I have a defined contribution pension that I built up through my working life and apart from a few years at the start of my career, I’ve never had a final salary scheme.
My pot is worth £900,000 and I am 59 and hope to retire in two years.
How much retirement income can I safely expect to get from my pension pot – and if I died would my wife face inheritance tax on it?
Rob Morgan, of Charles Stanley Direct, replies: When you decide to retire you’ll have two main options for your pension pot. Keep investing and draw a regular or flexible income out or buy an annuity – guaranteed income for life from an insurance company.
An annuity is the safer but less flexible option. Once you have bought it you can’t reverse the decision, and for lots of people 61 is too soon for an annuity purchase unless they are especially risk averse.
A pension of £900,000 is a healthy pot but what income will it deliver?
Annuity rates are lower when purchased at a younger age meaning you lock in a less favourable income for life, and you lose flexibility.
However, to give you an idea, a 61-year-old today could secure an annuity income of 6.82 per cent on a level basis and 4.44 per cent on an inflation linked basis assuming a 5-year guarantee period and 50 per cent per cent spouse’s pension.
So that’s £46,021 a year or £29,961 a year, respectively, on a £900,000 pot after taking the maximum tax-free cash of £225,000 which could also be used to generate an income on top.
Drawdown is a riskier alternative, but it can keep your pot growing further than inflation levels and therefore give you a better outcome, especially if you plan on leaving the pension pot to your wife should she outlive you.
Although you can build in a spouse’s pension and other guarantees into an annuity, the flexibility of leaving all the remaining pot to her is potentially good financial planning. Plus, should you unfortunately die before 75 she can also take all the money out tax-free.
The good news is there would be no inheritance tax (IHT) consequences of passing the pot to your wife. There is no IHT on assets left to spouses, so she can inherit the pot and enjoy the same retirement options with it.
Rob Morgan, from Charles Stanley Direct, says you have different options for pension income
How much can you safely take out of your pension?
That then leaves the question of how have much can you safely withdraw from the pension pot in drawdown.
The ‘classic’ answer to this is about 4 per cent, which I would also extend to any tax-free cash you invest – ideally most of it in Isas to grow your money and pay income tax free.
Using the ‘4 per cent rule’ means you could ‘safely’ generate £36,000 a year before tax, rising with inflation.
Why 4 per cent? It’s a level thought be ‘safe’ enough for your money to last 30 years, based on historical stock and bond returns – even through relatively poor periods.
However, arguably there is no such thing as a ‘safe’ rate. Asset class returns significantly lower than historical averages could present difficulties, especially in the event of a market crash in the early years of retirement – a concept known as ‘sequence of returns risk’.
This is why some advisers suggest 3-3.5 per cent as a more conservative level, or suggest dynamic strategies where withdrawals are based partly on market performance. It’s also possible that you may be able to increase the rate of withdrawals if your investments do well.
You will also need to consider your pattern of spending. Expenditure in retirement is often described as ‘smile’ shaped. Typically, the earlier years are more active, and costly, and later years less so, before spending rises again in the case of care needs.
> Read Charles Stanley Direct’s guide: How to combat drawdown risk
It’s not an all or nothing affair?
It’s also worth noting that you can mix and match an annuity and drawdown and you don’t have to choose one or the other.
Many people like to use an annuity to match their essential spending and use drawdown for top up or more discretionary spending – and accept that they may need to be flexible about withdrawals to help preserve the pot in the event of poor investment performance.
Also factor in that your State Pension will begin at 67, which serves as a guaranteed income stream increasing at present by the triple lock, which is the higher of 2.5 per cent, inflation or average wage increase, in which case you can potentially take a bit more from your pension in the early years of retirement in the knowledge you can dial back once that comes on stream.
> Is it worth deferring state pension? Read Charles Stanley Direct’s guide
Don’t forget tax
There’s tax to consider too. Many people automatically take their maximum tax-free pension lump sum in one go, and in many circumstances this can be a good strategy. You can use the cash in the early years of retirement, pay off any mortgage or use it to make Isa contributions to maximise tax efficiency.
However, there are alternative ways of drawing on the pot to consider, notably the UFPLS – or ‘uncrystallised funds pension lump sum’. This involves slicing off part of your pension and leaving the rest untouched.
Every time you take money from your pension pot as an UFPLS, 25 per cent of the amount is tax-free with tax payable at your highest marginal rate of income tax on the other 75 per cent, and this can sometimes be more tax efficient and therefore offer more income.
> UFPLS explained: Charles Stanley’s guide to taking money from a pension
How Charles Stanley Direct can help
With lots of moving parts it is hard to decide which is the right course of action, so I would encourage you to speak to a financial professional to help weigh up your options and decide what is right in your circumstances.
Charles Stanley Direct offers a free, no commitment, 15-minute call with a qualified professional to discuss your needs. You can then decide whether further financial coaching or more in-depth and specific financial advice would be useful.
An adviser can look at all your assets, model different scenarios and help you understand the risks and opportunities around different courses of action, as well as potentially add significant value from a tax perspective.
> Find out more about free financial coaching at Charles Stanley Direct