Below, we explain how pension freedoms work, outline your options at retirement, and offer some guidance in deciding the best option for you.
Pension Freedoms and Your Retirement Options
Prior to 2015, it was expected that most people would use their pension pot to buy an annuity. Annuities offer a guaranteed income for life. You can also include options such as index-linking, a spouse’s pension, and capital guarantees.
Drawdown was already an option, but this was subject to limits. It was mainly considered suitable for retirees with large pension pots and a reasonable level of financial experience.
With pension freedoms, all restrictions on pension benefits were removed. You can use your pension in any of the following ways:
- The rules around tax-free cash were unchanged – you could still take 25% of your pot as a tax-free lump sum.
- You can opt for flexi-access drawdown (FAD), withdrawing a regular or ad hoc income as best suits your circumstances. This triggers the Money Purchase Annual Allowance (MPAA), restricting future pension contributions to £10,000 per year.
- If your pension was already in drawdown prior to 2015, you could opt to stay in ‘capped drawdown.’ This means you can continue to take income without triggering the MPAA, but only within certain limits.
- You could withdraw your pension as an Uncrystallised Pension Funds Lump Sum (UPFLS), incorporating 25% cash and 75% taxable income. Most pension providers allow you to take ‘slices’ of your pension in this way, rather than encashing the whole pot.
- The rules allowed up to three small pots of £10,000 or less to be fully withdrawn without triggering the MPAA or being tested against the Lifetime Allowance. The Lifetime Allowance is now in the process of being scrapped.
- Annuities remained an option but became significantly less popular with the introduction of pension freedoms, particularly as interest rates were low. As rates are now rising again, the annuity market has picked up.
Pension Death Benefits
Prior to 2015, there were limitations when it came to passing on your pension fund. This depended on your age and whether or not you had taken benefits:
- If you were under 75 and had not yet taken benefits, your pension could be passed on as a lump sum or designated to provide a dependant’s pension.
- If you had already taken benefits or were over age 75, a dependant’s pension was the default option. Any lump sum payments would be subject to tax at 55%.
- The main changes introduced as part of pension freedoms were:
- Removal of the 55% tax charge. Death benefits are now fully tax-free before age 75, and subject the beneficiary’s marginal rate of tax where the scheme member was over 75.
- It is now possible to pass your pension on to anyone you choose rather than dependants only. This remains at the trustees’ discretion, but they will normally follow your wishes.
As pensions are not subject to Inheritance Tax (IHT) they can be an extremely effective way of passing on wealth to the next generation. The scope has increased even more with the increase in the annual allowance to £60,000 and removal of the Lifetime Allowance. Many people defer taking benefits from their pension, or even leave their pot untouched, as it is more tax-efficient to spend other assets first.
Downsides of Pension Freedoms
While choice and control over your retirement options can only be a good thing, not everyone is equipped to make these complex, and potentially life-changing decisions. Previously, the default option was to buy an annuity. And unless they had a reason to explore other options, this is what most people did.
Now, there is no default option. The decisions around retirement can be overwhelming and confusing, but are also critically important.
Pension Wise is a service set up by the government to offer free, impartial guidance for people over 50 who are considering their retirement options. They can’t make recommendations or make decisions for you, but using the service ensures that you are making an informed choice.
If your situation is more complex, or you would like specific advice, it may be worth speaking to a financial adviser.
Planning for Retirement
Below are our top tips for making sure you are on the right path when planning for retirement:
- Consider your goals and lifestyle. Do you think you will retire gradually or on a fixed date? Do you see your spending patterns varying throughout your life?
- Think about other sources of income you may have in retirement. For example, if you have an occupational scheme that pays out at age 65 and you want to retire at 60, you may need to use your private pension flexibly to bridge the gap.
- Don’t forget about other assets. It can be more efficient to spend cash and taxable investments before touching your pension.
- Make sure you have a sensible investment plan. If you plan to use your drawdown pension to support you throughout your life, you will probably still need to take some investment risk. However, the strategy is unlikely to be the same as when you were building up your pension. For example, you will probably want to keep a reasonable amount in cash to cover your income.
- Review your situation regularly. If investment returns are below expectations or you spend over your budget, you may need to make some adjustments. The earlier you can do this, the easier it will be.
Retirement planning can be confusing, but understanding the options and having a good idea of what you want to achieve can make the whole process easier.
Please don’t hesitate to contact a member of the team to find out more about retirement planning.
