The first five years of retirement: are you prepared?

After a long working life, those early years of retirement are a time to cherish and enjoy. At last, it will be up to you to decide how you spend your week.

But while that freedom makes it an exciting stage of life, the shift in your finances can introduce an element of anxiety. You’ll want to make the most of this time, but you won’t want to worry about money either.

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David Gibb, a chartered financial planner at Quilter Cheviot says: “The first five years set the tone for the rest of your retirement. You’re at your youngest, and often healthiest, so you’re likely to want to spend more doing the things you’ve been looking forward to while you are most able, such as holidays abroad and active pursuits. But it’s also important to understand and get used to your new spending habits as your income changes, to ensure you don’t overdo it and run the risk of running out of funds later in life.”

As such, the decisions you make during these years will impact your finances for the rest of your life. So, whether you’re newly retired or have a few years to go, here’s what to think about to help you strike the right balance.

The best way to take income

If you’ve got a defined benefit (DB) pension, you’ll start getting a regular income as soon as you retire. However, if you’ve got any defined contribution (DC) schemes, you’re going to need to do some planning.

“The main decisions will focus on how much money you should take and how you take it,” says Gibb.

The two main ways of generating regular income from your pension are:

• Moving into income drawdown - where your money remains invested and you manage your own withdrawals
• Buying an annuity - an insurance policy that pays a guaranteed income for life

Both options have pros and cons.

Income drawdown, using something like a self-invested personal pension (SIPP), provides the opportunity for further capital growth, which can be invaluable in a retirement that could last as long as your working life. It’s also flexible – you can take as much or as little out of your pot as you like – and, when you die, any remaining funds can be passed on to your loved ones (tax free if you die before age 75 and if you pass away after 6 April, it might be subject to inheritance tax.)

However, you’ll still be exposed to market risk and will need to choose and manage investments yourself.

Annuities, on the other hand, provide a regular income that’s guaranteed for life and are completely “hands off”. But they’re inflexible and, unless you pay for additional guarantees or protection, there won’t be any money left for family when you die.

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Gibb says working out what’s right for you can be tricky, but he stresses that you can keep your options open.

“It’s a complex and individual decision for every retiree – there are several factors to think about such as other income sources, whether you have any dependents, your views on interest rates and inflation, the need for flexibility, and so on. Annuities provide the peace of mind of a guaranteed income and protection from market fluctuations but they are fixed, so could fall short of inflation rates, and once you’ve taken one out there are no options to make changes.”

He adds: “With drawdown, you always have the option to purchase an annuity at a later date, and in the meantime, you have more flexibility and growth potential, but of course also the risk of falling markets."

Spending and tax-free cash

“Retirement can be a big lifestyle change and often income decreases,” says Daniel Roberts, private client director at AAF Financial. “But retirees still have plans and dreams they want to fulfil, so the first five years is often when large capital expenditure occurs.”

Everyone can take 25% of their pension as a tax-free lump sum (either when they go into drawdown or buy an annuity) and this could be an obvious way to cover these costs.

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Advisers and pension providers are reporting increased enquiries from savers looking to take their tax-free cash, ahead of fears that the limit – currently £268,275 – could be lowered to as little as £100,000.

However, what to do with your tax-free cash, or when to take it, are not necessarily decisions to be made in a hurry or on the back of rumour.

“We would consider all areas of the client’s finances, depending on individual circumstances,” explains Roberts. “Beyond taking 25% cash tax free, they may not have the opportunity to take further lump sums across their retirement. Do they intend to make changes to their property? Buy a car? Assist family with home deposits or school fees? Are they planning any expensive holidays? All decisions such as these can influence the requirement for the lump sum access.”

But Gibb stresses that if you don’t have a specific need for the money, you don’t need to take it straightaway: “If there’s no need to take the full lump sum then, generally speaking, it’s advisable to leave some or all of it invested to allow it to continue to grow,” he explains.

However, it’s not always wise to delay indefinitely. “You should aim to take all your lump sum by age 75 because if you die after that timewithout taking it, then your beneficiaries will pay income tax on the money, meaning the tax-free element effectively disappears,” he adds.

If you don’t have any major costs, one option is to use your tax-free cash in stages to top up your income, without increasing your tax bill.

Getting the balance right

Although it’s exciting planning what you’ll do when you first retire, Roberts says it’s important to be realistic. “This requires sitting down and being honest about what income can be achieved, with a focus on your budget and spending plans. You also need to consider potential future costs such as care homes and medical bills, ensuring sufficient funds are available to last throughout your retirement.”

But, with the right planning, he says you don’t necessarily need to sacrifice fun in the early years to achieve security in later life. “If done carefully, a combination of the two can be achieved. Plans such as travel tends to be covered in the early years of retirement with care and medical costs covered in the latter years.”

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Financial advice at this point can be invaluable as it enables you to access in-depth cashflow analysis. “This brings to life the realistic picture of what income would be available throughout the retired years ahead,” says Roberts.

For many savers, the process can deliver the valuable reassurance that both their pot and spending are sustainable. “There are two main risks in retirement,” says Gibb. “One is running out of money and the other is dying without having spent as much money as you could have. People typically live for 20 to 30 years or more in retirement, and over that time inflation can have a devastating impact on the value of money.”

Cash-flow planning, he adds “can factor in potential inflation rates, model ‘what if’ scenarios and spot potential shortfalls, helping to ensure (as much as possible) that you can live comfortably without running out of money – it’s a fine balance.”