We have previously argued that if you have a pension fund, then you must buy an annuity to insure yourself against the risk of living a long time and requiring the income to match. If you do live a long time, then you get a cross-subsidy from all the other pensioners who die before you, and this keeps your annuity going. I have tried some spreadsheet modelling on this, and there is no magic scheme which can guarantee a substantial lifelong income other than the standard annuity.
However, if you buy an annuity and then die early, you will be subsidising someone else’s pension, and your own descendants won’t inherit anything. That’s built in to the nature of the annuity contract. This is a point which obviously will not be popular with pensioners, but you cannot have it both ways.
Current tax rules allow you to draw out a 25% lump sum tax-free upon retirement. The other 75% is applied to buying an annuity, and income from the annuity is taxable as deferred income from employment. You could refrain from drawing the lump sum, but then 100% would be taxed as income from employment and all your pension fund would be locked up.
What you could do is to reinvest the 25% lump sum in another type of annuity called a purchased life annuity which is taxed more leniently because the “income” paid back to you is mainly a return of capital. Alternatively you could invest the lump sum in shares or a unit trust or an investment trust and live off the dividends. The dividend rate would be lower than the annuity rate, but you would have both an emergency fund and the prospect of leaving an inheritance.
However, the 75:25 split between annuity and other investments is being dictated to you by tax considerations. What if you wanted some other split, such as 50:50 for example? New legislation allows you to draw a lump sum of more than 25%, but you will pay 20% tax on the extra lump sum, which may defeat the point of saving for a pension in the first place. I don’t see this as a good idea except in the circumstance that you have been diagnosed with a terminal illness, have no descendants and just want the money now. Even then you might get an impaired life annuity which pays at a higher rate to reflect reduced life expectancy.
What you can do instead is to look to apply the 75% pension pot to an annuity with some element of guarantee. If you are married or in a civil partnership, then you can buy a joint-life annuity which provides an income for both of you until you both die. It is hardly likely that you will both die the day after buying this annuity, so this is a start. There are guaranteed annuities which guarantee to pay an annuity for five years even if you die within this period. You can then just save the difference between 50% and 75%, or one third of the annuity you receive.
Of course, any annuity with an element of guarantee will pay out at a lower rate. As far as your dealings with the pension company are concerned, you get what you pay for. However, this approach optimises the tax treatment of your pension fund and is something to consider.
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