10/05/19Weighing up the pros and cons of different Pension Freedom options
Retirees are increasingly concerned about their money running out. With more responsibility placed in the hands of the individual around how, when and how much income they’ll withdraw from their pension, it’s no surprise.
Pension Freedoms were introduced in 2015 with the aim of giving retirees more flexibility in how they used their retirement savings. The changes reflect a shift in retirement. In the past, many retirees followed a fairly similar path of giving up work on a set date and then using their pension to purchase an Annuity, providing a guaranteed income for life. However, retirement lifestyles have changed considerably in the last few decades. Pension Freedoms make it easier to match income with the desired lifestyle for retirement.
However, this extra choice comes with more responsibility for retirees. It’s led to increasing concerns among those both planning for retirement and those that have already started withdrawing from a pension. Research from Aegon found 38% of financial advisers say running out of money is their clients’ primary concern as more retirees opt to access pensions flexibly over purchasing a guaranteed income.
With this in mind, it’s important to weigh up both the pros and cons of each option, in relation to your personal retirement goals, before accessing a pension.
What are your options?
When accessing a pension, you’ve been paying into over your working life, there are three main options.
1. Annuity: First up, is an Annuity. This used to be the most common way to access a Defined Contribution pension. It’s a policy that you purchase with your Defined Contribution pension fund, which will then deliver a pre-defined income for the rest of your life. The level of income will depend on a range of factors, including your age and health.
There are many different Annuity providers to choose from, so shopping around for the best deal is important. There are also various Annuity products to consider, some, for example, can be linked to inflation to maintain your spending power or will continue to pay out to a named partner on your death.
The key benefit of an Annuity is that the income is guaranteed; you don’t have to worry about running out of money in your later years. However, this comes at the cost of inflexibility and you may find that the rate offered isn’t as attractive as forecast investment returns.
The income you receive from an Annuity may be liable for Income Tax if you exceed the Personal Allowance. Should you choose to, you can take a 25% lump sum from your pension tax-free and use the rest to purchase an Annuity.
2. Flexi-Access Drawdown: Since 2015, Flexi-Access Drawdown has also been an option for retirees. Typically, your money will remain invested and you’re free to access the funds as and when you choose to.
The essential thing to keep in mind here is that your money is invested. As a result, the value of your savings can rise and fall. Investment returns can help your savings keep up with inflation and hopefully improve your retirement income. However, you also need to consider what you would do if investments performed poorly.
The advantage of using Flexi-Access Drawdown is that you can change the level of income throughout retirement. As more retirees continue to work in some form or plan large one-off expenses, this may be useful to you. You’re also in control of your income. Of course, this comes with responsibility and can be viewed as a drawback as well as a benefit. You’ll need to ensure you’re withdrawing sustainable levels of income; there is a risk of spending too much too soon.
Income withdrawn through Flexi-Access Drawdown may be liable for Income Tax. You have two options here for taking advantage of the ability to withdraw a lump sum tax-free. You can either withdraw 25% of your pension in a one go, which would be tax-free or plan to make several withdrawals, in which case the first 25% of each withdrawal would be tax-free.
3. Lump sums: Should you choose to, you can withdraw your pension through a lump sum or multiple lump sums without using flexi-access drawdown. These lump sums are called Uncrystallised Funds Pension Lump Sums or UFPLS. Only the first 25% of each withdrawal is tax-free therefore this option may not be the most tax-efficient as the remainder will be taxed as income.
However, there are times when a lump sum may suit your lifestyle goals. For instance, taking a lump sum could mean paying off your mortgage, funding a once in a lifetime trip or completing a home renovation project. It’s an option that can help make your retirement dreams a reality. As well as the tax implications you should carefully consider how you’ll create an income, do you have other pensions or assets that you could use? Taking a lump sum without a long-term plan could leave you financially vulnerable in the future.
You can combine taking a lump sum with the other options above. Again, usually only the first 25% would be tax-free.
Remember, you’re not obliged to access your pension at any point. Should you choose to, your pension can be left where it is. This can have some benefits if you’re concerned about Inheritance Tax, as money held within a pension is usually considered outside of your estate for this purpose.
Deciding which option is right for you
There’s not a single solution for creating the perfect retirement income. It will depend on your personal situation, provisions and priorities as you prepare to give up work.
The decisions you make around accessing your pension can affect your income for the rest of your life; some decisions are irreversible. As a result, it’s important to consider how your needs and goals may change throughout retirement, as well as how decisions could deplete your wealth. This is an area where financial planning can help. Our goal is to help you find a financial solution that is appropriate for the retirement lifestyle you want to achieve.
Above, we’ve outlined the three main options open to you when accessing a Defined Contribution pension. However, you don’t have to exclusively choose one option, though you can if you prefer. Many retirees use a hybrid approach to create an income that suits them. For instance, you may choose to purchase an Annuity to create a base income that’s reliable, accessing the remainder of your pension flexibly as and when it’s needed.
If you’d like to work with us to discuss your retirement income options, please get in touch.
Please note: A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.