How should I take my pension benefits?
Since the chancellor, George Osborne, gave his Budget speech, the media has been full of scare stories about people blowing their pensions on fast cars and holidays. But what’s the reality for most people? Jason Butler gives an overview of the options.
“Pensioners will have complete freedom to draw down as much or as little of their pension pot as they want, anytime they want. No caps. No drawdown limits.…. No one will have to buy an annuity.” – George Osbourne
The main factors that you need to consider when deciding how and when to take your pension benefits are:
◾ Your annual cashflow needs
◾ The rate of future inflation
◾ Your life expectancy and any dependants’ circumstances
◾ Your income tax, capital gains tax and residence status
◾ The pension lifetime allowance
◾ Investment risk and taxation of non-pension investments
◾ Taxation of the payment of pension benefits on your death
Estate planning considerations
The earliest age at which you can take benefits from your pension is usually 55, unless you were in a special occupation, and had pension arrangements in relation to that occupation, which permitted earlier access (e.g. sportsperson, model, diver etc) before 6 April 2006, or you qualify for a severe and permanent ill-health pension. There is no longer an upper age limit by which pension benefits must be taken, whether that is as an income or lump sum.
Life expectancy and your dependants
Despite the perception of poor value, a guaranteed pension annuity (whether level or inflation protected) is insurance against living too long. Life expectancy has been rising in the UK over the past 50 years. Unless you have a terminal health condition, or a family history of short life expectancy, it is impossible to know how long you are likely to live. All the evidence suggests that it will be a lot longer than you think.
Life expectancy at age 65
Source: The Financial Times Guide to Wealth Management (2nd edition), Butler, J, Prentice Hall. Data source: Office for National Statistics: Historical and Projected Mortality Data from the Period and Cohort Life Tables, 2012-based, UK (December 2013)
As a general rule it doesn’t make sense to take on the risk of living too long (longevity risk), particularly if you expect above-average life expectancy. Therefore, for most people a guaranteed annuity is likely to be a good choice for some or all of their pension assets. It’s also low cost, simple and requires no ongoing management.
Pension benefits are usually available in the form of a taxable income and a tax-free lump sum, known as a pension commencement lump sum (in most cases this is 25 per cent of the fund value). In the case of a defined benefits pension scheme, the lump sum can be in addition to the guaranteed pension income (most commonly in government-backed schemes or those operated by companies that were previously government-owned) or in return for giving up some of it, known as commutation.
You can take pension benefits gradually over a number of years and use tax-free lump sums to provide cash inflows to meet your lifestyle expenditure each year, together with taxable income either directly from the fund or from the purchase of an annuity. You could take the maximum pension commencement lump sum from your whole pension and then have the choice of taking a taxable income or, from April 2015, you may also take the entire fund of a defined contribution pension scheme (after deducting the tax-free lump sum amount) as a taxable lump sum. Prior to that date, taking a taxable lump sum requires the member to have a secure (as in state pensions, guaranteed annuities and benefits from a defined benefits scheme) pension income of at least £12,000 per annum.
Taking the taxable portion of your pension as a single lump sum needs to be carefully considered in the context of:
◾ Your other taxable income and capital gains
◾ Whether you can mitigate any income tax arising on the withdrawal (i.e. investing in an enterprise investment scheme or similar tax shelter, or by offsetting trading losses)
◾ What you intend to do with the funds
◾ Whether or not you want/need to remove longevity risk by buying a standard or enhanced annuity (i.e. which is higher if you are in poor health)
◾ Whether and to what extent the withdrawn capital would give rise to a higher inheritance tax liability for your estate and whether this is a concern for you.
State and private pension income, lump sum taxable pension fund withdrawals and income from employment and self-employment form the first slice of taxable income. To the extent that such income (or taxable capital pension withdrawals) uses up some or all of your lower and/or higher rate income tax bands, it can affect whether or not you retain your personal income tax allowance and the rate of tax that you pay on rental income, interest and dividends, which form the top slice of taxable income. The tax rate applied to taxable pension lump sums is determined in the tax year in which you take the benefit.
The chart below shows the cashflow position of a £250,000 taxable lump sum taken from a pension fund, compared to taking an annual withdrawal of £20,000 within the basic rate income tax band. Disregarding investment returns and inflation, taking the regular withdrawals provides the higher amount of net cash after just six years. Clearly different assumptions will produce different breakeven points, but the key point is that for many people, particularly with larger funds and other sources of taxable income, taking the pension as a single taxable lump sum is likely to result in a lower cash outcome.
Source: The Financial Times Guide to Wealth Management (2nd edition), Butler, J, Prentice Hall.
◾ As a general rule using pension funds to provide a guaranteed annuity should be the default choice for most people, from which all other options are compared
◾ You might be able to improve the guaranteed annuity rate by up to 20 per cent if you have a condition
◾ Inflation-linked annuities are currently very expensive and they will be most attractive for people who expect to live well beyond the average and anticipate high (greater 4 per cent) annual inflation
◾ Drawing a regular income from any portfolio, regardless of whether it is from a pension plan or not, involves a number of variables and risks and there is no perfect solution
◾ You are highly likely to live longer than you think, and your pension and other assets may have to support a three, or even four, decade retirement so think LONG TERM
◾ Drawing a regular income directly from your pension under drawdown becomes more risky and expensive as you get older, particularly from age 75
◾ Try to go for the simplest solution possible because as you get older you might not want to be making complicated financial decisions
◾ It may be that a mixture of guaranteed standard/impaired life annuities, income drawdown and lump sum withdrawal will help you to have a successful retirement.
If you have low confidence about how to take your pension benefits and the financial impact of a bad decision would be high, then seeking the advice of a qualified and regulated UK financial adviser might cost you some money in fees, but is likely to be the best investment you ever make.
About the author
Jason Butler is a Chartered Financial Planner and Investment Manager at Bloomsbury Wealth. He has 23-years’ experience in advising successful individuals and their families on wealth management strategies.
Please note: The opinions, beliefs and viewpoints expressed by our contributing authors do not necessarily reflect the opinions, beliefs and viewpoints of unbiased.co.uk.