If you have a £100,000 pension pot, your retirement income will probably be around £4,000 to £5,000 per year, not including the state pension.
However, it could be more or less than that, depending on various circumstances including what products you choose, and how and when you decide to access your pension.
Here’s how to estimate your retirement income.
Whether you plan on relaxing beside a pool in retirement, travelling the world, or taking up a host of new interests, there’ll be one big question at the front of your mind. How much will you have to spend?
If you have a defined benefit pension scheme (now less common), you’ll know the answer to this question shortly before you retire, because the scheme quite simply tells you (hence ‘defined benefit’).
But assuming your pension is part of a more common defined contribution scheme, your retirement income will depend on a range of different factors.
The biggest factor is the size of your pension pot. For this example, we’ll assume this is £100,000. Here are the other elements that will determine your eventual income.
What age do you expect to retire?
A big factor in how much pension income you’ll get is when you choose to retire. As things stand, you can choose to access your pension pot at any age from 55 onwards, rising to age 57 from 2028 onwards.
However, the sooner you do this, the longer you’ll have to make your pension pot last and the smaller your income may be.
A 55-year-old man in the UK can, on average, expect to live to 84, while a 55-year-old woman would, on average, live to 87. Of course, your own life expectancy will depend on your health and lifestyle.
The current state pension age in the UK is 66, and is scheduled to rise to 67 by 2028.
So, if you’re a woman retiring at the state pension age you should assume you have to make your pension pot last for around 21 years. Bear in mind that it may be considerably longer.
How will you take your pension?
The size of your income in retirement, and how long this income may last, depends on how you choose to access your pension pot. Here are your options and the impact they can have.
The 25 per cent tax-free lump sum
Everyone is entitled to take 25 per cent of their pension pot tax free.
The vast majority will choose to do this, as there are no real disadvantages to doing so. One exception might be if you are buying an annuity and want this to be as big as possible – in which case you could spend the entire pot on the annuity.
However, annuity income is taxable, so you would lose out in that respect.
Assuming you do opt for the tax-free lump sum, this leaves you 75 per cent of your pension pot (i.e. £75,000) to set up your long-term retirement income. You have a few options here.
Option 1: An annuity
With an annuity, you use your pension pot to buy an insurance product that gives you a guaranteed income for the rest of your life, no matter how long you live for.
The level of income you’ll get depends on the annuity rate at the time you buy it. For example, if annuity rates are 5 per cent, you’ll receive a sum equal to 5 per cent of your pension pot each year.
In March 2020 the best annuity rates were around 5.2 per cent for someone retiring aged 65.
So a remaining pension pot of £75,000 would buy you an income of £3,900 per year (remember you’d also have £25,000 in cash to spend as and when you wish).
If you didn’t take the tax-free lump sum and spent the whole £100,000 pension pot on a annuity, it would buy you a pension income of £5,200 a year.
An annuity will usually not pay out to your spouse after your death unless you buy a joint annuity. However, this additional protection will reduce the level of income paid out.
How can I get a larger annuity?
Annuity rates may look disappointing – four to five thousand a year seems very little for such a large outlay.
But this is because the provider has to allow for the fact that you might live a very long time.
If you were to live to a hundred, say, then the annuity would have paid out £136,500 – far more than the £75,000 you paid for it. The standard figure assumes you’ll live about another 20 years.
This means that you can obtain a higher income if the provider thinks you may not live that long.
Having a health condition, or other risk factors in your lifestyle, may qualify you for an enhanced annuity. This will pay out more per year than a standard annuity. If your health conditions are serious, the income may be a great deal higher.
You can also achieve a higher annuity by buying it later in life. Annuity rates in July 2022 were nearly 7 per cent for people aged 70, and over 8.5 per cent for those aged 75.
Option 2: Drawdown
With drawdown, your remaining pension pot is invested in a fund of assets, and you can draw out as much as you wish each year.
In this respect it is up to you how large your income is – but of course, the more money you take out, the faster the pot will shrink.
There are no guarantees with drawdown – once the money is gone, it is gone. This means you need to work out a ‘safe’ income level that will use up your savings at the right speed.
Both the lifespan of your drawdown fund and the ‘safe’ income level will depend on one big unknown factor, which is the performance of the stock market over the course of your retirement.
It’s possible to make predictions using an average growth rate (say 3 per cent), but this can’t take into account periods of strong growth, or stock market crashes. All such predictions should therefore be treated with caution.
For example, suppose you put your £75,000 pot into drawdown with a steady 3 per cent growth rate and a 0.3 per cent annual fee.
This would (in theory) allow you to take the equivalent of what you’d get from an annuity (£3,900) for just over 26 years. Alternatively, you could (again theoretically) take around £4,800 a year from the pot for 20 years.
On the face of it, this is a considerably higher income than you’d get from an annuity. However, there are several big caveats:
- If you live a long time, you eventually run out of money
- An average 3 per cent level of growth (or better) is not certain
- Growth will not be steady, but will rise and fall
Point 3 is especially important. Over 20 years the stock market will almost certainly have several stronger periods divided by big slumps.
The big danger comes when you have to draw money out during a slump. This ‘crystallises’ (i.e. makes real) your loss, while reducing the size of your pot, which makes it harder for your pot to recover during growth periods.
This means that the strong growth periods won’t necessarily ‘balance out’ your losses. In short, drawdown can be a bumpy ride.
How can I make my drawdown pot last longer?
Here are some tips for taking a drawdown income, to reduce the risk of running out of money.
- Be a pessimist
Don’t bank on a high average level of stock market growth. If you do your sums based on average 3 per cent growth, you should have a better margin for error.
- Pace yourself
Having a large pension pot to spend is a big temptation. Resist it. Ask your financial adviser to calculate a safe level of income for you, and stick to this rule as much as you can.
- Watch the markets
If possible, try to avoid drawing money out when the market is falling. This makes it harder for your pot to recover later. It may make sense to draw out slightly more than you need during periods of high growth, and keep this extra money aside as a fall-back option for when the market crashes.
- Keep some of your lump sum in reserve
Again, resist the temptation to blow all of your tax-free lump sum on a boat. An emergency fund can be invaluable for those periods when you need to reduce your drawdown income.
- Only draw as much income as you’re going to use
Other than building up an emergency reserve (see point 3), limit your income to what you know you’ll spend. You are taxed on all your pension income above your personal allowance, so there’s no point being taxed on money you won’t use that year.
- Consult an independent financial adviser
All of the above are merely pointers. Do not make any drawdown decisions without talking them over with your IFA.
Option 3: Drawdown plus annuity
A third option is to split your pension pot between an annuity and a drawdown scheme, to try and get the best of both worlds.
Based on the assumptions used above, this might give you an income along the following lines:
In this example, the combined solution comfortably beats using an annuity alone for the first 20 years, after which only the annuity income of £1,950 is left.
An alternative option is to wait before buying the annuity, to obtain a better rate (and perhaps an enhanced annuity on health grounds) when you are older.
Your private pension and your state pension – how they can work together
But you should of course factor this in when working out your overall retirement income.
If you’re entitled to the full new state pension, then from 2020/21 this is £9,110 a year.
When added to the various forms of private pension income discussed here, this would give you a total income (not counting state pension increases) of
- £13,010 (if using annuity alone) for life
- £13,910 (if using drawdown) for 20 years (£9,110 thereafter)
- £13,460 (if using a combination) for 20 years (£11,060 thereafter)
These are just some of the combinations you could consider.
Your financial adviser will be able to recommend the best way for you.