More retirees are choosing to take a lump sum out of their pension and use Flexi-Access Drawdown to pay an income. But with fewer people opting to purchase an Annuity with their pension, is it a move you should be considering?
When Pension Freedoms were introduced in 2015, it gave retirees more flexibility. But it also made pension decisions more complex. If you choose not to purchase an Annuity, you’re responsible for ensuring that your pension provides you with the income needed.
One of the key decisions those approaching retirement need to make is whether to take a lump sum out of their pension fund. You can take up to 25% of your pension tax-free. You can take this tax-free portion in one go or in smaller withdrawals over a longer period. It’s an attractive option for many.
So, is it something you should take advantage of? Weighing up the pros and cons is crucial.
The advantages of taking a lump sum
- More flexibility: The biggest draw here is the flexibility that a lump sum provides you with. You’re not tied to an Annuity or an investment strategy that’s defined by your scheme. If you have a clear idea of how you’d like to use your pension, it can be a big draw.
- Invest how you want: If you want to continue growing the value of your pension, taking a lump sum gives you more freedom to invest in a way that suits you. This approach could yield higher returns, but, of course, there’s always the chance that your pension will decrease in value at points too.
- Support early years of retirement: The early years of retirement are often more active than the later ones. Perhaps you want to travel or take up a new hobby. Taking a lump sum from your pension can give you the cash injection needed to support your aspirations. Alternatively, you may still have debts, such as a mortgage, that you want to clear as you enter retirement. A lump sum may be one of the easiest ways to do this.
The drawbacks of taking a lump sum
- Pension needs to provide consistent income: While taking a lump sum out of your pension might seem like a good idea, you should balance this with the long term. Your pension needs to provide you with a sustainable level of income throughout your retirement years. Taking a lump sum out of it early on could affect your income for the rest of your life considerably.
- Pension value can decrease: If you choose to withdraw and hold the money in cash, for example in a savings account, the value can decrease in real terms. It can mean your spending power falls, in turn, affecting your retirement lifestyle. As a result, it’s important to decide how you’ll use the lump sum beforehand.
- May be liable for tax: You can take out 25% of your pension tax-free. However, beyond this amount, you may need to pay tax. With this in mind, effective planning is important to minimise the amount of tax you’ll pay.
Even after taking a lump sum out of your pension, there are still important decisions that need to be made. How you access the remainder of your pension, for example. Among your options are:
Leaving your money invested in a pension
After taking out a lump sum, this is one of the most popular options among retirees. In fact, 60% of pensions that entered drawdown last year did not see any further withdrawals once the tax-free lump sum had been taken, figures from the Financial Conduct Authority (FCA) show.
As you can take your lump sum from your pension at 55, you may not need to draw an income immediately. Leaving your pension invested in a fund is usually a good option if this is the case. It means the value of your pension will potentially continue to increase tax-free, providing you with more income once you access it.
Purchasing an Annuity
With what’s left in your pot, you can purchase an Annuity. The most common type of Annuity is a Lifetime Annuity; this provides you with a guaranteed income for the rest of your life.
The Annuity rate is the amount that you will be offered for each pound in your pension fund. These rates can vary between providers but will also be dependent on your personal circ*mstances, for example, your life expectancy. The income that you receive from an Annuity will be taxed.
Use Flexi-Access Drawdown
Flexi-Access Drawdown is where your remaining fund will be re-invested with the goal of providing you with a regular, taxable income. You’re able to set the income you want. But you do need to keep in mind that you need to take an income from this for the rest of your life.
Unlike an Annuity, the income you draw in this way isn’t guaranteed. You will need to manage your investments and regularly review the income you’re taking depending on performance. It can provide you with more freedom but it does come with risks too, for example, you may outlive your money.
You don’t have to choose just one of these options. You can take a mixed approach to suit your lifestyle and retirement plan. Contact us today to better understand which option is best for your pension.
