Work, says: “With careful planning, it is possible for individuals to utilise their available tax allowances in a structured way to maximise returns and reduce, or even eliminate, potential tax charges.
For example, where possible it may be beneficial to draw money from taxable savings rather than from the tax-efficient wrapper of a pension.”
10. Can I cash in my annuity?
In 2015, the government announced plans to create a secondary annuity market that would have enabled dissatisfied annuity holders to trade in their guaranteed lifetime income for a cash lump sum. It planned to launch the scheme in April 2017. However, after consultation, the government decided to renege on the scheme. It said that it would have been too difficult to create a market that would provide often vulnerable policyholders with sufficient value for money and consumer protection.
Policyholders were furious but while it might appear that the door has been closed to annuity sales, Mr Smith-Thompson says this might not necessarily be the case: “Until very recently, the answer to this question would have been a straightforward ‘no’, but at the end of 2017 Phoenix Life announced that it would do exactly that for people who had very small annuities with them. Will other insurance companies follow suit? I think it is likely, provided it is in their own interests. Phoenix made no secret that it is costing it money to run these very small annuities, so it works for all parties to cash them in. I can’t see this extending to larger annuities any time soon though.”
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