Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Using your pension in retirement
This article looks at the different ways you can access the money in your defined contribution pension. Examples of defined contribution pensions include SIPPs and personal pensions.
The minimum age that most people can access their pension is currently 55. This will increase to 57 in 2028 and could be subject to change in the future.
People in ill health or with a protected pension age can access their pensions earlier.
WHAT ARE MY OPTIONS?
You don’t have to choose a single option from the below – your circumstances might mean that a mix might work best for you.
If you have more than one pension pot, you might want to choose a different option for each pot or you might consider combining your pots before making a decision for some or all of the funds.
The main options for defined contribution pensions such as SIPPs and personal pensions are:
- Tax free cash and annuity
- Tax free cash and drawdown
- Pension lump sums
TAX FREE CASH
Most people can take 25% of their pension pot as tax free cash. This is officially known as a pension commencement lump sum (PCLS).
If you choose to take a PCLS, the two income options for the balance are: an annuity, or flexi-access drawdown.
ANNUITY – A GUARANTEED INCOME FOR LIFE
An annuity is purchased from an insurance company using all or part of your pension after tax free cash. In exchange, they will pay you a guaranteed income for life.
Further options can be included - such as provision for loved ones following your death and inflation protection to ensure your income keeps its purchasing power - but these will lower the initial income amount. These options, together with the income amount and frequency are decided at outset and cannot normally be changed.
If you are considering an annuity it is vital that you shop around for the best deal. Your health can impact the amount of income you could get in exchange for your pension fund. For example, someone who is a smoker or has a health condition could find they are offered a significantly higher annuity rate and therefore a higher annual pension amount, than an individual in good health.
HOW DRAWDOWN WORKS
An alternative option for the balance is to leave it invested in your pension to provide an income. This income can be taken on a regular basis or as and when you need it.
Flexibility and control are the main advantages of drawdown – you can vary the income you take in line with your circumstances. The funds that stay invested could even grow in value over time.
Your loved ones will also be able to benefit from any funds left following your death.
However, the income will not be guaranteed. As you will be subject to investment risk, your fund could be depleted rapidly if you are taking withdrawals in times of a market downturn or increasing withdrawals to keep pace with rising inflation.
You will need a plan in place to regularly review your incomes levels, investment choices and the likely level of tax you will pay to ensure that your fund will last you through your retirement.
PENSION LUMP SUMS – AD HOC OR REGULAR LUMP SUMS
A newer option (introduced in 2015) is a pension lump sum – officially known in the pension rules as an UFPLS (uncrystallised funds pension lump sum).
Instead of taking tax free cash and choosing an option for the balance, you can draw an ad hoc or series of lump sums which are 25% tax free and 75% taxable.
The advantages and the risks are very similarly to drawdown – this option gives you flexibility and control, but any funds you choose not to withdraw will remain invested with a need to review and manage them.
The lifetime allowance is currently £1,073,100 and is set to remain frozen until 2025/26.
There is a test against the lifetime allowance each time you take a lump sum, purchase an annuity, or enter drawdown. Any funds you have not accessed will be tested at age 75 or upon your death before age 75.
If you exceed your lifetime allowance, then there will be a tax charge on the excess amount. You may have a higher allowance if you have claimed protection.
WHAT ABOUT INCOME TAX?
After taking up to 25% tax free, the rest of your pension income, annuity income or lump sum will be subject to income tax.
Your pension provider will use the PAYE system to deduct tax using a tax code provided by HMRC. You could therefore move into a higher income tax band depending on your other income for the tax year.
If HMRC has not supplied a tax code when you take your first taxable payment, your pension provider will have to deduct income tax using either the tax code on your P45 or an emergency tax code. If you take out a large amount from your pot this could mean that you overpay tax and will have to claim it back.
CAN I CONTINUE PAYING MONEY INTO A PENSION?
Yes, but taking any income from a pension as flexi-access drawdown or taking a UFPLS will trigger the MPAA (money purchase annual allowance). This means the amount you can pay into your pension without being liable to a tax charge will be more restricted.
The MPAA is set at £4,000 for the current tax year (2021/22). It includes all pension contributions made by you personally to a SIPP or any other personal pensions but also any contributions made on your behalf by your employer.
Once you have triggered the MPAA, you will be unable to carry forward any unused allowances from previous years for use in your SIPP and other money purchase (defined contribution) plans. Contributions above the limit will be subject to a tax charge.
The MPAA does not apply to contributions to defined benefit pension schemes and is not usually triggered when you receive income from an annuity.
HOW MUCH INCOME SHOULD I TAKE?
In all cases, you should work out the likely income you will need at the start and throughout different stages of your retirement. The income you receive (after your 25% tax free cash) will be subject to income tax.
You should also find out when your state pension is due to start and obtain a forecast of the amount you are likely to receive. This will help with your initial planning and any reviews of your income and investment strategy throughout retirement.
An annuity will pay you an income for life and cannot normally be varied. It might increase with inflation or continue after death, depending on options at the time of purchase.
Drawdown income or pension lump sums can be varied to suit your income needs over time. However, if you continually take out money at a higher rate than the growth in your underlying investments, your pension fund might not last you through your retirement.
WHERE SHOULD I INVEST?
Funds that remain within your pension wrapper will need an investment strategy.
If you choose to manage the investments yourself then you should consider the level of income you plan to take in the short term as well as your current age and any other assets you plan to use to support you in retirement. Someone turning age 65 today could be expected to live for another 18 to 21 years based on figures from the Office for National Statistics.
Investment risk and volatility mean that the value of your investments could fluctuate over time and money lost in retirement can be especially difficult to get back.
Some people choose a cash reserve at outset of around one to two years of planned income withdrawals. The remaining balance is then invested in assets designed to produce an income. This income tops up the cash reserve over time, reducing the need to nibble away at the capital and allowing you to keep calm when the value of the investments inevitably move up and down.
If you leave a large proportion in cash to avoid investment risk, then this money will be vulnerable to inflation over the long term. It is also unlikely to last you throughout your retirement. Some providers will offer investment pathways. Pathways were introduced by the FCA to provide an investment option matched to four broad retirement strategies.
Investment pathways do not consider your personal circumstances and are not a substitute for personal advice.
Small pension funds
If your pension pot is worth £10,000 or less, then you might be able to withdraw the whole pot as a single lump sum. This called a small pot lump sum and will be 25% tax-free with the balance subject to income tax.
A small pot lump sum will not trigger the MPAA, nor will it be counted against your pension lifetime allowance.
WHERE CAN I GET FURTHER HELP?
An FCA-authorised financial adviser will be able to advise you on the best options given your circumstances and objectives both at and through retirement. They will charge a fee for their services.
The government offers free guidance via the Pension Wise service. This will give information on the options available but will not recommend a course of action or be able to tell you which option might be best for you.