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Should you take tax-free cash from your pension?
The opportunity to take a quarter of your pension pot as a tax-free lump sum is usually too tempting to resist.
Should you take tax-free cash from your pension? Photo: GETTY
By Emma Simon
5:45AM BST 16 Jul 2011
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Those approaching retirement face some difficult decisions that have not been eased by the news this week that annuity rates have fallen again and are now at their lowest ever levels.
As the graph opposite shows, annuity rates have more than halved over the past 20 years, thanks largely to increased longevity. In 1990 a man retiring at 65 with a £100,000 pension fund would have been able to secure a pension of £15,650 a year for life. Today the same pension fund will provide just over £6,500 a year. This tumbles to just under £3,000 a year if you want to inflation-proof your income and add a spouse's pension.
Such low rates mean that some people are having to rethink their retirement plans radically – not least the assumption that on retirement they will collect a large tax-free cash sum to spend as they wish.
According to Prudential this week, nearly eight out of 10 people retiring last year took a tax-free lump sum from a company or personal pension scheme.
The amount you can take can differ between schemes; but as a rule of thumb most people can take a quarter of their fund tax free; the rest being used to secure an income, via either a traditional annuity or an income drawdown plan.
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But it appears that a significant number of people later regret taking this lump sum. More than two in five pensioners told the Pru that they were living a "cautious" retirement and worried about having sufficient long-term income to get by. One in ten said they wished they had not taken the lump sum.
Vince Smith-Hughes, the head of business development at Prudential, said: "The days of buying a shiny new car or going on a once-in-a-lifetime holiday may be gone, to be replaced by making savings and investments with the lump sum to supplement retirement income."
It is not difficult to see why many pensioners are finding that their money does not go as far as they expected. On the one hand, low interest rates have battered any income they receive from savings accounts, and on the other they are seeing living costs soar.
Ros Altmann, the director general of Saga, pointed out that the unexpected fall in inflation this week didn't provide much comfort for pensioners on a fixed income as the headline figure still masked the fact that fuel and food prices were rising steeply.
But, as Mr Smith-Hughes acknowledged, there is no "one-size-fits-all answer" to the question of whether or not to take the tax-free lump sum. So what considerations need to be borne in mind?
Laith Khalaf, a pensions expert with Hargreaves Lansdown, the advisory firm, summed up the main problem: "For most the decision will centre on whether they need this capital sum immediately. They may have debts to pay, or need urgent house repairs. The other side of this coin is clearly what income they need in retirement. If you take the tax-free lump sum, are there sufficient funds in your pension to produce the income you need?"
He said this calculation was different for those with a "gold-plated" final salary scheme. These pensions are still common in the public sector and many people retiring today would also have some final-salary benefits from private company schemes.
"With some of the older public sector schemes you built up a separate entitlement to the tax-free cash. So there isn't really any decision to make – by not taking this money you don't get a bigger pension," Mr Khalaf said.
However, with most defined benefit schemes employees build up a pension entitlement, typically one 60th of their final (or average) salary for every year they work, and at retirement they have the option of "commuting" a portion into tax-free cash.
Mr Khalaf said: "The exact commutation rate varies between schemes. But typically people get between £12 and £15 for every £1 of pension income they give up [up to a set maximum]. Remember that with the vast majority of schemes this is £1 of index-linked benefit that will almost certainly pay a 50pc benefit to a surviving spouse."
He said that although lots of people might well want the cash sum, taking it was often not value for money. "If you look across at annuities it is going to cost between £20 and £25 to buy this same pension income."
He added that for those who hadn't built up large pensions in these schemes there was a very strong argument for not taking the lump sum, although again it would depend on personal circumstances.
With defined contribution or money purchase schemes the choice of whether to take the cash or not is more straightforward: would you rather have cash in hand today or a promise to get a higher pension tomorrow?
For those who take the money upfront, preferring not to gamble on their own longevity, it can pay to make sure the money is invested tax efficiently. It might be a tax-free lump sum, but if you simply stick it in the building society you will find any interest on it is taxed.
Isas are an obvious choice, as these wrappers ensure that no income tax or capital gains tax is paid. The other option is, of course, income drawdown plans – which give individuals the option of taking the lump sum, after which they are not required to take any further income until they need it.
As the remaining investment is still within the pension wrapper, any further growth is tax-free. But this is only really a suitable option for those with sufficiently large funds to bear the investment risk.
The opportunity to take a quarter of your pension pot as a tax-free lump sum is usually too tempting to resist.
By Emma Simon
5:45AM BST 16 Jul 2011
Those approaching retirement face some difficult decisions that have not been eased by the news this week that annuity rates have fallen again and are now at their lowest ever levels.
As the graph opposite shows, annuity rates have more than halved over the past 20 years, thanks largely to increased longevity. In 1990 a man retiring at 65 with a £100,000 pension fund would have been able to secure a pension of £15,650 a year for life. Today the same pension fund will provide just over £6,500 a year. This tumbles to just under £3,000 a year if you want to inflation-proof your income and add a spouse's pension.
Such low rates mean that some people are having to rethink their retirement plans radically – not least the assumption that on retirement they will collect a large tax-free cash sum to spend as they wish.
According to Prudential this week, nearly eight out of 10 people retiring last year took a tax-free lump sum from a company or personal pension scheme.
The amount you can take can differ between schemes; but as a rule of thumb most people can take a quarter of their fund tax free; the rest being used to secure an income, via either a traditional annuity or an income drawdown plan.
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But it appears that a significant number of people later regret taking this lump sum. More than two in five pensioners told the Pru that they were living a "cautious" retirement and worried about having sufficient long-term income to get by. One in ten said they wished they had not taken the lump sum.
Vince Smith-Hughes, the head of business development at Prudential, said: "The days of buying a shiny new car or going on a once-in-a-lifetime holiday may be gone, to be replaced by making savings and investments with the lump sum to supplement retirement income."
It is not difficult to see why many pensioners are finding that their money does not go as far as they expected. On the one hand, low interest rates have battered any income they receive from savings accounts, and on the other they are seeing living costs soar.
Ros Altmann, the director general of Saga, pointed out that the unexpected fall in inflation this week didn't provide much comfort for pensioners on a fixed income as the headline figure still masked the fact that fuel and food prices were rising steeply.
But, as Mr Smith-Hughes acknowledged, there is no "one-size-fits-all answer" to the question of whether or not to take the tax-free lump sum. So what considerations need to be borne in mind?
Laith Khalaf, a pensions expert with Hargreaves Lansdown, the advisory firm, summed up the main problem: "For most the decision will centre on whether they need this capital sum immediately. They may have debts to pay, or need urgent house repairs. The other side of this coin is clearly what income they need in retirement. If you take the tax-free lump sum, are there sufficient funds in your pension to produce the income you need?"
He said this calculation was different for those with a "gold-plated" final salary scheme. These pensions are still common in the public sector and many people retiring today would also have some final-salary benefits from private company schemes.
"With some of the older public sector schemes you built up a separate entitlement to the tax-free cash. So there isn't really any decision to make – by not taking this money you don't get a bigger pension," Mr Khalaf said.
However, with most defined benefit schemes employees build up a pension entitlement, typically one 60th of their final (or average) salary for every year they work, and at retirement they have the option of "commuting" a portion into tax-free cash.
Mr Khalaf said: "The exact commutation rate varies between schemes. But typically people get between £12 and £15 for every £1 of pension income they give up [up to a set maximum]. Remember that with the vast majority of schemes this is £1 of index-linked benefit that will almost certainly pay a 50pc benefit to a surviving spouse."
He said that although lots of people might well want the cash sum, taking it was often not value for money. "If you look across at annuities it is going to cost between £20 and £25 to buy this same pension income."
He added that for those who hadn't built up large pensions in these schemes there was a very strong argument for not taking the lump sum, although again it would depend on personal circumstances.
With defined contribution or money purchase schemes the choice of whether to take the cash or not is more straightforward: would you rather have cash in hand today or a promise to get a higher pension tomorrow?
For those who take the money upfront, preferring not to gamble on their own longevity, it can pay to make sure the money is invested tax efficiently. It might be a tax-free lump sum, but if you simply stick it in the building society you will find any interest on it is taxed.
Isas are an obvious choice, as these wrappers ensure that no income tax or capital gains tax is paid. The other option is, of course, income drawdown plans – which give individuals the option of taking the lump sum, after which they are not required to take any further income until they need it.
As the remaining investment is still within the pension wrapper, any further growth is tax-free. But this is only really a suitable option for those with sufficiently large funds to bear the investment risk.
