Ill-health retirement: what are your options?

What are the retirement income options for those with chronic health issues? The spectrum of ill health is a broad one, of course, but if your condition makes it difficult for you to work, you may well be wondering whether early retirement is a realistic possibility in financial terms.

For those who are terminally ill, there may be greater flexibility to access retirement savings and other financial support.

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Below, we take a look at the options.

Pension access

Although it’s possible to access your workplace or personal pension before the age of 55, it’s not normally advisable because you’ll incur a swingeing 55% tax charge on your withdrawals.

However, pension providers may make exceptions if you meet their ill-health criteria, allowing you to start drawing a pension income before minimum pension age without the usual penalties.

Those criteria will vary between providers, so the place to start is with your pension paperwork or helpline.

“You’d normally have to provide medical evidence that establishes that you are permanently unable to work, and that there are no treatments that would improve the condition to a state that would enable you to return to work – even if the employer made allowances and/or provided support such as visual aids or flexible working,” says Dawn Mealing, financial planning business manager at atomos.

If you are able to start drawing your pension, your income will be taxed in the usual way.

Terminal illness

“If you’re terminally ill - defined as being expected to live less than a year – you can usually take the entire pension as a tax-free lump sum,” says Tom Kimche, senior client adviser with Netwealth.

You’ll need to be under age 75 and with less than the Lifetime Allowance (LTA) of £1,073,100 in pension savings to qualify for that option. If you’re older or your pension is worth more than the LTA, then you will pay income tax on some or all the lump sum. Be aware too that some providers may keep 50% or more of the fund for your spouse.

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However, Kimche makes the point that while this sounds an attractive proposition, if you have a large estate, it’s important to be sure you’ll be able to spend the money before you die, because any remaining funds will be taken into account when it comes to inheritance tax (IHT), whereas assets in a pension wrapper are not included.

Annuities

If you are able to gain early or full access to your pension fund, one option is to use it to buy an annuity paying a secure income for life.

The amount of annual income your lump sum will buy is shaped (among other things) by life expectancy, so if you have a condition considered to reduce the length of time you can expect to live, then you may qualify for a so-called enhanced annuity paying a higher income. (Those with a life expectancy of less than two years probably won’t be eligible for an annuity.)

The list of qualifying medical conditions varies between providers, but it is quite a long one. Even a relatively minor ailment such as high cholesterol may qualify for an enhanced payout if you’re taking prescribed medication for it.

“It’s estimated that nearly three-quarters of 65 to 74-year-olds have been diagnosed with at least one long-term medical condition and about half of those have two or more conditions,” says Steve Lowe, director at retirement specialist Just Group.

He gives the example of a 65-year-old asthma sufferer with type two diabetes, high blood pressure and high cholesterol, who could get an additional 12% compared with the best rates. For stage three lung cancer, the uplift could be as much as +88%.

“Our analysis suggests nearly two-thirds of retirees can receive higher income than ‘standard’ rates, but the latest figures from the Financial Conduct Authority suggest only about a third of the 80,000 annuities bought in 2021-22 were enhanced,” Lowe continues. “With annuity rates and sales rising strongly since then, it’s likely 30,000-plus people are missing out on extra income each year.”

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One important consideration for married or civil-partnered people thinking about annuities is the question of provision for their other half.

This is less of an issue if the partner has decent pension provision of their own, but if they don’t, it may be sensible to consider a joint life annuity that will continue to pay out through both lifetimes.

However, warns Kimche: “An enhanced annuity on a joint life basis is not likely to be much more beneficial than a standard one if the other party is in good health.”

More generally, he stresses that although enhanced annuities may provide financial security, they are not necessarily the best choice for everyone in this position.

“This is certainly not worth doing if an annuity is not right for you more generally. If you are comfortable taking risk, or want to maximise death benefits in a pension, then drawdown may well be more appropriate,” he says.

Income drawdown

The drawdown alternative involves leaving your pension fund invested and taking an income directly from it. The advantage is that you can adjust the amount you draw down as you need to.

A further plus point is that whatever’s left after your death can be passed to your partner or to younger family members, and won’t be counted as part of your estate. If you die before age 75, they can inherit it as a lump sum completely free of tax; otherwise they may have to pay income tax on it.

“To be able to pass on the pension pot tax-efficiently, you may consider using other non-pension assets or investments from which you can draw an income during retirement,” suggests Mealing.

If that’s not feasible, she advises skimming off any growth or taking income distributions as they arise from the underlying pension investments. “The general rule of thumb is to take no more than 3-4% of the fund each year to preserve the value.”

Whether or not you’re worrying about IHT considerations, the downside for the income drawdown option is that your income is not guaranteed, and the onus is on you (or your financial adviser, if you use one) to manage your investment effectively.

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That could be a challenge if you live longer than expected and have to make the money last too. Planning for your partner may be a further important consideration.

It’s therefore important to do some homework before you invest, or take advice if you don’t feel up to managing your money yourself. There are several things to bear in mind.

Are you taking the right amount of risk? Being overly cautious and holding too much cash can be damaging to your wealth because it may not keep up with inflation over the longer term.

Against that, if your health outlook is poor, you want to make the most of your remaining few years, and if there are no dependents likely to outlive you, it may make sense to stick primarily with cash.

Tom Kimche also flags up the risk of an inefficient drawdown strategy: “For instance, you may not be utilising the basic-rate tax band, or drawing too much and straying into a higher-rate tax bracket.”

Tax reliefs and wrappers are important too, he adds. “Be mindful of your ability to reinvest proceeds from a pension into an individual savings account (ISA) or a general taxable account (where you can use your £6,000 capital gains tax and £1,000 dividend allowances).” However, both these allowances will be halved in the new tax year.

State pension

Sadly, you cannot claim your state pension early on grounds of ill health. However, you may be eligible for other state benefits at any age, including Employment and Support Allowance (ESA), Universal Credit and Personal Independence Payment (PIP).

This latter replaces Disability Living Allowance and is available to those with long-term physical or mental health conditions that impact on their ability to get around or look after themselves.

Kimche highlights the “special rules for end of life” that may apply in cases of terminal illness. “If a doctor says you may have 12 months or less to live, you might be able to get benefits at a higher rate or get extra money, and also start getting payments more quickly than usual.”