Every time anyone in the UK puts money into a pension, a deal is struck. The government adds tax relief to the contribution, and the quid pro quo is you have to lock that money away for retirement. Hence why you can only access a pension after the age of 55, rising to 57 from 2028.

The idea is that if you’ve got your own funds to live on in retirement, you won’t fall back on the benefits system and cost the exchequer more money in the long term. This unwritten private pension contract is not without its controversy, particularly around the issue of allowing tax relief for higher rates taxpayers, but that’s the system the UK and many other countries operate to incentivise retirement saving.

DRAWING EARLY

The inability to draw on your money until age 55, or 57, is undoubtedly a reason why some people spurn private pensions, seeing it as an unappealing constraint. But actually, if you’re saving for retirement, 55 is a pretty young age to start drawing on your funds. Life expectancy for a 55 year old man is 81, and for a woman is 84, and these being averages, 50% of people can expect to live longer than that. So, if you access your pension in your mid 50s, you could easily be drawing on your retirement fund for as long as you’ve been saving into it. If you’re contributing somewhere in the region of 10% of your salary while working, you would therefore be relying on Herculean levels of investment growth to maintain your standard of living in retirement.

Despite this a large number of people are drawing their pension early. Around a third of those who made regular withdrawals from their pension in 2022/23 were between the ages of 55 and 64, according to the Financial Conduct Authority. 

One of the benefits of saving into a private pension is you take control of your retirement, and having a robust retirement fund as you approach your 60s means you can call the shots on when to take a step back from work. But clearly accessing your pension early opens up the possibility you might run out of money later on in your retirement. But how can you get a handle on how big a risk is involved?

DIFFICULT TO PLAN

They say nothing is certain apart from death and taxes, and that includes the timing of the former. Not knowing how long we will live for is a gigantic encumbrance when it comes to retirement planning. But you can take some lead from annuity rates. These are produced by insurance company based on stacks of data about how long people live. If you hand over £100,000 to an insurance company at age 55, they will provide you with an income for life of £5,940 each year. At 65, the same sum would snaffle you an annuity payment of £7,010 a year. This means your pension needs to be about 20% bigger if you want to retire at 55 compared to 65, or at least that’s what an insurance company actuary would say. These figures reflect average life expectancy, so if you’re a teetotal marathon runner with a family history of longevity, you might find yourself relying on your pension for even longer.

As well as having to sustain you for a longer period, if you use your pension to retire early you also lose out on growth on the money you withdraw and spend. Every £1 in your pension at age 55 would be worth £1.46 in real terms at age 65, assuming 6% fund growth and 2% inflation. This money also grows free of income and capital gains tax within the pension wrapper, so if you’re considering withdrawing cash from your pension pot to fund investment elsewhere, your decision should factor in whether you’re moving money from a tax-free to a taxable environment. 

It’s also worth considering the inheritance tax situation. Your pension fund can be passed on to beneficiaries free from inheritance tax, but if you take money out and hold it in cash, or invest it in a property, that then forms part of your estate and is potentially liable to IHT.

LIMITS ON WITHDRAWALS

Depending on how you go about it, drawing your pension early might also reduce the annual amount you are permitted to save into a pension from £60,000 to £10,000. You might think that once you start taking your pension you won’t want to put any more money into it. That makes sense but might not necessarily end up being the case. If you continue working while drawing your pension, your employer is required to offer to pay into a pension for you.

You also might find yourself with a lump sum, for instance from an inheritance, which you might like to use to bolster your retirement fund. Accessing your pension early could therefore limit your ability to reload your retirement fund.

Clearly the ability to draw on retirement funds earlier rather than later is one of the main reasons some people save large sums into their pension. This might not mean entirely disappearing from the workforce, it could simply mean working fewer days, or going freelance, and using your pension fund to top up your earnings. This sort of flexibility around your retirement options is one of the rewards of prudently putting enough money aside every month while you’re in the full swing of working. But it’s still important to take a lengthy pause for thought before dipping into your pension pot for the first time, and if in doubt, consider taking professional financial advice.

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