Research published recently by the Prudential shows that the majority of people, nearly eight out of 10 in fact, take a tax free lump sum from their personal pension plan or company scheme, when they retire.
Pension savers have historically used the lump sum for a variety of different things, perhaps a once in a lifetime holiday, a final new car, repaying some lingering debt or simply as a nest egg for future use.
The research done by the Prudential shows that around 30% of retirees spent their lump sum on home improvements with the same number of people using it to pay for a holiday. One in five people used the money to buy a new car.
Annuity Rates
Most people are aware that over the past few years Annuity rates have fallen significantly, the two major contributing factors to this reduction have been increased longevity and a reduction in gilt rates.
It is possible that lower Annuity rates will force pension savers to change their buying habits when they reach retirement. The tax free lump sum may no longer been seen as a bonus but in fact vital to producing sufficient income to meet living costs.
So, with falling Annuity rates, rising inflation, and historically low interest rates what are the main things you should think about when you are deciding whether or not to take a tax free lump sum from your pension:
Income or capital, which is more important? This is probably the most fundamental question you need to answer when deciding whether or not to take your take free lump sum.
If capital is required, are there other options? We have already seen how capital could be needed for all sorts of things. It can be extremely tempting to see the tax free lump sum as an easy way of meeting your need for capital, but take a second look.
Make sure you consider all the possible options, could your savings be used to meet your capital requirements and allow your pension to provider a greater income?
In the current climate of relatively high inflation and historically low interest rates it is unlikely that your savings will be attracting an interest rate above inflation. Consider whether these should be used to meet your requirement for capital instead of the tax free lump sum.
Your savings may of course be insufficient to meet your capital needs, you may therefore have no alternative but to use some or all of your tax free lump sum.
If you need income consider all the options If income is a greater priority for you think about how best you can use your pension to maximise the income you will enjoy for the rest of your life.
Many people simply use 100% of their pension fund to buy an Annuity. If you are thinking of doing this then consider whether you would benefit from combining a traditional Lifetime Annuity with a Purchase Life Annuity.
A Purchase Life Annuity benefits from preferential tax treatment. HMRC deem part of the income to be a return of capital, it therefore does not attract tax. This can often mean that the net income of a Lifetime Annuity and Purchase Life Annuity combination is better than using your entire pension fund to buy a Lifetime Annuity.
The exact tax savings of a Purchase Life Annuity vary according to your own personal circumstances but for both basic and higher rate taxpayers they are certainly worth considering and often overlooked.
Another popular alternative is to invest the tax free lump sum with the objective of producing an income. Many people have found this route attractive as it preserves access to the capital, which is not the case if the entire fund is used to buy an Annuity. The downside to this option is generally an increased level of capital risk, assuming of course that any asset class other than cash is used for the investment.
Sufficient income and no need for capital Some people are in the great position of having sufficient income for their needs with no need for additional capital.
Despite this fortunate position care is still needed to make the right decision.
Should the lump sum be taken and invested? Would using it to buy a Purchased Life Annuity be advantageous? Could the lump sum be put to some other use?
These are just some of the many questions which people in this position may wish to consider.
No going back Whether you decide to take your tax free lump sum or not, think all the options through carefully because whatever decisions you make cannot be changed.
An Annuity can never be altered and once you have taken the tax free lump sum there are rules preventing it being recycled into a pension.
Conclusion
There is no one size fits all approach to retirement planning; each set of circumstances requires an individual solution.
Independent financial advice can help you consider all the options fully to make sure that you get the important decisions right.
Finally, even if you decide to take independent financial advice do some research beforehand, read up on the main options you have available, use a pension annuity calculator to look at sample figures, think about what is really important to you.
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