What are my pension income options?

This week’s article focuses on Defined Contribution (also known as Money Purchase) pensions only, as they are the most common form of private pension provision in the UK today. The following excludes Final Salary Pensions and the State Pension.

Before I start, what is a Defined Contribution pension? Well, in its most simple form, it is a long-term savings account, which will be required in future to provide an income, to replace earnings once you have stopped working. The larger your pension pot at retirement is, the more income it will provide you for the rest of your life.

Broadly speaking, there are two main options: a ‘Lifetime Annuity’ and ‘Flexi Access Drawdown’ (FAD). There are other hybrid type products available, but these two are by far the most common. It is worth noting, that it is not a case of selecting one or the other, you can split your pension savings to have a bit of both.

With both these options, you are entitled to 25% of the pension pot tax free. However, the way on which you can take this differs across the products. The remaining 75% is taxed at your marginal rate upon withdrawal.

These options are very different and choosing the right path is one of the biggest financial decisions you will ever make. Remember, this will provide your income for the rest of your life which could be 30-40 years. If you are unsure, this is the time to seek advice from a professional who will recommend the most suitable product for you.

I can’t tell you which is best, as it is purely down to your personal circumstances as to what is most suitable. What I will provide is a high-level overview, highlighting the positives and negatives of each option.

Option 1: Lifetime Annuity

This is effectively a life assurance product, whereby the annuity provider, using health statistics, will attempt to guess your life expectancy and will pay you a guaranteed income for life, in exchange for a large lump sum (your pension pot).

To give a simple example; a healthy 65-year-old might be expected to live for 20 years. Therefore, in exchange for a £100,000 pension fund, the annuity provider makes a promise to pay £5,000 income per year, guaranteed, until the individual dies.

Each individual is underwritten on their medical conditions and the sicker you are, the more income you will receive - this is to reflect a shorter than average life expectancy. This is the only time you want to be sick when underwriting an insurance policy! Using the above example, lets assume that the individual was overweight, a heavy smoker and recently had a heart attack. The annuity provider instead estimates the life expectancy to be just 10 years and will therefore pay an income of £10,000 per year, rather than the £5,000 which a healthy person would get.

The above is a simple example. Like all insurance policies, there are other features you can include, but the more of these you add, the lower your income payment will be. These features are:

• Indexation. You can ensure the income increases every year to keep pace with inflation. You can choose to have this fixed at a certain percentage (e.g. 3%) or to a specific index such as RPI or CPI. Alternatively, you can keep it ‘level’ meaning it will remain the same throughout.

• Dependents pension: You can select a percentage at the outset such as 50/67/100% which your dependent (doesn’t have to be a spouse) will receive as guaranteed income following death. If the annuitant was receiving £5,000 per year and had a 50% spouses’ pension, following death, the spouse would receive £2,500 per year until death.

• Guarantee period: This guarantees that the full income will get paid for the remainder of the guarantee period, should the annuitant die earlier than expected. If the annuitant had set up a 10-year guarantee period and died after 4 years, the annuity income would continue to get paid to the estate for the remaining 6 years.

Best annuity rates today using a healthy 65-year-old, spouse 3 years younger. £100,000 pension fund:

- Single Life/level/nil guarantee (most basic): £4,785 pa
- Joint Life 100%/level/nil guarantee: £3,776 pa
- Single Life/RPI/nil guarantee: £2,681 pa
- Single Life/level/10 year guarantee: £4,720 pa

To summarise:

Positives:
• Pays a guaranteed income for life, even if you live to 150.
• No investment risk.
• Simple to understand/no requirement for ongoing advice.
• No ongoing charges.
• A range of features available to suit your circumstances.

Negatives:
• You lose financially if you die earlier than expected.
• Once annuity is set up, it cannot be changed. It is completely inflexible.
• The annuity dies with you, or your dependent, so cannot be passed to your descendants.
• Loss of a capital lump sum at the outset which will have no opportunity to benefit from potential investment growth.
• The 25% tax free cash must be taken in its entirety as a lump sum at the time of purchasing the annuity.

Option 2: Flexi Access Drawdown (FAD)

This option has become far more prevalent since the introduction of Pension Freedoms in 2015. With FAD, you can simply draw as much or as little income as you want, whenever you want. This comes with an element of risk.

Imagine a bucket of water. The water in the bucket represents your pension life savings. Whilst it remains in the bucket, it is invested and benefits from tax free investment growth. Upon reaching retirement, you fix a tap to the bottom of the bucket. Whatever comes out of the tap is your income. You can turn this on/off whenever you like, but the danger is that the water in the bucket might run out in future.

There are no income rates to show for FAD, like there are with a lifetime annuity. Scientific analysis believes that a 4% withdrawal rate would be sustainable for life (withdrawing £4,000pa from a £100,000 fund).

This might seem quite straight forward from the above analogy but is far more complex than an annuity as I will explain.

Positives:
• Completely flexible. Income can be adjusted to suit circumstances.
• Access to capital lump sums.
• Tax efficient. For example, income can be tailored so that it doesn’t exceed a certain tax threshold.
• The 25% tax free cash doesn’t need to be taken at the outset. It can remain invested and can be drawn out in smaller parts when required. It can even be used for additional regular withdrawals to supplement other income.
• On death, the remaining pension can be passed to anybody. Furthermore, this will be tax free if death occurs before age 75. If death occurs after age 75, it will be taxed at the recipient’s marginal rate.
• Remaining pension will sit outside of the estate for IHT purposes. It’s one of the best vehicles for inter generational wealth planning.
• Opportunity to benefit from investment growth (it can also go down).
• You are not locked in. You can still purchase an annuity in future if you desire.

Negatives:
• More complicated – it is always recommended that you take ongoing financial advice.
• Charges apply. These include pension administration, investment charges and IFA charges (these vary, likely to be 1.5%-2% per annum in total of the pension value)
• Investment risk. Investments can also go down as well as up. Coronavirus would be a daunting time for those in FAD.
• No guaranteed income. If investments perform badly and/or you live longer than expected, you might run out of money in future.

Arranging your pension income is one of the biggest financial decision you will ever make as it might need to last you for 30-40 years

As ever, please ask or pm me if you have any queries.

On this point, the industry came under heavy scrutiny several years ago as providers were making it too easy for retirees to simply accept the first annuity rate being offered to them.

This meant that retirees were not shopping around for the best rate and losing out on millions of pounds of income. It is so important to shop around and speak with an Adviser when reaching retirement.

Guaranteed income (annuity) and Drawdown often compliment each other well. Some people like to have a baseline of guaranteed income to cover their 'essential' expenditure, such as bills and food. This can be from a combination of State Pension, annuity and final salary pension. The rest of the pot (Drawdown) can simply remain invested and be used to dip into occasionally for large ad-hoc costs such as holidays, gifts and new cars.

Morning Cryrst, no worries, just call when you're free.

Yes, you are correct in your understanding.

The mechanics would work as follows: You would need to 'crystalise' £20,000, of which 25% is your £5,000 tax free amount. The other £15,000 would be designated to drawdown, where you could either withdraw it as taxable income or leave it invested to grow.

The remaining £80,000 of 'uncrystalised' pension can remain invested. Let's assume over the next 5 years this grows to £90,000, you would then in future be entitled to 25% of £90,000 (£22,500). Like before, you don't have to take it all in one go.

Mr Goal Machine,

You say that if the pensioner dies before age 75, what is left of his pension will be taxed at the recipient's marginal rate - which could be up to 45%. That seems to mean that a widow "inheriting" a pension pot of £400k could immediately have to give at least £80k, and up to £180k, of that sum to the tax man. I have always thought it was only the recipient's withdrawals from the pot that were taxed. Could you please clarify?

PS: Do you ever regret starting this thread?!

Mr JRW2,

Ha! No, I don't regret (yet!). Hopefully people are getting some benefit out of the thread. You never know, if someone would like help from an IFA one day, they'll think of me.

When the pensioner dies before 75 it can be withdrawn tax free by the beneficiary.

Using your example, when the pensioner dies after 75, it will pass to the widow tax free, but will be taxed at the widows marginal rate upon withdrawal - this could be 0% / 20% / 40% / 45% depending on their situation.

So yes, you are correct. Just had the before/after 75 the wrong way around.

GM I appreciate the response. It certainly sounds like the charges will be a barrier. I am in a fortunate position that between my wife and I we have 3 decent final salary pension schemes and 2 cash buyout pots. So I suspect we will leave them as they are maximising the monthly income, and using the cash funds as flexi draw downs. Congrats on a very interesting and useful thread.

Human nature kicks in and rash financial decisions are made. It's foolish though, as you say, because even a casual glance at the stock market suggests that it's important to just sit tight and hang on in there. The old "time in the market, not timing the market" again. I saw a comment recently from someone losing it over the ups and downs of the current market and wondering what to do. A reply to them that summed it up said typically you have two options

- to lose money quickly
- to make money slowly

Constant rash decisions lead to the former!

Hi GM
Just seen nationwide has increased its LTV rate.
Problems or sensible and will it affect you and your customers generally? It doesnt affect me as I'm not moving or buying but imo seems harsh and lacking in faith in the individual not the market.
I would have thought a system of deferring the extra 10% or increasing the term on that bit to reduce the payment amount with the option to pay a bit extra on that portion when you can. Might be too complicated but some now wont be able to buy.

Building a successful savings plan

It’s easy to save money, right? Wrong! If you’re one of those whose money runs out a few days before pay day and you’re surviving on beans on toast, you’re not alone. This article is designed to encourage better behaviours to help you reach your financial freedom.

Here some key stats from April 2020:

• 1 in 10 (10%) Brits have no savings at all
• A third of Brits have less than £600 in savings
• The average amount invested is now just £813, down from £1,050 just two years ago
• The average Brit has £6,756.81 put away for a rainy day.
• 40.93% of Brits don’t have enough savings to live for a month without income.
• While 22-29 year olds are the least likely to save, with 53% having no savings at all

Why aren’t Brits saving?

• 40% reported lacklustre earnings as the reason for not saving
• While nearly two thirds of Brits didn’t have a financial plan in place
• 91% of Brits did report they planned to add the same if not more to their savings in 2018 than they did in 2017

Here are some suggestions to help combat these.

Step 1 – Work out your income and expenditure

Quite simply, if you don’t know how much money you need each month to cover your livings costs and bills, how do you know how much you can afford to save each month? Going through this exercise works as a real motivator. You’ll often be surprised at how much surplus income you actually have.

If you budget, say £2,400 per year on holidays, be disciplined and pay £200 per month into a separate ‘holiday account’. This will avoid the need to pay large lump sums, or even loans, and won’t feel like such big hit when holidays come around. The same goes for hefty annual subscriptions you may have.

If you are genuinely struggling to cover your living expenses, try to adjust and see where you can cut costs. Packed lunches and avoiding your morning Starbucks are two easy wins.

Lastly, pay yourself at the start of the month, not the end.

Step 2 – Build an ‘emergency fund’

It is recommended that individuals build an emergency fund equal to at least 3 months salary. This should be held in an instantly accessible cash account and only used to pay for unexpected costs such as replacing a kitchen appliance or a new boiler, or even worse, replacing your income if you find yourself out of work.

Stage 3 – Building your investment pots

By following the first two steps, your investment pot should be able to grow uninterrupted and benefit from long term compounding – this is the ‘snowball’ effect.

It’s vital that you identify an end goal for your investment pot, such as what is the savings pot for and when are you looking to achieve it? It’s important as the length of the investment will impact how much risk you can afford to take. The general principal is that the longer the time horizon, the more risk you can absorb, as a long-term investment has time to recover from short term volatility, whereas a short one doesn’t. History has so far proved that stock market investing over the long term outperforms all the other main asset classes. Separate your pots for each of your goals and treat each pot differently.

An example of a ‘short-term pot’ might be saving to pay for a wedding or a mortgage deposit. If this is less than 5 years away, a ‘cautious’ investment approach would be sensible.

A typical ‘long-term pot’ would be your pension savings. For someone with 15+ years to retirement, although it may seem daunting, an ‘adventurous’ investment approach should be strongly considered to maximise the growth. Over time, a pension pot would eventually become a short-term pot and the investments can be adjusted accordingly then.

The majority of people in the UK build their long-term savings in cash as it is deemed ‘safe’. This is one of the mostly costly financial mistakes you can make. If interest rates are at 0.5% and inflation is at 2.5%, the spending power of cash reduces by 2% per year. Imagine this over 20 years. In the year 2000, 30p would buy me Mars bar, today it would buy me a Freddo! Don’t make this mistake.

Remember that investments can go up and down in value, so you could get back less than you put in.

If you need help with a budgeting questionnaire or help choosing the right investment, please don’t hesitate to make contact.

How much do I need to save for retirement?

Where do I start with this? Research from Fidelity suggests that ‘savers should be putting away at least 13% of their pre-retirement annual income before tax, each year, from the age of 25’.

25-years olds are typically saving for their first deposit, wedding or have kids. How can they possibly afford 13 percent per month?

The introduction of Auto Enrolment, which is the requirement for employers to automatically enrol new starters into the workplace pension scheme, has helped but the minimum contribution requirement is 3% from the employer plus 5% from the employee. This is still 5% short of Fidelity’s 13% suggestion.

Now factor in the ageing population in the UK with the plans to increase the State Pension age beyond 67. This clearly raises questions about the sustainability of the State Pension. Will Millennial's even have a State Pension in 40 years’ time?

If any of this is worrying you, then good. This is designed to shock as too many are sleeping walking into financial worry.

My issue with Fidelity’s statement is that it is far too simplistic. Someone with a desired retirement age of 55 will need to save considerably more than someone who wants to retire at 70. One person’s dream retirement could be to travel the world and take up new hobbies, which will require more income than their best mate who just wants to watch telly and walk the dog. Retirement planning is complex and unique as there so many variables to consider.

Here are a few steps to hopefully put you on track.

Step 1:
In today's terms, try to estimate how much income you need to fund your lifestyle. Things to consider include deducting expenses which will be gone by retirement such as kids becoming financially independent, mortgage cleared, and costs associated with work i.e. travel and clothing. You also need to factor in possible additional costs such as increased holidays or that new golf membership.

Step 2:
Increase the figure from step 1 to account for future inflation up until your desired retirement age. Inflation averages at roughly 2.5% over the long term. If you don’t know the calculation, this can be found on the internet. As an example, if I need £20,000 income today, in 10 years
time I’ll need £25,601.

Step 3:
This is where it becomes tricky. Try to guess how many years you will live. The average 65-year-old male will live to 85 whereas the average female will live to 87. Consider the history of longevity in your family and how your current health may impact this. Multiply this by the figure in step 2 and factor in even more future inflation. Suddenly the numbers become very daunting.

To put this into context, if you are cautiously minded and are attracted to the simplicity of a guaranteed income for life in retirement (known as a lifetime annuity), a £10,000 per annum inflation linked income with no death benefits or guarantees would cost a healthy 65-year old approximately £375,000.

Try this pension shortfall calculator to see where you currently are: [Link]

Ultimately, the only person who can help you, is you.

Here are my tips:

• Start saving early. The effects of compounding (the snowball effect) will be far greater for someone starting in their 20’s compared with someone in their 40’s.

• Maximise your employer contribution. Most settle for the default minimum contribution upon joining the workplace pension. Speak to your HR department as many employers will increase their contribution if you do. If your company will offer you free money, you might as well take it, right?

• Review your pension investment. The default choice will be a run of the mill ‘lifestyle’ approach which gradually de-risks as you get to within 10 years of your selected retirement age. Many employer sponsored arrangements have up to 200 other funds to choose from. Is there a better option to make your investment work harder for you?

• Keep track of previous pensions. There is over £10 billion of lost pensions in the UK as people move job and forget about their old pension. It often make sense to transfer your old pension into your current one for ease of administration, but check charges before doing this. Here is the link to the governments Pension Tracing Service: [Link]

• Use the correct tax wrapper. A pension will benefit from full tax relief on a contribution and growth will also be tax free. I recently met a client who had been saving towards retirement via a stocks and shares ISA. 20 years of contributions had been missing out on 20% tax relief and investment growth.

• Love your pension. You may not feel it now, but one day you will be grateful for the small sacrifices. Get in the habit of checking your pension value at least once a month.

A financial planner will have access to cashflow forecasting software which will help you to project into the future and identify any shortfall.

As always, comments and questions are welcome. Feel free to PM me if you'd like any assistance with your own arrangements.