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If you are starting to plan for retirement, you may be thinking about the level of pension income you need.
In this guide, we look at the factors that will affect your retirement income, and how you can plan for them.
1. The Type of Scheme
Your retirement income will depend on the type of pension scheme you have.
If you are fortunate enough to have a defined benefit pension (either a final salary or career average scheme), your eventual retirement income will depend on how long you work for your employer and your earnings. Any investment risk is taken on by the scheme – fluctuations in the market won’t affect your retirement.
Defined benefit pensions are increasingly rare today, with the public sector being one of the few employers still offering them. Many other organisations have closed their defined benefit schemes, although if you were previously a member of such a scheme, you will still receive the pension you have built up.
If you have a defined benefit pension, points 2-5 below won’t apply to you unless you transfer your benefits outside the scheme.
A money purchase pension allows you (and often your employer) to make contributions which are then invested. Your eventual retirement pot will depend on the contributions made and the investment growth received. These factors are covered in points 2 and 3.
There are a few different types of money purchase pension:
- Personal pensions
- Stakeholder pensions
- Group personal pensions or group stakeholders, which are set up through an employer.
- Occupational money purchase pensions – these are similar to group personal pensions, but may have specific scheme rules.
- Self-invested personal pensions (SIPPs) which allow you to invest in funds, shares, commercial property, and any other permitted investments.
So if you have a defined benefit scheme, you should have a good idea of the pension income you will receive. If you have a money purchase scheme, a little more planning will be needed.
You and your employer can contribute to your pension. Contributions can also be paid by third parties, for example by a parent to a child’s pension.
Contributions are limited as follows:
- Anyone can contribute up to £3,600 per year (gross).
- Personal contributions above this level only receive tax relief up to the value of your relevant UK earnings. This includes salary and trading profits, but not investment income such as dividends or property rental.
- Both personal and employer contributions are capped by the annual allowance. This means that a total of £40,000 can be contributed to your pension in a single tax year.
- If you are a member of a pension scheme but do not fully use up your annual allowance, you can carry it forward by up to three tax years. This means that in 2020/2021 you can contribute £40,000 for the current tax year, plus £120,000 for the three previous tax years.
- The annual allowance may be reduced if you are a higher earner or if you have already taken benefits from your pension. It is best to seek advice if these apply to you.
Pension contributions are extremely tax-efficient. For every £80 you contribute personally, a further £20 will be credited to your pension by HMRC (subject to the limits above). Higher and additional rate taxpayers can claim further relief through their tax returns.
When considering the level of pension contribution to make, you will need to think about:
- Your retirement goals
- The timing and frequency of your contributions, i.e. monthly or annually
- Whether the contributions should increase every year
- Any limits that apply to your contributions
A cashflow plan can help you decide how much to contribute.
3. Investment Return
Your pension contributions can be invested in a range of different assets, for example:
- Funds, which may be multi-asset or specialise in a particular area
- Investment trusts
- Direct shares from the UK and abroad
- Fixed interest securities
- Property, either directly or through funds
These vary in terms of risk and growth potential, so it is preferable to hold as wide a spread of investments as possible. This avoids taking too much risk in any one area, while still capturing market growth.
It might also be appropriate to change your investment strategy as you get closer to retirement.
You should think about the following when deciding on your investment strategy:
- The returns you would like to achieve
- How much risk you are comfortable with
- The level of volatility, or market fluctuations you can cope with
- The timescale until you retire
- Your investment knowledge and experience
- Your other assets or sources of income.
Pensions are a long-term investment. It is usually counter-productive to make short-term tweaks or to try and time the market. The best investment strategy works alongside your financial plan to give you the best chance of achieving your goals.
Your pension fund will have charges deducted. These may include:
- Product costs
- Fund management charges
- Trading or dealing costs
- Advice charges
Every additional 0.1% of charges will have an impact on your retirement fund and eventual income. When investing for the long-term, it’s important to keep costs under control and ensure that you are receiving value for money.
If you have an old pension, or several plans which have built up over the years, it may be worth having these reviewed by an adviser. They will check if you can save on charges or improve on your investment choices by moving the funds elsewhere.
5. Your Choices at Retirement
When you retire, you have a number of different options:
Take tax-free cash
You will normally be able to withdraw 25% of your pension as a tax-free lump sum. You can take this as a single sum or phased over a number of years. This can be done either when you retire, or even earlier, providing you are over the minimum pension age (currently 55). The lump sum can be taken on its own or combined with taxable income, which is drawn from the remaining 75%.
Buy an annuity
You can use your remaining pension fund to buy an annuity if you wish. This is a type of insurance contract which usually provides a guaranteed income for life. Shorter term plans are also available.
The amount of annuity income you receive will depend on:
- Your age
- Your health and lifestyle
- Whether you include a spouse’s pension
- Any capital guarantees added, for example a partial return of fund if you die within 5 or 10 years
- Whether your annuity increases every year
- The frequency and timing of your income payments
- The company you choose. Your existing provider may offer a competitive annuity rate, particularly if the plan was set up with guarantees. However, you might find a better rate in the open market, so it is worth shopping around.
Annuities suit some retirees as they are guaranteed and do not require regular reviews. However, they are also inflexible and cannot be altered later in life if your circumstances change.
If you opt for drawdown, your pension fund will remain invested and you can withdraw an income as needed. This will be subject to your marginal rate of tax.
There are few things to take into account when considering drawdown:
- Your fund will continue to fluctuate in line with the market. It’s important to take an appropriate amount of risk.
- If you withdraw money during a market downturn, it will take longer for your fund to recover. It’s worth keeping a cash reserve to avoid selling investments at deflated prices.
- Your plan will need regular reviews to ensure your investment choice is appropriate and that your income levels are sustainable. There will be a cost for this.
But there are a number of benefits to drawdown:
- You can vary your income as required.
- You can continue to benefit from investment growth.
- The fund can be passed on to your chosen beneficiaries when you die.
- You still have the option to buy an annuity at a later date.
If you choose, you can withdraw your entire pension pot as a lump sum. But remember, 75% of the fund value will be taxed at your marginal rate. This is usually only appropriate for smaller plans, which are not your main source of retirement income.
6. Life Expectancy
Your pension income will be affected by your life expectancy. This works in the following ways for different types of income:
- Defined benefit schemes – the scheme calculates the level of income and contributions based on the collective life expectancy of the scheme members. Some members will die before they can take their full benefits. This subsidises the costs for the other members who may live even longer than a typical life expectancy.
- Annuities – your income will be calculated based on your own life expectancy. This takes into account your age, where you live, your medical history and any lifestyle factors such as smoking. Once your annuity is in payment, it cannot be changed. Annuities offer better value if you live longer than expected.
- Drawdown – the longevity of your pension fund will depend on how much you withdraw and the investment returns received. It’s important to keep your plan under review to ensure that you don’t run out of money.
A financial adviser can help you balance all of these factors to plan for your ideal retirement. Please don’t hesitate to contact a member of the team to find out more.
Please don’t hesitate to contact a member of the team to find out more about retirement planning. Book a free call with a member of our team today, without obligation. We look forward to speaking with you.