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To be able to select the right options at retirement, you need to be able to organise your affairs correctly in the lead up to and at retirement. I want to guide you through the tools you have available to use, so you too can get yourself organised before retirement.
The Security of An Annuity
When you get to retirement with a Personal Pension, use the 75% to purchase an annuity. Annuities are an insurance of a future income until you die. Annuities provide predictability, guarantees and security. Once you are locked into an annuity, you cannot change to another provider if rates improve in the future.
While annuities provide you with certainty, they also have problems. To begin, most people tend to opt for a level annuity rather than one that increases in line with inflation, because the income at the beginning of the latter is so much lower than that of the former. But it is a risk with an unknown future: The higher inflation reaches, the poorer they get each year.
There is also the risk that your circumstances will change in the future after you have bought that annuity. The biggest problem with annuities though is that if you don’t get to use all of the money you have put into the annuity because your annuity provider benefits from it, not your loved ones.
The Flexibility of Drawdown
With Pension Drawdown, you can take your tax-free lump sum and leave it in the pension. You can leave the money growing tax-free and draw an income from the proceeds.
The first opportunity that Drawdown provides is that you can increase, decrease, stop and start your income. This allows your money to continue to grow and avoid adding an extra income that would be better deferred, so that you don’t pay more tax than is necessary.
This ability to increase and decrease your income allows you to plan much more effectively. This income is taxed in the same way as an annuity income is, but it offers more flexibility to minimise the tax you pay. More importantly, whatever is left on your death is given to your children.
The risk of drawdown is that the funds remain invested. If those investments were to fall, so could your income. If you take too high an income, or the investment performance is worse than you forecast, you could run out of money. It is important that you treat drawdown with more caution than you would when buying an annuity.
It’s worth taking a moment to think about the drawdown risk. Have an idea of your target retirement income and start to think about this in relation to a lump sum of money. Also, think about your capacity for loss, and also for your loss of returns.
When looking at drawdown as an option, you need to be aware of the risks and continue to monitor them, either yourself or through your trusted adviser. With a traditional annuity, you have made your final call; however, with drawdown you always have other options. You can always buy an annuity at a later stage.
The finer details of Pension Freedom change constantly. As it currently stands, you can decide to take your whole pension out if you want to, but you will be subject to an Income Tax charge that is determined by your other earnings.
Unless there is a really good reason you want your money out of the pension, it is not sensible to take all this money out of the pension in one go, depending on the value. For most people, it will be better to take the pension income more gradually rather than grab the lot. The best thing to do to come up with a decision is to seek independent advice that can take into account your specific situation.
The Annuity Evolution
After Pension Freedom, companies in the annuity market will have to innovate or face extinction, so expect some interesting developments in this space.
As an annuity can be seen as an insurance on your income, combining an annuity with a drawdown strategy may be the best way to facilitate your income in retirement and add security to your future.
The Third Way
There have already been some interesting developments between annuitisation and drawdown. These in-between products were referred to as ‘the third way’. We had seen a rise of companies that would offer the benefits of drawdown with the security of having a minimum guaranteed income.
The Final Salary Hook
As a member, or a deferred member, of a Final Salary Pension Scheme, you can ask your scheme for what is known as a ‘Cash Equivalent Transfer Value’ (CETV). Instead of receiving a fixed, increasing income at a chosen retirement date for the rest of your life, you can ask for a CETV.
Most schemes that can afford to would ideally pay you to clear off and manage things yourself. At Efficient Portfolio, we have been reviewing Final Salary Pension Schemes for over ten years. We advise the holder to keep that particular scheme as it is, because the lump sums offered did not sufficiently compensate them for the income they would be losing in the future.
The possibility of transferring is becoming more and more appealing for people in this situation. They have the same drawdown analysis as someone coming from a Personal Pension environment, but with many more factors to consider. It is a massive decision to transfer out of a Final Salary Pension, and it is important you understand the pros and the cons. If this does apply to you, don’t wait until you are about to retire to make the decision. Ask a qualified adviser to assess your pension to see if this is a viable consideration. My team and I at Efficient Portfolio are qualified to help! Please call us on +44 (0)1572 898 060 or email firstname.lastname@example.org.
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