After decades of building up your retirement savings, the thought of drawing money from your pension is probably quite daunting.
While it might be tempting to stick your head in the sand, a much better way of tackling your retirement concerns is to do your research and plan ahead.
There are lots of options to choose from when you’re deciding how to fund your retirement. This flexibility means you can find the solution that works best for you.
But it does mean you need to do your homework. So, in this final instalment in our retirement report series, we explore some of the main retirement income options available.
Certainty versus growth
One of the key factors to consider when you’re deciding how to fund your retirement is whether you want a guaranteed income or would like to keep your pension invested so it has the potential to keep growing. There are pros and cons of each approach, which we’ll come onto shortly.
In our recent retirement survey1, we found a real mix of preferences, with 30% of respondents wanting a guaranteed income, 28% wanting the opportunity for investment growth and 33% wanting a mix of the two.
Preference for certainty versus growth
The good news is that solutions exist to cater for all these preferences. Before we explore each of the options in turn, it’s worth remembering that you can take up to 25% of your pension as tax-free cash. This is currently capped at £268,2752. Further withdrawals will be taxed at your normal rate of income tax, whether the income is from an annuity, flexible income drawdown or individual lump sums.
Annuity
An annuity is a type of insurance product that you buy with your pension or other savings. It pays out a guaranteed income for a set period or for the rest of your life. Annuities offer the security of knowing you have a guaranteed, regular income. If you have an ‘escalating’ annuity, the income will increase in line with inflation or at an agreed fixed price each year. There are also short-term annuities, where you use part of your pension to buy an annuity for a fixed period of time and leave the rest of your pension invested. A ‘joint life’ annuity will pay an income to your spouse or partner after you die.
Once the annuity is set up, you can’t change your mind and you can’t increase or decrease the amount of income to suit your needs. We don’t offer annuities at Vanguard.
Flexible income drawdown
With flexible income drawdown, you choose how much income you need. You can change this amount whenever you want to. If you retire gradually, for example, you could start off by drawing a small income to top up your salary and then draw a larger income when you stop work completely.
The money that you don’t withdraw remains invested, which gives it the opportunity to keep growing. However, investments can go down as well as up. If your investments don’t perform as well as you hoped, your pension might not last as long as you need it to.
Carefully planning your pension withdrawals can help to reduce the risk of running out of money. One approach is to start taking a fixed percentage of your pension each year, but you adjust that amount depending on how the markets perform. These adjustments can help to protect your pension from market downturns while also ensuring you draw enough money to sustain your lifestyle. At Vanguard, we call this approach ‘dynamic spending’.
Individual lump sums
Another approach is to take a series of small lump sums over time. Whatever you withdraw will be a mix of up to 25% tax-free cash (capped at £268,275 in total) and 75% taxable income. For example, let’s imagine you have a pension of £100,000 and decide to take £40,000. Of that, £10,000 will be tax free and £30,000 will be taxable.
You might find this approach useful if you haven’t yet decided how to take your pension over the long term.
Mix and match
Each option has its own pros and cons, which makes it tricky to decide between them. But pensions are a lot more flexible than they used to be. It’s even possible to take a mix and match approach – perhaps buying an annuity to cover your essential expenditure and using flexible income drawdown for discretionary spending.
It’s also worth bearing in mind that income in retirement doesn’t only have to come from pensions. When we asked our survey participants which financial products they considered to be in their pension pot, they cited a wide range of savings and investment accounts.
What's in the 'pension pot'?
Taking a broad view of your savings and investments could help to alleviate some of the pressure on your pension and may also prove tax efficient.
You don’t pay tax on withdrawals from an individual savings account (ISA), whereas pension income is taxable. ISAs also form part of your estate for inheritance tax (IHT) purposes, which means they might be subject to 40% IHT when you die. Pensions usually sit outside your estate, so they can be a tax-efficient way of passing on wealth to the next generation. That’s why it often makes sense to deplete ISAs before pensions in retirement.
It’s also usually wise to preserve your pension and ISA tax wrappers for as long as possible so that your investments can continue to grow tax free. For many people, that means drawing income and capital from general accounts and cash savings before pensions and ISAs. However, this depends on your individual circumstances, so we’d suggest speaking to a financial adviser if you’re at all unsure.
You can read more about how to make your retirement more tax efficient in this earlier article.
1 Vanguard commissioned Boring Money to survey 1,500 savers and investors aged 50 to 70 in January 2024. Survey participants had at least £75,000 in workplace or private pensions, or if they couldn’t provide a pension value, a minimum income of £30,000 (retired) or £40,000 (non-retired).
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