So now that you have saved into a pension all of your life how do you use this money for income?
– buy a guaranteed income for life (an annuity)
– take a flexible income (drawdown)
– take a one off tax-free lump sum (or several tax free lump sums over a period) and leave the rest invested for future use (drawdown)
– take a mixture of regular income combining tax free and taxable income
– mix your options with a combination of annuity and drawdown.
We will help you make a plan on how best to take income and we will help you manage that income and the remaining funds invested over time.
The funds that remain invested in your new retirement plan may also need to be re-arranged and may look quite different from when you were simply building up the fund, because income that you need in the short, medium and longterm may need to be invested in different ways.
Traditionally your pension fund would grow until you needed it when you stopped working. Let’s say you have a fund of £100,000. You might then ask the pension provider what ‘guaranteed income’ they would give you in return for ‘giving away’ the fund to them – In return the pension provider would offer you various different income options – this is called buying an ‘annuity’. (Annuity means a guaranteed income for life).
The annuity provider might say ‘we will give you 5% a year or £5,000 per year from your £100,000 fund and this would remain the same for as long as you live but the income would end when you die’ – the annuity provider would keep any residual fund value remaining.
If you lived 3 years you would have taken £5,000 x 3 = £15,000 and the provider would keep the remaining fund.
This might sound like a bad deal but had you lived for 30 years you would have had £5,000 X 30 = £150,000 back during which time you would not have had to be concerned about whether your fund was growing at 5% a year or whether the fund would last long enough to pay out the £150,000, this is the providers ‘risk’.
Having been offered 5% a year you might say to the provider ‘actually I want my spouse to continue to have 50% of the income or 100% of the income if I were to die’, in which case the provider might say ‘in that case we will give you 4% (£4,000 per year) instead.
You might also ask whether the income could keep increasing with inflation rather than staying at the same amount, in which case the provider might say ‘we will give you 2.5% (£2,500 per year)’ as a starting amount instead.
When buying an annuity you have to make a decision at the start of the process because the provider is taking on the ‘investment risk’ of the fund in exchange for giving you a guaranteed level of income. We will help you understand what the choices and options you have are and the pros and cons of each element and help you set up the annuity of your choice. As this is a one time decision making the right decisions at the outset are paramount.
In recent times an alternative method of taking income has become popular because people felt that annuity rates were low and they did not like the thought of ‘giving away’ the fund even if guarantees were given.
So, the main alternative to buying an annuity is in effect exactly the opposite process which is called ‘Drawdown’.
Instead of giving away the fund you keep the fund and draw an income from it yourself.
Having kept the fund you now also have the risk of whether the growth of the fund keeps pace with the amount of income taken from it.
So, if you take 4% per year of income from the fund and it grows at 4%, in theory, you still have £100,000 at the end of the year. But if you were to take 10% per year of income from the fund and it only grows at 4% a year, the fund would be losing 6% per year and in theory there would be no fund left from which to take an income after about 12 years.
However, in return for taking on the risk, if the amount of income taken is less than the growth achieved, there should be a remaining fund left when you die to pass on to your spouse, or even to your children, as it remains in your estate having never left it.
Alternatively you may feel comfortable with drawing higher levels of income from the fund knowing that the fund will diminish over time until your death – however the timing of this is usually an unknown quantity and therefore care and consideration is required to monitor how the fund is matching your requirements.
Early retirement might mean there is a gap before your state pension starts and therefore you may require a plan to take more income from the drawdown fund in the early years until the state pension starts and then reduce the income from drawdown fund in order to preserve the fund for a longer period.
You may also be in the fortunate position of not needing income from your pension fund because you have sufficient income available from other assets but you are facing a likely Inheritance tax bill on death. In such circumstance you might feel that preserving the pension fund which sits outside of your estate, might be a tax efficient method of passing assets down to your beneficiaries after taking into consideration the difference in rules before and after age 75.
Note that there are some alternatives to annuities and drawdown.
If you want a review of your Pension(s) or would like to understand more about how pensions work; get in touch with our advisers to arrange an initial consultation.