If you have a defined contribution pension, you now have far greater freedom than you used to over how you choose to use your pension pot to fund your retirement.
Accessing your pension
From the age of 55*, you can access your full defined contribution pension and use it however you like. 25% of what you withdraw is completely tax-free, whilst the remainder is taxed as income. Should you take large withdrawals from your pension, you could be pushed into a higher tax bracket.
You may not necessarily want to start using your pension when you reach 55, especially if you intend to work another decade and that's fine. You can leave your pension fund untouched for as long as you like even indefinitely.
* Rising to 57 from 2028
Prior to the pension reforms, you could access 25% of your pension as a lump sum and most people had to use the remainder to arrange a retirement income. That's all changed, and you can withdraw the full amount as a lump sum, using the money however you like.
Besides the tax implications of withdrawing too much in one year (it's taxed as income), you need to be mindful of making sure your pension lasts. It might be tempting to withdraw it and splash out on a big ticket item; but if you don’t have any other major income sources to fall back upon, you could live to regret any rash decisions.
Taking advantage of the pension freedoms
With the added flexibility, a pattern has already emerged that more people are keeping their pension invested in retirement, usually through a drawdown plan.
One benefit of doing so is your pension can potentially benefit from further investment growth, and in the meantime you can make withdrawals or take a regular income from the fund (both of which are taxable).
If you would like to go down this route, you need to be prepared to regularly review your pension – perhaps with the help of an expert – to ensure it remains suitably positioned and to keep track of its performance and ability to fund your retirement.
Don’t forget, whilst your money is invested it will remain subject to the risk that it could lose value or run out altogether, especially if stock markets fall or you're taking an unsustainable level of income.
Arranging an annuity
For people who would like to secure a guaranteed level of income in retirement, buying an annuity with some or all of the pension pot might be the best option. This is where an insurance company converts your pot of money into an income, which they then pay to you over the term of the annuity. (It could be for a fixed term of, say, 10 years, or a lifetime annuity that continues to pay an income until you die.)
If you'd like to take this route, it's important to shop around for the best possible deal for your circumstances. It could be worthwhile paying for financial advice to ensure you get the right annuity for you.
There are different annuity features that you might want to build in, such as ensuring your partner still receives an income if you die before them. If you have a health or medical condition, you might qualify for an enhanced annuity that could potentially pay a higher level of income.
Combining the two options
One potential option is to use a portion of your pension pot to arrange an annuity, and invest the rest of your pension savings in a drawdown plan.
This option would potentially offer you the best of both worlds: a guaranteed level of income, potentially for a fixed period of time, via an annuity, plus the option to make flexible withdrawals from a drawdown arrangement.
That said, you need to be mindful that the part of your capital in a drawdown plan will be exposed to investment risk. This means your pension pot could lose value, particularly if your investments go down in value or take too much income too quickly. If the annuity income isn’t enough on its own to live comfortably on, any loss of capital could have an adverse effect on your future.
Again, financial advice is vital in devising the right plan for your needs. Regularly reviewing these arrangements will be important too.
Inheriting your pension
The pension reforms also brought changes to the tax treatment of pensions when they're passed on to beneficiances. This means you now could have a real opportunity to leave some, or all, of your pension to your loved ones to inherit in a tax-efficient way.
For retirement solutions such as drawdown, your capital is at risk so you may get back less than you originally invested. The value of investments and the income from them may fall as well as rise. If you take too much income too quickly your fund could become depleted or run out altogether. Annuity rates depend on your individual circumstances such as age, health and lifestyle factors as well as the rates available at the time of purchase. A conventional annuity has no cash-in value to you as an individual and once selected the options chosen cannot usually be changed.