Creating your own salary for retirement
Stopping work for good can be an exciting but also scary prospect, given that you’ll be giving up the regular income you’ve been receiving from it. Looking to the next phase of your life you are instead faced with a lump sum that you’ve tirelessly saved over your lifetime - and this has to see you through your retirement years. So, how do you create your own salary in retirement, so that you can spend with confidence and not worry that your money will run out?
What are my options?
On reaching the age of 55 you have the option to start taking any pensions you have accrued over your working life, excluding any state pension. For defined contribution pensions (meaning those built up by your own and your employers’ contributions) there are a few retirement options that will be available to you that are specific to each pension plan. The main two that will create an income in retirement are taking your money as an annuity, or through flexi-access income drawdown. Income drawdown is essentially a way to access your pension money either on a regular basis or when you need it. Both options have their advantages and deciding between the two boils down to what works best for you and your circumstances.
What is the difference between an annuity and income drawdown?
An annuity is the traditional way in which a retirement income is taken, and it guarantees you a regular income for the rest of your life. An annuity is purchased when you retire by using the money built up in your pension and pays out to you every month with an agreed amount.
This differs from taking your retirement income via flexi-access drawdown as this allows you to take an income from your pension pot and – importantly - keep your money invested – giving your pension pot the opportunity to grow even after you have stopped making contributions. It is important to clarify your options as not all pension plans, particularly policies that commenced before new Pension Freedoms Legislation was introduced in 2015, will provide this flexibility.
How do I decide which option works best for my situation?
In order to assess which of these options suits your situation in retirement, it is important to look at the advantages and disadvantages of both options. It is important to note that with each of these retirement options, the first 25% of the money you take as income is usually exempt from taxation – after this whatever money you receive is subject to your marginal income tax rate.
Annuities are a popular choice with those who want a steady, stable income. The income level is predictable, it either stays constant throughout your retirement or it rises by a fixed amount or in line with inflation (this is called an escalating annuity). This constant income level could, however, create problems if you were to suffer unforeseen circumstances that require more accessible cash, as you will usually be unable to change the original terms of your annuity. Annuities are unaffected by fluctuations in the stock market or economy and they can never run out.
The income from an annuity is guaranteed for life. This means the annuity rate you get from a provider will usually be lower the younger you are, i.e., where you are likely to have a long retirement ahead of you. And once you buy an annuity, you cannot change your mind. There is also the option with annuities to take them on joint-life basis – so in the event of your or your partners death, the surviving person still receives 50% of the annuity. This can, however, mean that the annuity rate you receive is lower, to account for this benefit. Recent years have seen annuity rates drop to low levels which means that more people may look to a drawdown option.
Flexi-access drawdown differs from annuities in many ways: firstly you can increase (or decrease) your income level whenever you like, but this could lead to your money running out if the income level is not planned carefully.
If you die before 75 whilst taking drawdown, your beneficiaries can inherit any remaining funds tax-free, whilst after this point, any remaining funds are taxable at the beneficiary’s marginal income tax rate. However, with an annuity, the provider keeps whatever money you leave behind, unless a joint-life basis has been chosen at outset. With income drawdown you keep control of your pension pot – it is even possible to change your mind and buy an annuity later down the line. Unlike an annuity, your pension pot stays invested, so it is susceptible to losses as well as gains.
As mentioned above, it is possible to move from taking income from a drawdown account, to purchase an annuity later in retirement. This may be something to consider as you are likely to get a better annuity rate the older you are, and this may provide the option to remove investment risk in later retirement. There is also the option of taking an annuity and income drawdown at the same time. For example, half the pension pot could be secured via an annuity, giving a smaller but guaranteed income for life and the other half of the pension pot could be converted to flexi-access drawdown to provide some flexibility, to be accessed when and if is necessary.
What if you are unsure what income your pension pot could provide in retirement?
Nobody should go into retirement without a clear picture of what is ahead. Pension options are specific to each plan and it is important to have a clear understanding of what options are available to you. At TPO we can help you to live comfortably throughout retirement and have confidence to spend your hard-earned money on what you enjoy most.
We provide a full picture of what your financial future could be like using our cashflow planning service that can forecast your required expenditure throughout retirement and help you decide which income option is right for you. We can give you a clearer picture of your financial situation and help you enjoy a stress-free retirement.
Please note: The Financial Conduct Authority (FCA) does not regulate cash flow planning.
Investment returns are not guaranteed and you may get back less than originally invested; past performance is not a guide to future returns.