The idea of finally retiring fills many with joy but it can also be a great source of anxiety.
The dream of long summers in the sun, luxury meals out, and big family trips are enticing – but how are you going to fund this new life without a salary?
Below, experts break down what your options are and how you can make the right decision for your retirement.
What is a pension?
A pension is a pot of money that you’ll have saved into during your working life, which is usually invested in a bid to help it grow.
The money that you save gets a boost from tax relief, so effectively you are saving out of untaxed earnings.
In retirement, you can then access your pension to buy yourself an income or draw on it. Alternatively, if you are lucky, you will have a defined benefit scheme – often known as a final salary scheme – where your employer promises you a set income in retirement for life and picks up the tab.
Most people usually start their pension through their workplace, but you can also set up and manage your own through a personal pension.
How does a pension work?
Typically, you put a set amount of money into a pension each month and the money is locked away for the future. Often, contributions will be made by you, your workplace (if it’s a workplace pension) and the Government (to pay tax relief).
Currently, once you reach 55 you can access up to 25 per cent tax-free from your personal or workplace pensions, but from April 2028, the age will rise to 57.
What can I do with my pension pot?
People have much more choice these days when it comes to converting their pension savings into income when they retire.
There are three main options – buying an annuity, income or pension drawdown, or taking lump sums.
Should I buy an annuity?
An annuity was the main way that people funded their retirement in the past if they had a personal or workplace (defined contribution) pension.
Traditionally, people would buy an annuity with their defined contribution pension savings and it would pay a guaranteed income for the rest of their life.
The 2015 pension freedoms rules meant that you no longer had to do this – you can access all of your pension savings from the age of 55 (which is set to change to 57 in 2028) and do whatever you like with them.
According to consumer champion Which?, it’s likely to suit you if…
- You want a guaranteed income for the rest of your life.
- You don’t want your retirement income to be subject to stock market fluctuations.
- You want your income to rise with inflation.
Speaking to i, Becky O’Connor, director of public affairs at PensionBee, said: “An annuity provides a guaranteed income for life or a set period and is purchased with a lump sum from your pension pot. This stable and predictable income stream can offer important peace of mind, helping to avoid the rise of outliving your savings and aiding in budgeting.
“Some annuities can also be indexed to inflation, protecting your purchasing power in times of high inflation.”
She did warn that annuities are less flexible than other methods, as once purchased, the terms cannot be charged. In a low-interest environment, annuity rates may be less favourable, and if you pass away early in the annuity period, the insurer keeps the remaining balance unless you have a guaranteed period or joint life annuity.
Should I use pension drawdown?
Income or pension drawdown has become the most popular option for many retirees when they convert or access their defined contribution pensions.
Drawdown allows you to keep your pension fund invested in the stock market, and draw out income as and when you wish. You can take out as much as you want each year (subject to taxation).
The drawdown rules changed in 2015 to allow beneficiaries to take a lump sum or income tax-free if you die before 75 and at their marginal rate if you die after 75.
It is likely to suit you if…
- You want your money to continue to be invested.
- You want the flexibility to take sums out as and when you want.
- You want to take out different amounts each year.
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Income drawdown offers greater flexibility. You draw an income as needed while leaving the rest invested where it can hopefully grow over time.
“However, you need to monitor your withdrawal rates carefully to make sure you don’t take too much and leave yourself at risk of depleting your pension pot. This could leave you having to make tough spending decisions further down the line.”
Ms Morrissey suggested that retirees take a natural yield approach – which is where you only take the income generated by your investments rather than a fixed amount every year.
This would mean there are periods of time when you would take less income. However, she said she would recommend retirees have one to three years worth of essential expenses in an easy access cash account that they can use to supplement their income if needed.
Should I take lump sums?
The pension freedom changes introduced a new, flexible way to take money out of your retirement savings. You leave the money in your current pension fund and take out lump sums when you need to.
The technical term for this is uncrystallised funds pension lump sums which means that you haven’t ‘crystallised’ your pension pot by turning it into an income.
It’s similar to using your pension like a savings account, taking cash out when you need, with the rest continuing to grow.
Each withdrawal is 25 per cent tax-free, with the rest charged at your normal income tax rate when your other income is taken into account.
It is likely to suit you if…
- You want to take varying amounts of money each time.
- You want to spread your 25 per cent tax-free allowance over a period of time.
- You don’t want to expose your pension to investment risk.
Myron Jobson, senior personal finance analyst at interactive investor, said: “Savers can take their pension as one big lump sum, or multiple lump sums amounting to 25 per cent of your pension value. The remaining 75 per cent is subject to income tax at your marginal rate.”
Taking cash lump sums is extremely popular but most experts said don’t just take it because you can. Taking large sums can incur unnecessary tax bills and if you don’t have a plan for how you are going to use it there’s a chance it just gets placed in a low interest cash account.
What are the different types of pension schemes?
- Workplace pensions
Most employees will have a workplace pension and under this scheme, both the employer and employee make contributions, which need to add up to a minimum of eight per cent of your pre-tax salary.
This is a minimum of three per cent from the employer, and five per cent from the employee. Many employers will in fact pay in more than this – and might also match your contributions if you choose to pay in more than five per cent.
Pension contributions are often deducted from your salary, and your workplace’s pension scheme invests them on your behalf.
- Private pensions
A private pension – also called a personal pension – is something you can set up to help you save money for retirement. These are usually defined contribution pensions, which means the money you receive at retirement is based on the money you’ve paid in and the performance of your investments.
- State pension
The state pension is a weekly payment from the government that most people can claim once they reach state pension age (which is currently set at 66). It is set to rise to 67 by 2028, and 68 between 2044-46. To qualify, you must have paid National Insurance (NI) contributions during your working life.
The current new full state pension is currently worth £221.20 per week, totalling £11,502.40 per year. It is adjusted each year based on the ‘triple lock’ guarantee, which means that each April it increases by the greater of September’s price inflation, earnings growth or 2.5 per cent.
For those who reached the state pension age before April 5 2016 will receive the basic state pension, also known as the “old” state pension, which is worth £169.50 per week.