Converting a pension pot into cash and income is an important financial decision that generally requires specialist financial advice.
It is easy to think that very small pots should be taken as cash, average size pots (around £30,000) should purchase an annuity and everybody else should invest in drawdown. This black and white approach is no longer appropriate because everyone can take advantage of the new flexible options.
If you decide to take defined contribution pension advice to transfer your pension fund out of your employer’s scheme to a Personal Pension (PP), the choices are (subject to any Lifetime Allowance restrictions):
You can purchase an annuity which gives you a guaranteed income for the rest of your life.
There are many types of annuity to choose from, with different features including:
- Payment increase rates
- Spouse’s, civil partner’s or dependant’s pension
- Guarantee period
- Impaired life enhancement
Additionally, a number of retirement providers offer investment linked annuities and fixed term products.
The income from an annuity would be taxable, although you would still be able to take up to 25% of the total value of your benefits as a tax free lump sum when your annuity commences.
If interest rates rise in the future, the cost of purchasing an annuity may fall – which could make annuity purchase more attractive.
Cash Lump Sum
There is the option to take your entire PP fund as a cash lump sum.
The first 25% would be tax-free and the residual amount would then be taxed at your marginal rate.
Flexible Income – Drawdown
There are two ways you can get a flexible income from a Personal Pension (PP) fund. The main difference is how you can take the tax-free cash part:
- Flexi Access Drawdown (FAD)
You can take 25% of your whole PP fund as a tax-free cash lump sum when you first set up your FAD arrangement.
Once the FAD is set up the balance of your PP funds is invested on your behalf and you can make withdrawals from the funds whenever you choose (although providers of these arrangements may impose rules around withdrawals and charges may apply).
Each future withdrawal will be counted as income and taxed at your marginal rate. Your provider will pay the drawdown amount to you after deducting any income tax due.
- Take a series of cash lump sums (UFPLS)
With this option, you cannot take 25% of the whole of your PP fund as a tax-free lump sum at the outset, but instead you can get 25% tax free each time you take money from your PP fund.
You can take a number of cash sums at different stages. How often you take money out and how much is up to you (subject to any rules imposed by the provider of the pension arrangement) but 25% of each sum you take is tax free.
The remaining 75% of each sum you take is subject to income tax at your marginal rate.
With flexible income arrangements, the pension provider has numerous funds with different risk profiles available to choose from allowing us to efficiently and effectively invest and manage your PP funds on your behalf to provide a flexible income.
Any Combination of Annuity, Cash & Flexible Income
Pension freedoms allow those over 55 the choice of how to best utilise their PP funds in retirement.
You can choose any combination of annuity, cash and flexible income.
There are many pension providers and products available in the market that can:
- combine annuity purchase and drawdown within the same policy.
- offer plans that guarantee income for a fixed term with a guaranteed PP fund amount at the end of the term.
- offer investment linked annuities.
- offer investment “risk free” cash deposit only plans.
Defined Contribution Pension Advice
Before a decision can be made about taking cash, income or purchasing an annuity some very important issues must be considered:
- When and how much pension income is required?
- Is it better to take income from savings or pensions?
- What are the tax implications?
- How much income should be guaranteed and how much flexible?
- What is the associated level of risk involved?
When and how much pension income is required?
The best way to find this out is to utilise a cash flow forecast – we have these for you to complete.
It might be tempting for someone to dip into their pension pots when they reach age 55, but if this is done without good reason, for instance they think it is better to have the money in their own bank account rather than leaving it in a pension, they will probably not get the best outcome.
Sound financial planning is required to accommodate taking cash or income to fund:
- a special purchase
- a shortfall between income and expenditure
- to bridge a gap before the start of the State or a Defined Benefit (DB) pension.
Is it better to take income from savings or pensions?
Now that pension pots can be transferred to any beneficiary after death, there is an argument for taking income from savings before accessing pension pots. By deferring pension income, the maximum amount is available for estate planning purposes.
A counter argument is that it might be better for clients to enjoy the benefit of the pension themselves rather than sacrifice income in order to benefit their beneficiaries. Another reason is that a future government could change the rules and make transferring pensions on death less attractive.
What are the tax implications?
There are a number ways of arranging pension income in a tax efficient manner and these should be always be considered.
For example, phasing cash sums or income over several tax years can significantly reduce the overall amount of tax payable for those who would otherwise pay higher rate tax.
How much income should be guaranteed and how much flexible?
One of the benefits of planning ahead for retirement is it helps when calculating how much income is required to meet essential expenditure.
Current practice normally suggests the use of lifetime annuities to meet essential expenditure requirements. However, the requirement for a secure income does not need to be secured by a lifetime annuity. Although annuities are the only available product that can guarantee income for life, there are other ways of securing a guaranteed income albeit not for life.
Fixed term income plans and some guaranteed income funds are alternative options that should also be considered.
The amount of guaranteed income you require may increase or decrease as you get older. It might be a mistake to lock into too much guaranteed income too early, especially if other sources of guaranteed income e.g. State or DB pensions are payable later.
What is the associated level of risk involved?
This question is inextricably linked to the question about certainty or flexibility. Someone may want flexibility over their pension income options but can they accept the risk associated with this flexibility?
Before retirement the main risks are framed in terms of the gains and losses associated with market volatility. During retirement, the assessment of risks should take other factors into consideration such as income risk, health risks and longevity.
Theoretically, clients should not invest in drawdown or other riskier retirement options unless they have their essential needs secured and/or have other sources of income to fall back on if their drawdown plan goes through a difficult patch.
How much risk should I take?
It is complicated, but you need to take enough risk to avoid being locked into very low returns forever, but not too much risk that you put your future retirement plans in jeopardy!
When assessing how much risk to take you should consider not only your attitude to risk but also your capacity for loss. Attitude to risk is an easy concept to grasp and is normally expressed as low risk, medium risk or higher risk.
Low Risk – You would prefer to have most of your investments in cash and fixed interest securities in order to protect the value of your capital.
Medium Risk – Someone who would like to take advantage of equity investment with the prospect of good long-term returns but can accept some short-term volatility which may result in a fall in the value of the investment.
High Risk – You will consider exposure to higher risk investments despite the potential loss of capital.
Your attitude to risk is normally measured as your tolerance to taking investment risk and we have special questionnaires and tools to help assess your risk profile.
Capacity for loss
is described as your ability to absorb falls in the value of your investments or income without it causing you adverse financial hardship or emotional strain.
There are many other different risks you should take into consideration during your retirement. These range from the risk that you might be too cautious and therefore get locked into low returns to being too optimistic and therefore run the risk of losing your cash or running out of income.
- Income risk – If you don’t plan wisely you may end up short of income in later life and at the very worse run out of income
- Annuity rate risk – You may decide to purchase an annuity at some time during your retirement and if annuity rates reduce you will get less income. If annuity rates improve you will get more income
- Stock market risk – If your pension funds are invested in the stock market the value will rise or fall depending on equity prices. If you invest in drawdown you must watch out for ‘sequence of returns risk’
- Inflation risk – This affects your future spending power so if your income does not increase over time you might not have enough income to maintain your lifestyle
- Health risk – If your health deteriorates you may have to pay for long term care or help with daily living. It is important to consider this when thinking about your income requirements
Defined Contribution Pension Transfer Advice Cost
The cost for defined contribution pension transfer advice ranges between 0.5% and 1% of the CETV amount – depending on the CETV size.
There is a minimum fee of £1,000.