Now is not the time to make quick decisions about your pension!
Making a decision about your pension isn’t something to rush. In this short blog I’ll help you understand the different types of pensions, different options for drawing your pensions and some of the important considerations to make the most of what you’ve got.
Don’t rush and take good advice
Deciding when and how to draw your pension takes careful thought and preparation. The decision you make could affect how much income you receive in total, how long your pension pot will last and to what extent you’ll be able to change things in the future. To add to the mix, pensions can be devilishly complicated, with all sorts of rules, charges and investment options to consider. How you draw your pension may affect the amount of tax you pay and any State benefits you are entitled to.
Let’s start by talking about the types of pensions out there
If you’ve worked for a big employer for many years, the chances are that you’ll have some form of workplace pension. These are generally divided into ‘Money Purchase Pensions’ and ‘Defined Benefit Pensions’ (sometimes referred to as ‘final salary pensions’). If you’re self-employed, any personal pension you are presently paying into will also be a Money Purchase Pension.
Money Purchase Pensions
For a Money Purchase Pension, the value of your pension pot will be based on how much money has been paid in, how the funds you have invested in has performed and any charges that have been deducted. There’s generally no guarantees, although some funds come with guaranteed growth rates. Basically, when you choose to draw your pension, which would now be anytime after age 55, you would have a single pot of money to play with.
There’s a number of options open to you at that point. You could buy an annuity which will provide the security of a guaranteed income for the rest of your life. If you’re in poor health, annuity providers can offer ‘enhanced rates’.
Alternatively, you could choose to draw your pension flexibly – taking what you want, when you want it. Also, drawing your pension flexibly could mean that if you die before drawing all your pension pot, your beneficiaries will inherit what’s left. You’d also benefit from any future growth on money not yet drawn down, although it could fall in value too. This is commonly referred to as ‘pension drawdown’ or ‘flexi-access drawdown’. It’s important to remember that, unlike an annuity which is guaranteed to pay you an income at the same level for the rest of your life, taking your pension as drawdown would not guarantee you an income.
So, let’s take a closer look at this new flexibility. Under new ‘pension freedom’ rules introduced in 2018, you’re now able to draw all of your pension as a single cash lump sum. The first 25% will be paid tax free, with the balance being treated as income received in that tax year; this may affect the rate of income tax you pay on other income you receive.
Of course, you could choose to mix flexibility with security. Either way there’s a lot of advantages of each option and you’ll need some good financial advice to select what’s best for you.
One final option is to do nothing. Reaching a certain birthday doesn’t mean you need to decide what to do straight away.
Defined Benefit Pensions
A ‘Defined Benefit Pension’ does largely what it says on the tin. It’s generally only available to employees or directors of larger companies or if you’re employed in the the public sector. It’s designed to provide a guaranteed pension which is based on the numbers of years you’ve been a member of your employer’s pension scheme and your final years’ earnings, or an average of your earnings over years leading up to your retirement. Excluding public sector pensions, it is possible to transfer your defined benefit pension as a ‘cash equivalent transfer value’ into a more flexible money purchase pension as defined benefit schemes offer limited flexibility, including death benefits, However, Defined Benefit Pensions are very attractive as, come what may, your pension is guaranteed by your employer and money purchase pensions are generally unlikely to match the same level of guarantee.
For both Money Purchase Pensions and Defined Benefit Pensions, when you are taking pension, you’ll also have the option to draw a certain amount of cash which is tax free. Taking a cash lump sum under bother both types of scheme would normally reduce the amount of remaining pension you can receive.
Do I really need the pensions freedom?
Life can be unpredictable. We have all experienced that over the last few months…
So, having the flexibility to draw the amount of pension you want and when you want it, means that you can flex the amount you draw based on your changing needs. You can access your pension from age 55, so this may be an attractive option, especially if you are needing to top up any other income. But think carefully before you do this. Remember that whatever’s left will need to last you for the length of your retirement. And don’t underestimate how long your retirement could last. According to the Office of National Statistics, based on data taken between 2016 – 2018) a 65 year only male could live a further 18.5 years and a female 21 years.
I’ve got no idea where to invest my money
If you have a money purchase pension, building your pension pot before you retire and even during retirement means investing in different funds. Choosing the right fund, or combination of funds, should be based on a number of factors including :
How long do you have before you wish to take receive your pension – commonly known as your ‘time horizon’.
The extent you’re prepared to take a risk that your pension pot may fall in value due to movements in investment markets. This is commonly known as your ‘attitude to risk’.
The extent that you could absorb any falls in value without affecting your standard of living, e.g. if you have other income to fall back on. This is commonly known as your ‘capacity for loss’.
The amount of income you’re needing to receive and any other likely sources of income.
Let’s talk about tax
All pensions income, including any State pension you’re entitled to, will be subject to income tax when you receive it. This means that any income, including your pension you receive above your personal allowance will be taxed at the basic, higher or even the additional rate of income tax.
So, at a time when your earned income stops altogether, or perhaps reduces down as you ease into retirement, the amount of tax you pay on any pension will have a direct impact on your standard of living. One way you control your tax, is to consider drawing your pension partly as tax-free cash spread over several years and the other as normal pension, but only up to your personal allowance. This would mean you’d effectively pay no income tax at all on this income.
The role of a Financial Adviser, is to take all these factors into account and build a tailored investment portfolio for you. This could be a multi-asset type fund through to a diverse investment portfolio comprising of investment funds from different geographical and market sectors. Like most of us, Financial Advisers don’t have a crystal ball. But they understand the types and objectives of different funds and will look to blend these to provide the optimal return.
The pension payable and any tax-free cash sum will depend on investment returns achieved, annuity rates and interest rates at the time, charges and the effect of taxation and legislation, and they may be higher or lower than the existing benefits.
If you are not in good health at the time of a transfer and should die within the two years following the transfer, it is possible that some or all of the death benefits from this plan could be included in your estate for Inheritance tax purposes.
You should understand that you would lose access to the capital invested in your pension until you decide to draw the benefits. Under current HM Revenue & Customs’ practice, it is not normally possible to access the fund(s) prior to the age of 55 (expected to increase to age 57 from 2028 with further increases as the state pension age goes up).
Any employer contribution to your plan is dependent upon the continued solvency of your employer.
If your employment status changes, it is important that your retirement planning is reviewed.
Depending how it is taken, your pension income may also depend on interest and annuity rates at the time you retire.