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Pension Income - Guide to putting a pension into service

 

Introduction - Taking an occupational pension

Rolls of notes floating down on parachutesFrom age 55 onwards it is possible to take your occupational pension, although depending on your pension scheme and the normal retirement date that is specified in the scheme, if you take early retirement it will typically be reduced by a specified percentage for each year you retire early.

If you only have a final salary scheme pension (also known as a defined benefit scheme) from your employer, based on your salary prior to retirement, then you have relatively few decisions to make, typically just the decision of when to retire and whether to take a lump sum, unless you also have an AVC (Additional Voluntary Contribution) scheme.

However with the closure of many final salary schemes in recent years, more and more of us have employer schemes or personal pensions that are based purely on what we, and possibly our employer, have paid into them (known as defined contribution schemes). The money paid in will have been invested according to the schemes options and will hopefully have grown over the years to give us a pension pot of the value we hoped for.

So when we decide to retire, or want to look at our options for retirement, we need to look at the options for how we will turn this pension pot into retirement income.

Pension Freedom

With effect from April 2015 we were given new options as regards accessing our pension funds and turning those funds into income. These mostly affect Defined Contribution Pension schemes but there are also additional options for Defined Benefit scheme members.

If you have a Defined Contribution Pension:

  • You now have full access to your pension fund from age 55 and can take money out in whole or in part (as long as your pension provider allows this), although you will need to understand the tax implications of doing this.
  • The traditional option of purchasing an annuity; a guaranteed income for life, remains but this will be supported by options allowing you to withdraw your savings as quickly as you like. Restrictions on annuities have also been relaxed so there will be even more choices as new products are developed over time.
  • Income drawdown is more widely available and many more people are likely to find this attractive as a way of taking money from their pension pots as and when they want, while leaving the remaining money invested. You will need to understand the risks involved in this compared to annuities and the dangers of depleting funds below a level that will give you an adequate future income.
  • We are likely to see new financial products emerge as the pensions industry identifies the opportunities and also to see hybrid strategies emerge such as using part of income drawdown funds to buy short term annuities.

Please note that your pension plan provider is under no obligation to offer any of the new freedoms, but you will have a strengthened right to transfer savings to a vehicle that does.

There are also implications for inheritance with tax changes which allow more of your remaining pension fund to pass to your heirs.

To help you navigate through the maze of options, everyone is entitled to guidance information - see https://www.pensionwise.gov.uk. Pension Wise only provides guidance on defined contribution pensions. You can find out what you can do with your pension pot, how to shop around and what to look out for with taxes and fees. Pension Wise explains how to avoid pension scams and the importance of taking your time to make sure your money lasts as long as you do.

The guidance is free and impartial but is not able to recommend or point to any solutions; the next step should typically be to seek financial advice once you have a clearer understanding of the options available to you.

  • The principal considerations for anyone making decisions regarding how to use their pension savings are:
  • whether you desire certainty or flexibility when it comes to the income you receive
  • what the tax implications of any decision might be
  • whether your pension savings are going to last as long as you do
  • how your pension savings should be invested both before and after you stop working, and
  • what happens in terms of any income or remaining savings when you die.

You may also like to make use of the step by step guide to Pension Freedom available at http://www.laterlife.com/jelf-guide-to-pension-freedom.htm

If you have a Defined Benefit or Final Salary scheme

People who are in a private sector final salary (defined benefit) pension scheme through their employer are now allowed to change their pension pot to a personal pension arrangement so that they can take advantage of pension freedom. However, before they can do this, they will have to show proof that they have taken financial advice from a registered financial advisor.

Annuities

Prior to Pension Freedom annuities were the option for most people to turn their pension into a guaranteed income for life. Although the options are now wider it may still be the appropriate option for all or part of pension funds. 

Turning funds into income is traditionally done through taking what is called a Lifetime Annuity and it is worth understanding this first before considering other more complex options such as Short Term Annuities, Unsecured Pensions (also known as Income Drawdown), or Phased Retirement or Third Way options which are covered later.

Six to three months before the retirement date set in your scheme you should receive an annuity quotation pack from your provider. Contact your provider - some providers may contact you first but you can get a head start by checking with your pension provider to see how long it will take to buy an annuity and to get a valuation - although this may change by the time you retire.  Ask your provider for a number of different annuity scenarios e.g. with different levels of escalation (see the list of options under Lifetime Annuities below). This will help you in reaching an appropriate decision.  You'll need to apply to all your providers if you've got multiple pension sources, however it is unlikely to be the best option to put each into service independently but is often better to move to one provider using the open market option explained below to choose the best. 

You'll need to consider your options carefully as you can't change your annuity once it's been purchased. Once you make a decision and buy an annuity it normally takes a few weeks for your fund to be converted into an income and for you to receive your first payment.

Whatever you do make sure you understand the Open Market Option described below as this can make a very significant difference to the amount of pension you receive. Ideally speak with a financial adviser to consider all your options and retirement plans.

Also make sure you read our section on inflation and take this into account in your thinking.

Under current pension legislation in the UK, you are allowed to take a tax free lump sum from your pension scheme of up to one quarter of your pension pot, when you retire. So you will also need to consider whether you should take this or not. See our separate guide to Pension Lump Sums.

You may also have made contributions into either an Additional Voluntary Contribution (AVC) arrangement run by your scheme trustees, or a Free Standing AVC. Much of this section applies equally to AVCs and you will have the opportunity to turn the AVC fund you have built up into a pension and also take a tax free lump sum of up to 25%.

You can see a summary table of the different annuity options if you wish too, but we would suggest you familiarise yourself with the basic Lifetime Annuity described below first and especially with the Open Market Option which can make a difference of as much as 20% to your income in retirement.

The Basics - Lifetime Annuities

Conventionally, on retirement, our pension pot would be used to purchase an annuity and optionally to take part of our pot as a tax free lump sum. An annuity is a contract to pay you an income for your life time. The amount payable depends on:

  • your age at the outset and personal situation (i.e. health, postcode, smoking habits)

  • the prevailing annuity rates, which generally move in line with long term interest rates

  • and the inclusion of any of the additional benefits which you can choose such as:

Guarantee period – pension paid for whole of period even if you die beforehand
Capital protection – capital payment on death, based on value of fund remaining
Level of Escalation - % increase in payments each year e.g. to mitigate inflation
Survivor’s benefits – payments continue after first death to second person of a couple
Frequency of payment – e.g., monthly, quarterly, annually, in advance or in arrears
Proportionate payment – pays balance after death when payments made in arrears e.g. annually
Guaranteed Annuity rates – some providers contracts provide higher income but under certain conditions

The above options are all explained in more detail by clicking on each link.

Lifestyle annuities take into account certain factors related to lifestyle and background which could affect an individual’s life expectancy. For example, an office worker may be expected to live longer than a person who has been in heavy manual employment during their working life.

If you suffer from poor health or have certain medical conditions you may be able to get an Enhanced or Impaired Life Annuity which pays higher rates because of low life expectancy.  Relevant health problems might include, for example, cancer, chronic asthma, diabetes, heart attack, high blood pressure, kidney failure, multiple sclerosis or stroke. Some annuity providers offer a higher income to people with such health problems. An Impaired Life annuity is likely to require a medical, whereas an enhanced annuity usually requires completion of a questionnaire.

Furthermore, enhanced terms may also be offered to smokers but this does not constitute a recommendation to take up the habit at this stage in life!

Purchased Life Annuities

Another form of annuity is a ‘purchased life’ annuity  (as opposed to a pension annuity). This is where you use your own money (rather than a pension fund) to buy an annuity. There are some tax advantages by buying a ‘purchased life’ annuity because some of the income is deemed to be a return of capital and therefore ‘tax free’ whereas all of the income generated by buying a pension annuity is taxable.

 

Open Market Option

You do not have to purchase an annuity from your pension provider. Most pension providers allow you to transfer the pension pot you have accumulated to purchase an annuity with another company, which ensures that you get the best possible rates available on the open market. This is known as the Open market option and is an extremely important option in ensuring you maximise your retirement income, which far too many people still don’t take advantage of.

We all suffer from inertia and too many people when they receive their annuity quotation pack from their pension provider, simply tick the box which leads them down the path of taking the offer from that pension provider without considering the open market option.  They may have been the best provider for accumulating funds but that doesn't necessarily mean they will provide the best annuity.

 

Pros and Cons of Annuities

The major advantage of a conventional pension annuity is that it offers you considerable security and certainty with a secure income payable throughout life.

Another advantage is that you can benefit from the ‘cross subsidy’ arising out of mortality. In effect, those people who die earlier subsidise those who live longer, thus allowing a higher income to be paid.

However, there are a number of disadvantages to annuity purchase

Timing – if you buy the annuity at a time of low interest rates, you will be locking into a low income for life

Death Benefits – annuities are only usually payable for life. If you die soon after the annuity has been purchased, it is unlikely that you will have received benefits up to the full value of your retirement fund. (But see the options listed above).

Investment Control – by purchasing a conventional annuity, you exchange control over the investment of your retirement fund in return for a guaranteed income.

Before making a decision as to whether conventional annuity is for you, you should understand and consider the more flexible, but riskier, option of an Unsecured Pension (also known as income drawdown) or one of the so called ‘third way’ products that lie between these two extremes.

 

The European Union Gender Directive

As from 21st December 2012 it became no longer possible to offer separate annuity rates for men and women based on the fact that statistically women live longer. This means that after this date Annuity rates for men effectively worsened and for women improved.

NEXT STEPS

To learn about the other options you can proceed to the next section on Annuity Variants.

If you want you can view a summary table of the different variants before reading about each in detail.

Once you have understood as much as you need to about annuities, be sure to use our Retirement Finance Checklist in your run up to retirement.

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 

   
 
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