We are now into the era of “Pensions Reform”, which allows you to cash in your pension and take it all as a lump sum, subject to a tax charge. Let’s just pour some cold water on this idea.
If you are retired and have built up a substantial fund to keep you in old age, then there are sensibly two things to do with it, leaving aside tax considerations:
(1) You can invest it in shares, preferably shares known to have a low risk, and live off the dividends. You can expect a return on investment of up to about 3% per annum in good times. This return should keep pace with inflation, and there will be a decent inheritance for your children in due course. You also have a fund to use in emergencies. However, the 3% return is not that much.
(2) You can buy an annuity from an insurance company. This is a contract which pays you an income for the remainder of your life, giving a return of 5% or more, depending on the age at which you purchase the annuity. There is no inheritance for your children, and no emergency fund. Instead, you have a guaranteed income for life. If you die the day after the annuity starts, your estate loses everything. If you live on for a very long time, you get a cross-subsidy from all the other people who pre-decease you, after allowing a profit for the insurance company.
I have done some spreadsheet modelling on this, and there is no magic formula where you can get a return of more than 3% by living off capital without depleting your pension should you live for a very long time. This means that at least some of your retirement fund should be applied to buying an annuity to insure yourself against the risk of living for a long time and thus requiring an income for a matching period. It is only the cross-subsidy from other people which can achieve this long-term security of income.
Fetching in the tax rules, a money-purchase pension allows you take a 25% lump sum tax-free, and a final salary scheme offers something similar. It makes sense to buy an annuity with the remaining 75%, and to take the lump sum up to the maximum extent. You can keep the lump sum as an emergency fund, you can invest it in shares and just live off the interest, leaving a modest inheritance, or you can buy a second annuity known as a purchased life annuity if your fund is large enough.
If you apply the entire 100% to purchasing an annuity, then you will be taxed on your pension in retirement as if it were income or deferred salary. If you apply 75% to one annuity and 25% to a second purchased life annuity, you will pay a little less income tax because some of the income from the purchased life annuity is a return of capital.
This should be enough choice for most people. Some people may realise that they will not live long but do not qualify for an impaired life annuity for some reason. Other people may have a grandchild to assist, for example to get a professional qualification. These small groups of people could benefit from the new pensions reform. However, most people will just become the target of spivs promising “pension liberation” or whatever. Just remember the old saying that a fool and his money are soon parted.
David Porthouse & Co is a forward-looking firm of accountants based in Carlisle with a keen interest in new technology with the aim of speeding up accounts production and making accountancy more affordable for our clients.