Count back 10 years from the point at which you think you will retire, and that's when you need to start thinking about how to extract maximum value from your pension pot(s) and to make sure they last for as long as you need them.
The introduction of pension freedoms in 2015 by then chancellor George Osborne has given retirees more ways in which to fund their later years. For example, retirees now have the option to go into drawdown instead of simply buying an annuity, meaning they can remain invested in the stock market.
But while we all like choice, sometimes it can be overwhelming. And with so many people living another 30 years or more beyond the age at which they retire, individuals need to begin planning how they are going to fund their twilight years sooner rather than later.
“By the time your retirement is within sight – say within 10 years or less of your proposed retirement date – you should really be thinking about how and when you intend to start taking money out of your pension plan,” says Fiona Tait, technical director at Intelligent Pensions.
Hargreaves Lansdown reports that back in 2015, 43 per cent of its clients started planning a year before retiring – that figure is now down to 24 per cent. And assessing pension funding 10 years from retirement should ensure individuals have enough time to set more aside if their pot needs topping up.
Myron Jobson, personal finance campaigner at Interactive Investor, says at this point the first step is to have an honest assessment of your current financial position.
“This can be difficult because it could mean admitting that you’re ill-prepared for retirement, but having a clear understanding of your financial position is paramount to create a plan to plug a financial shortfall which may exist. Ten years is enough time to fortify and bolster your financial position,” he says.
“This could mean ramping up your appetite for risk for the potential for better returns – with people living longer, our money needs to work harder and for longer, which can mean revisiting that risk profile.”
Not only should prospective retirees be thinking about whether they have enough money to see them through their retirement lifestyle, but also exactly how they are going to take an income from the money saved.
Helen Morrissey, pension specialist at Royal London, suggests the questions you should be asking yourself are: do you want to take a lump sum and leave the rest invested? Do you want a regular income via income drawdown? Or do you want the guaranteed income that comes with an annuity?
The flexibility that comes with pension freedoms means there is no right or wrong answer.
“You don’t have to limit yourself to just one option,” says Ms Morrissey. “For instance, you can annuitise part of your pot to give you a baseline income while using the rest to go into income drawdown. Working with an independent financial adviser will help you to determine the right options for you.”
Risk tolerance
For those running a self-invested personal pension (Sipp), the 10-year window before your planned retirement date might be the time to start making asset allocation changes, depending on how you plan to take your retirement income.
For example, if you plan to buy an annuity you should look to switch into less risky holdings to avoid being hit by a fall in your investments just as you are about to buy an annuity.
However, savers planning on making use of pension freedoms and entering drawdown rather than taking an annuity may still have a 20 to 30-year investment horizon. This means they have plenty of time to take risk and enjoy the market.
Mr Jobson adds: “The tricky part is to balance the need for regular income and maximise the return potential of the nest egg.”
Any asset allocation decisions are likely to come down to personal circumstances, as well as overall wealth and income needs, according to Tom Selby, senior analyst at AJ Bell.
“For many people, entering drawdown will not necessitate any significant asset allocation changes at all,” he says. “Those planning on withdrawing a significant proportion of their fund should consider reducing investment risk as the withdrawal date approaches in order to limit volatility.
“Ultimately the asset allocation choices you make will be swayed by both your risk tolerance and your withdrawal plan.”
Why delay?
You can check how much state pension you are entitled to and when you can get it at www.gov.uk/check-state-pension.
“The state pension provides a guaranteed income stream which can be very valuable, particularly if you have decided to leave the remainder of your pension invested in a Sipp or drawdown plan,” says Ms Tait. “This can be used to ensure you are able to cover your essential expenses, such as heating and food bills.”
But there is no rush when it comes to accessing this money, as the government allows retirees to defer their state pension. This can be helpful for those who want to increase the amount they eventually receive or who have other sources of income they can rely on first.
Ms Morrissey says that just because you have hit an age where you can access your pension, does not mean you have to.
“If you are still working, for instance, you might have enough money to cover your day-to-day needs and you can leave your pension pot invested for a while longer," she says.
“The same goes for your state pension. Many people do not realise that you have the option to defer taking your state pension and claim a higher one later on."
Individuals who choose to defer their state pension will benefit from higher weekly payments when they do start accessing it.
Mr Selby explains: “For those who reached state pension age before 6 April 2016, the government offers a particularly generous 10.4 per cent uplift for every year you delay taking the benefit.”
However, for those who reach state pension age on or after 6 April 2016, this rate has been cut to 5.8 per cent.
“If someone is entitled to the full flat-rate state pension of £168.60, deferring one year will mean that at age 67 they receive an annual payment of £178.38,” says Mr Selby. “If we assume both payments then rise by 2.5 per cent a year, it will take until around their 89th birthday to ‘break even’.”
Health and lifestyle may play a role in deciding when to take the state pension. Mr Selby suggests that if you are in good health, there is a decent chance deferring your state pension will eventually pay off.
But Michael Martin, private client manager at Seven Investment Management, says there comes a time when there is little point in deferring.
He explains: “There is some math to it – how much has it gone up by since last year, and how long would you live to get back the one year lost income versus the increase?
“Ultimately, it depends on people's views on their own mortality, but deferring more than about four to five years usually doesn't make sense.”
Crystallising your Sipp
When it comes to crystallising your Sipp, there are yet more decisions to make about whether to take it as a lump sum or go into drawdown. Deciding on the best route will once again come down to your own circumstances.
“This is a very individual decision and should be based on your capital and income priorities at the point of retirement,” says Ms Tait.
Mr Selby agrees: “If you decide to keep your money invested in retirement then whether you take an income via drawdown or an ad-hoc lump sum depends on your needs, priorities and personal circumstances.”
For example, some may prefer taking ad-hoc lump sums – with 25 per cent of each withdrawal tax-free – in order to allow the rest of their tax-free cash to remain uncrystallised and potentially benefit from investment growth.
“A similar result can be achieved by crystallising part of your fund in drawdown while leaving the remaining pot uncrystallised – with 25 per cent of the remaining pot also available tax-free when you decide to crystallise it,” says Mr Selby.
He notes that ad-hoc lump sums can be useful for people who want to access their pension flexibly but are members of a pension scheme that does not offer drawdown. An alternative is to transfer to a Sipp provider that does offer a drawdown facility.
The decision might be influenced by whether you remain in work at all beyond retirement age. Generally, more over-50s are in work now, with government statistics showing that in 2019 the average age at which men leave work is 65.3 and 64.3 for women.
Ms Tait adds: “If you are reducing or completely stopping your working hours you are most likely to need income to replace your lost earnings. You may also want to withdraw a lump sum to repay any debts or to fund a particular project, such as home improvements.”
Safe withdrawal rate
The million-dollar question is, how much income can you safely draw down? As we do not know exactly how long we have left to live and in what state of health, it is impossible to answer.
But there are ways to make sure whatever income you do decide to take will last as long as possible, while leaving you enough to comfortably live off.
Mr Jobson points to a number of drawdown calculators online that can help estimate how long your savings will last based on a range of different income levels in retirement. Most pension specialists say that 3 to 4 per cent is typically considered a ‘safe’ withdrawal rate, which is what many people opt to take.
“In basic terms, a ‘safe’ level of income is one that runs out at the point that you no longer need it – in other words, one that exactly matches your individual longevity, taking into account expected investment returns,” says Ms Tait. “Unfortunately, this is impossible to predict with any accuracy when you are in your 50s or 60s and likely to live for another 30 years or more.”
But, she adds, speaking to a financial adviser who will create and manage your own individual cash flow model can help.
Mr Selby says the 4 per cent withdrawal rate figure should only be used as a “starting point” by investors and that those who do decide to go into drawdown will have to remain engaged.
“Drawdown requires investors to engage [with] and review their strategy and withdrawals regularly – this means at least once a year,” he says. “You need to be prepared to reduce your income in the event that investment returns take a significant dip, while strong performance could allow you to up your income if you want to. In the latter case, make sure you consider any income tax implications from increasing your withdrawals.
“A ‘natural yield’ retirement income strategy – whereby you live off the dividends generated from your underlying investments – is worth considering. The benefit of this is that your underlying investments remain untouched, allowing them to grow in value over time.”
To annuitise or not to annuitise?
For some, the risk that comes with investing in the markets is too much, says Mr Martin. In which case, an annuity might be the best option for them at retirement. Annuities have been in the news lately, following reports that rates have declined.
But for many, the reassurance provided by a guaranteed income makes them far more attractive than other forms of retirement income.
“While annuities have received a lot of bad press, they remain a viable retirement option for people who want a guaranteed income for the rest of their life,” confirms Ms Morrissey.
“Peace of mind that an annuity can provide counts for a lot for many, but there can be strings attached and the suitability of such a product depends on your circumstances, needs and objectives,” notes Mr Jobson. “If you do decide to buy an annuity, make sure you shop around for the best rates.”
He reminds investors that they do not have to buy an annuity with all of their pension. Instead, retirees can use some of their nest egg to buy an annuity and put the rest into drawdown.
Tackling tax
There is no escaping the taxman, even in retirement. “If you have a defined-contribution (DC) pension, such as a Sipp or private workplace pension, 25 per cent of your fund can be paid to you tax-free and the remainder is subject to income tax,” says Ms Tait. “This is regardless of whether benefits are actually paid as a lump sum or in the form of income.”
But, she warns, one thing to be aware of is the way in which your first pension withdrawal is treated. “In most cases this will be subject to an emergency tax rate, which means that you are likely to pay considerably more tax on it than is actually due,” she explains. “This situation arises because this payment is effectively treated as if it were the first of a series of regular payments and not a one-off.”
Mr Selby notes: “If you receive a regular income, your tax position should be sorted automatically, but if not, you’ll need to fill out an official HM Revenue & Customs reclaim form. If you do this, you should get any overpaid tax back within 30 days.”
Recent HMRC figures show that more than 17,000 people reclaimed a total £46m in tax between 1 April and 30 June 2019, according to Ms Morrissey. And tax implications also apply even in death.
"Pension savers can take advantage of the death benefits regime. It is one of the tax benefits that is less well-known," Mr Selby adds.
“If you die before age 75, you are able to pass on your entire fund tax-free to your nominated beneficiary or beneficiaries, either within the pension or as a lump sum,” he says. “If you die after age 75, the money will be taxed at your beneficiary or beneficiaries’ marginal rate of income tax. This will be the case whether they take the money as a lump sum or leave it in the pension and draw an income.”
