It’s easy to take for granted the flexibility that pensions offer us when we retire, or start winding down from work.
Although pension freedoms legislation was only introduced in 2015, the days of retirees being railroaded into buying an annuity seem long gone. Now it’s possible to access your pension savings from 55 (rising to 57 in 2028) in any way that you like.
And savers are certainly taking advantage of that flexibility. According to the latest HMRC data, in the first half of this year, 1.1 million people took £7.5 billion out of their pensions – up 17% on the same period in 2022 and 67% since 2020.
But, while few of us would want to go back to the old days, managing your retirement income yourself is not as straightforward as it might seem. You can easily pay more tax than you need and there’s the risk that your money could run out, if you don’t manage it carefully.
To help you stay in control, here are some of the biggest pitfalls and the steps you can take to avoid them.
1) Raiding your pension before you retire
Under current rules, you can take your pension from age 55, rising to age 57 from 2028. But just because you can start taking money from your pension before you retire, that doesn’t mean you should. Your retirement could last, 20, 30, maybe even 40 years, so the more money you take out before you’ve actually stopped earning, the less money you will have when you really need it.
Taking money out at this point can also land you with a hefty tax bill. Although 25% of your pension can be taken as a lump sum, this is only possible if you are buying an annuity or moving into drawdown. If you are taking money out and leaving the rest invested, only the first 25% will be paid tax free and you will pay income tax on the rest. Depending on the size of your withdrawal, it could even push you into a higher-rate tax bracket.
If that’s not enough to put you off, you might also trigger the money purchase annual allowance (MPAA), meaning the maximum amount you can pay into your pension each year will be cut from £60,000 to just £10,000. That won’t be welcome news if you have plans to top up your pension in the final years of your working life with bonuses, an inheritance or any other windfall.
2) Spending your assets in the wrong order
Pensions have been specifically designed as a tax-effective way to save for retirement, but that doesn’t necessarily mean they should be your income “go to” when you stop earning. If you really want to minimise the amount of tax you pay, it might make sense to leave your money in your pension for as long as you can.
This is because money held in pensions will fall outside your estate when you die, meaning there won’t be any inheritance tax to pay on it. It’s also important to bear in mind that pension income is taxable, while money taken out of ISAs, is tax free. That means retirees can either spend down ISAs first, or use ISAs and pensions in combination to reduce the amount of tax they pay on their overall retirement income.
3) Underestimating your life expectancy
When you are working out how much you can afford to take out of your pension each year, you will have to think about how long you will need your pot to last. The average life expectancy for 65-year-old men is now 85, rising to 87 for women, according to the Office for National Statistics (ONS).
However, there’s also a one in four chance that a 65-year-old woman will live until she’s 94, a one in 10 chance that she’ll make it to 98 and a more than 5% chance of getting a letter from the King and turning 100.
It’s impossible for any of us to know what the future holds, but from a financial planning point of view, it’s prudent to work on the assumption that you will live longer than you think. In fact, many financial advisers now plan for a 100-year life when setting up retirement plans for healthy clients.
4) Failing to factor in inflation
Inflation has long been known as “the silent thief” but over the past year or so it’s been as subtle as an armed robbery, with prices rising faster than they have in 40 years. Although rampant inflation might now be starting to cool, recent events still provide an important reminder of the need to factor rising prices into your retirement income plans. With a greater proportion of their money spent on food and heating, older people are often hit hardest by inflation.
All retirees will get a degree of inflation-proofing, with the state pension protected (for the time being at least) by the triple lock. If your pension is in drawdown, or you have other investments, it’s also possible to give yourself some hedge against inflation by gearing a portion of your portfolio towards growth. However, it is harder when an annuity is delivering the bulk of your income as payments will be fixed. Although inflation-linked annuities are available, they have never been popular as they pay a much lower income at outset.
5) Persevering with income drawdown in falling markets
It’s important not to start making habitual withdrawals from a drawdown arrangement without keeping tabs on what is happening in the stock markets. So-called pound-cost ravaging occurs when you carry on making the same level of withdrawals when markets are falling and your pot is shrinking. This compounds the stress on your portfolio and makes it much harder to recover your losses when markets bounce back. However, it is possible to protect yourself from pound cost ravaging. By keeping a healthy cash reserve that you can call on when markets are falling, you can pause withdrawals from your pension and reduce the pressure on your pot.
6) Falling for a scam
We all like to think that we would never fall for a scam, but our pensions are an attractive target for fraudsters, and their tactics are becoming increasingly sophisticated. According to the Pensions Management Institute, nearly 1,600 scams were reported between 2020 and 2022, with the average victim losing £16,500.
Scammers might be offering a free pension review or tell you that you can get early access to your pension. Alternatively, they might be urging you to transfer your pension on the promise of high returns or tell you that they have got the skinny on a tax loophole that could save you thousands.
But it is possible to protect yourself – be wary of any approach that comes out of the blue, legitimate businesses won’t contact you in that way. You shouldn’t have to rush into making a decision either.
The Financial Conduct Authority (FCA) also offers a number of online tools to help you spot a scam.
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