EXTRACTING INCOME

UNTIL recently, most people with a pension fund had to buy an annuity to secure an income for life.

But the introduction of pension freedoms in April 2015 – and the collapse in annuity rates – means more people aged 55 and over are trying new tactics to generate a retirement income. Here, the Mail on Sunday considers the options:

1 BUY AN ANNUITY

AN ANNUITY provides a guaranteed income for life. It can rise steadily, or in line with inflation, and can include a widow or widower’s pension – all at extra cost. With most funds, you can take up to 25 per cent as a one-off tax-free lump sum at age 55. The remainder can be converted into a taxable lifetime income.

While an annuity guarantees a regular income, rates are at rock bottom levels. Neil Adams, a pension specialist at City- based adviser Drewberry Wealth, says: ‘An era of super-low interest rates and ever-longer life spans has scuppered annuity rates.’

A £100,000 annuity would today pay a 65-year-old an annual income of £2,570, guaranteed for five years, rising in line with the retail prices index of inflation, currently 3.7 per cent.

Patrick Connolly is an adviser with Bath-based Chase de Vere. He says: ‘You do not have to buy an annuity from your current pension provider. Shop around to find better value.

‘Those with a health condition or who smoke should take advantage of enhanced or impaired life annuities which pay a higher rate of income.’

But experts say youngish retirees in good health should not make an annuity their first port of call, lest they lock into an uncompetitive rate with an insufficient level of income.

2 DRAW AN INCOME

RATHER than buy a pension annuity, more Britons are looking to draw an income as and when they need it.

After taking 25 per cent as tax-free cash, the remaining 75 per cent remains invested throughout retirement to provide spending money.

While this provides flexibility, there are risks. Connolly says: ‘As the fund remains invested, it may fall in value, income levels might be unsustainable and additional charges may apply.’

Adams says drawdown can make sense, adding: ‘Even modest returns from your pension pot should allow you to draw a higher level of income than you would receive from an annuity while still seeing your underlying pension fund grow in value.’

According to Drewberry Wealth, a 65-year-old with a £100,000 pension pot who drew down the same £2,570 a year paid by an annuity, rising at 2 per cent a year to cover for inflation, would nonetheless see their fund grow to £ 127,000 by age 83. This assumes annual fund growth of 4 per cent after all fees are taken off.

Adams adds: ‘If someone made it to 100, the fund would be worth nearly £200,000, even though it had already paid a rising income for 35 years.’

Though the final fund figures do not allow for inflation, this pot could be passed down to a beneficiary, whereas an annuity leaves nothing.

Danny Cox, a pension specialist at adviser Hargreaves Lansdown, agrees that, with care, you can generate a rising income from your pension. He says: ‘As a rule of thumb, do not draw down more than four per cent of your pension in any year.’

While drawdown is appealing, there are concerns that many people do not understand the risks and are unaware of the tax implications.

Jonathan Watts- Lay of financial adviser Wealth at Work says: ‘It is likely that by using drawdown many people will end up paying more tax than they need to.’

Equally, if you end up living longer, or need to spend more than expected you may run out of cash prematurely.

3 CASH IN ONE GO

UNDER the new pension freedom rules, you can now take all of your pension pot as cash in most cases.

Cox warns: ‘While 25 per cent is tax-free, the rest is fully taxable. This means a higher-rate taxpayer could pay £15,000 tax on £50,000.’

Hargreaves Lansdown says people tend to cash in small pensions worth less than £15,000. Because of the evident risks, advice should be sought if you are looking to cash in.

4 LEAVE PENSION UNTOUCHED

SOME people delay taking a pension to allow a fund to continue growing.

Steve Webb, head of policy at insurer Royal London, says: ‘The piece of the jigsaw people often miss is the importance of putting off retirement.

‘For example, every year you put off taking your state pension gives you an extra 5.8 per cent of income for life. It also means more time for retirement money to grow. It should also mean that if you do buy an annuity, you will get a better rate in light of the fact that you are older.’