I’m nearing retirement – what are my pension options?

The beauty of defined contribution (DC) pensions – like self-invested personal pensions (SIPP) – is that it’s absolutely up to you how you use your hard-earned pot. From a financial planning point of view, this is fantastic - you’ve got total control over your money and the ability to flex your income to suit your needs. It does, however, mean that there’s a fair bit of decision making to be done.

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Here we explain the different ways you can use your pension to fund your retirement, all of which are available from the age of 55 (rising to 57 in 2028).

Taking lump sums out of your pension

If you wish, it’s possible to either cash in your entire pension, or make a series of partial withdrawals, and there are no rules dictating what you do with the money. You could even buy a Lamborghini as former pensions minister Steve Webb famously quipped when the 2015 Pension Freedoms were first announced.

This type of withdrawal is officially referred to as an ‘uncrystallised fund pension lump sum’, or UFPLS (arguably the worst example of pensions jargon) and, while it might be a convenient way of taking money out of your pension, there’s a sting in the tail.

That’s because only the first 25% of your withdrawal will be paid tax free. The remaining 75% will be added to your overall income for the year and taxed at your highest rate of income tax. And, depending on the size of your withdrawal, it could be enough to bump you into a higher rate tax bracket.

You will likely pay emergency tax on your withdrawal too, although you can claim the excess back from HMRC.

UFPLS withdrawals won’t just give you a big tax bill, they will also reduce the amount of money you can pay into your pension and still get tax relief on your contributions.

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As soon as you make a taxable withdrawal from your pension, you will trigger the money purchase annual allowance (MPAA), which will see the total amount you can pay into your pension fall from 100% of your earnings, up to £60,000, to just £10,000.

This should be an important consideration if you are accessing your pension before you retire and plan to carry on funding your pot. The benefit of paying bonuses or other lump sums (such as an inheritance) into your pension towards the end of your career shouldn’t be underestimated.

This means that unless you have a very specific need for a lump sum – which you can’t access more tax-effectively from other accounts – accessing your pension in this way may not make the most sense.

It’s also important to note that while pension rules permit this type of withdrawal, it may not be offered by every pension scheme. This means you might need to transfer your pension to an alternative provider to access this option.

Sitting outside of UFPLS, are the 'small pots' rules, which allow you to fully encash three pensions up to £10,000 each during your lifetime. Importantly, anything that qualifies under 'small pots' do not trigger the MPAA, so the amount you can pay into pensions every year and get upfront tax relief will not shrink to £10,000.

Pros:

• Offers access to cash lump sums from the age of 55
• You do not need to make any decisions about what to do with the remainder of your pension

Cons:

• You could be hit with a hefty tax bill (including emergency tax)
• Unless covered under 'small pots' rules, you may reduce the amount of money you can pay into your pension going forward

Income drawdown

Also referred to as ‘flexi-access drawdown’, this is the most flexible way to take money out of your pension.

With this option you get the ability to take up to 25% as a tax-free lump sum, the rest remains invested but you can make income withdrawals (which will be subject to income tax) as and when you wish.

You can decide how much you want to take and when, or, if you don’t yet need an income, you can take your tax-free cash and leave the rest of your pot untouched until you do.

And, because your money remains invested, there’s also the potential for further capital growth, providing a helpful hedge against rising costs as your retirement progresses.

When you die, any money that is left in your pension can be passed on to your chosen loved ones (and free of income tax if you die before age 75) but might be subject to inheritance tax (IHT) if death occurs after 6 April 2027. We’re still awaiting the final rules on this proposal.

These features all make drawdown a popular option. However, there are risks, which shouldn’t be overlooked: your income is not guaranteed and care needs to be taken with withdrawals to ensure you don’t run out of money. It’s also important to consider stock market risk and the impact falling returns would have on your future income.

Pros:

• You can decide how much income to take out of your pension and adjust it whenever you need
• Your fund remains invested, providing the opportunity for further growth

Cons:

• Your income is not guaranteed
• Poor stock market returns could reduce the lifespan of your pension, or force you to reduce your income
• You need to manage your pot and are responsible for all your investment decisions

Buy an annuity

If you don’t want the responsibility of managing your income in retirement, or rate certainty over flexibility, you might want to consider an annuity.

An annuity is a type of insurance policy - in exchange for all (or part) of your pension it will give you an income that is guaranteed for life. The exact income you get will depend on a range of factors including annuity rates at the time of purchase, your age and your state of health.

Typically, the younger and healthier you are when you buy your annuity, the lower your income will be. However, if you have any health problems, take regular medication, or smoke, you may be able to benefit from enhanced rates, because your life expectancy is likely to be lower.

Annuity rates themselves rise and fall in line with interest rate movements – the higher the official rate of interest is when you buy your annuity, the better the income you’ll likely get.

Your annuity payments will be subject to tax, but you’ll get the opportunity to take your 25% tax-free cash first.

The big appeal with annuities is that your income is guaranteed. No matter how long you live, you can be confident that your money won’t run out, nor will you have to worry about stock market performance.

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But that doesn’t mean annuities are risk free. Lifetime annuities are notoriously inflexible – after an initial cooling-off period you cannot change your mind and, if your circumstances change, you can’t adjust your income either. What's more, unless you choose an index-linked annuity, which means payments start much lower, inflation will eat away at your income over time.

It’s also harder to pass on your wealth with annuity. When you die, unless you only annuitized part of your pension, there won’t be a pot of cash to pass on.

If you do have loved ones that rely on you financially there are options to protect your income when you die – however, these will reduce the level of income you get initially.

And, while you might get a great return on your investment if you’re a smoker and live to 100, you could end up getting less back than you paid in.

Pros:

• Income is guaranteed for life
• You don’t need to worry about stock market performance
• You don’t need to manage your investments
• You can get a higher income if you smoke or have health problems

Cons:

• You cannot change your income if your circumstances change
• You cannot reverse an annuity, cash it in, or switch to another provider
• It’s difficult to pass on your pension wealth if you buy an annuity
• You may get less back than you paid in

Think about your options

There’s no ‘perfect’ way to turn your pension into income – every approach has its own pros and cons. What’s right for you will depend on your lifestyle, your income and how you plan to live in retirement.

However, you don’t need to make a decision right away and it’s not an either/or choice; you can use any number of the options in combination to come up with a plan that works for you.

Once you are 50 you can get free guidance on your options by booking an appointment with Pension Wise. Alternatively, if you feel you need bespoke advice it may be worth consulting a regulated financial planner.