Turning a pension fund into an income: the options, the decision factors, and the practicalitiesFebruary 15, 2022
For those with one of the ever-decreasing number of Defined Benefit or Final Salary pension schemes, receiving your pension in retirement is fairly straightforward. At the scheme retirement date, the pension will pay you an amount of monthly income - based on your salary and length of service - for life, with usually a widow(er)’s pension should you die before your spouse.
For those with personal or company pensions known as Defined Contribution or Money Purchase schemes, it becomes a little more complex, with a number of options available. Typically, you will have built up a pension fund over the course of your working life and the size of the fund will depend on the contributions made and any investment growth they have made up to retirement. When you wish to stop work, this fund needs to be converted to an income, by one of two main options:
An annuity is where your pension fund is given to an insurance company, which in return pays you an income for life. There are many different types of annuity and the amount paid will depend on the type selected. For example, you could choose to receive an income that increases with inflation each year, or you could opt for a higher starting amount that doesn’t increase. Furthermore, you could choose one that ceases on your death or one that continues paying a pension for your spouse.
The difference between the various scenarios can be significant. For example, at 65 years old with a fund of £100,000:
- Option A - single life non-increasing pension: £5,081 per year*
- Option B - 3% p.a. increasing pension with 50% to spouse on death: £2,903 per year*
In summary, a single life non-increasing pension has the potential to provide 75% more pension than one that increases by 3% p.a. and pays a spouse pension on death.
Once you (and your spouse, if applicable) have died, there is no residual benefit to be paid to your beneficiaries regardless of the length of time you receive pension income...
2. Pension drawdown
Drawdown is where the pension fund remains invested and you take income from the fund, leaving the balance invested. Assuming the fund is to be used for an income for life, a calculation would determine what level of income is achievable based on the fund size and your age. Every three years, a re-calculation will be done based on age and fund value at that point. On your death, the fund could be used to pay a dependent's pension (in the same manner) or paid as a lump sum to your beneficiaries.
Income levels are flexible and it is possible to take more or less income than that recommended. For example, you may wish to reduce the income amount once the state pension starts or to take no income at all-in-one year (if this coincides with an inheritance or extra funds available due to downsizing, for example).
Your choice of route will depend on several factors, including the importance you place on a guaranteed level of income for life. While an annuity is the only option to provide this, once it has been purchased it cannot be changed. In contrast, income drawdown allows for your income levels to be altered in line with your requirements as well as the recalculation of your available pension income on a regular basis.
In reality, the only way to be 100% sure of your best option is with hindsight. If you were able to know with certainty how long your retirement will last, whether you or your spouse will live longest, what investment returns will do and what the inflation rate will be in your retirement, the choice of annuity (and type) or drawdown (and how much to take) would be very easy! However, with the lack of a crystal ball, we would always recommend seeking appropriate advice.
Many people will have several pensions built up over their working life. It may be more cost effective, and efficient, to consolidate these with one provider and receive one income payment as opposed to multiple from different providers.
Annuity rates from providers can vary significantly so shopping around for the best rate is probably a good idea. Also, the decision over whether to opt for a spouse’s pension is important as this cannot be changed down the line.
Not all pension providers offer a drawdown option. It is, however, possible to transfer to a pension scheme that can provide drawdown if this is your preference. Choosing the right investments is important when opting for drawdown. The funds must last for a retirement potentially extending to 30 or more years and regular encashments need to be factored in. Additionally, you would need to consider where any unused funds would be payable after your death e.g., to a spouse, partner, children or other beneficiary.
Turning a pension into an income requires careful planning and attention, and advice should be sought based on your personal circumstances. For further information contact John Batty.
*[SOURCE: Hargreaves Lansdown Best Annuity Rates page, accessed on 8 February 2022: https://www.hl.co.uk/retirement/annuities/best-buy-rates on 8th February 2022