Yahoo Finance How to make sure your pension doesn’t die before you do
Making sure you have enough to enjoy a carefree retirement requires diligent saving throughout your working life – including during times when there are pressures on household finances, such as when you start a family or move house.
However, when you eventually retire there’s a fresh challenge. How do you make sure your pension lasts as long as you need it to?
There are no rules that say pension providers and investment firms have to alert people if their pot is getting low, so you risk running down your pension pot too quickly without realising. It’s up to you to make sure you make it last. This means setting a sustainable income level.
Now read: How to retire early (according to the experts)
How to start taking an income from a pension
When it’s time to take money from a private pension – whether it is a lump sum or regular monthly amount – you can convert your pension into what is known as an "income drawdown" account. This allows you to take out what you need and leave the rest invested.
Setting the right income level is not an exact science. There are many factors that dictate how long a pension will last, including your investment returns and your changing needs for income over your retirement. Many people use a portion of their pension to pay off a mortgage, after which monthly costs typically fall dramatically.
Most people are poorly equipped to work out how long they will for and life expectancy is changing all the time. Working out how much regular income to take is not straightforward.
Use our calculator to work out how long your pension could last under different market conditions and strategies.
There are a few schools of thought on withdrawal strategies.
The 4pc rule
One rule of thumb suggests a safe withdrawal level is 4pc. Becky O’Connor of Pension Bee says: “The 4pc rule is a handy tool to work out what you might need, roughly, in your pot when you retire to be able to afford the living standard you want.
“It’s what you should, all things being equal, be able to take out of your pot each year for it to last your whole retirement.”
Calculations by stockbroker Hargreaves Lansdown show that someone aged 65 taking 4pc per year (after their tax-free cash) from a £100,000 pension would have approximately £35,000 left in their pot if they lived to age 88, if their investments returned an average of 5pc per year.
However, if you only had investment growth of 2pc over that time then you would see your fund depleted by the time you hit age 86. And if global economic conditions are rough for a while, you need to be prepared to react to changes in the market environment.
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, says: “Markets go up and down and if you don’t amend your withdrawal strategy accordingly then you could find yourself running out of money more quickly than you first thought.
“This is particularly the case if you experience big market drops early in your retirement – if you don’t keep a close eye on how much income you are taking you could find your fund depleted and need to make some tough decisions later on in retirement about how much income you can take.”
O’Connor adds: “If the markets wobble, then 3pc might be more prudent. On the flip side, if your investments are growing well, 5pc might be possible.”
Now read: How much you should save for a comfortable retirement – and when your cash will run out
Taking the 'natural yield'
If your goal is not just about income but perhaps leaving some of your savings to beneficiaries perhaps, you might prefer another strategy aimed at preserving the value of the pot.
This is known as taking the natural yield - the amount of income your pension investments generate every year from dividends from shares or interest from bonds - leaving the capital untouched.
O’Connor says: “This natural yield might end up being roughly 4pc anyway, depending on what the dividend income produced by your investments is every year.”
In good years, this strategy would allow you to take more income and in poor years, you would have to get by on less, if you want to preserve your pension's value.
This strategy relies on having a heavy weighting towards stocks that pay dividends over those, such as fast-growing technology companies, that generally to not make payments to shareholders.
The verdict
To work out what strategy is best for you, you’ll need to know a bit about what your pension pot is actually invested in and whether it is producing dividend income from the shares held or interest from any bonds.
O’Connor says: “A pot with a lot of healthy dividend-paying shares might generate enough natural yield to keep you and your pot going throughout retirement in an ideal world. But dividends vary from year to year and so does interest.
“You might also still have a significant portion of your pot invested in equities for growth, which should increase your capital balance over time, but will also limit the proportion of your pot generating natural yield.
“You might have to alter which strategy you are using for income based on economic conditions, too, to optimise your pot and make it as sustainable as possible.”
You’ll ideally review the amount you take annually to check if any changes need to be made. Perhaps if the rate of inflation changes, you might need more – or less – income. Or if there’s a market shock and share prices drop you might want to adjust your strategy.
If you're not confident in making these kinds of decisions yourself, you can enlist the help of a financial adviser who can help set withdrawals levels and flag any big market changes that require any adjustment to your income or to the way your money is invested.
However, advisers don't come cheap. They typically charge an initial fee and an ongoing fee.
The latest data available from the Financial Conduct Authority (FCA) says just a third of people who accessed income drawdown plans for the first time in 2021-22 took professional advice.
Still unsure? Ask the Telegraph's expert:
Tax considerations
Income from a pension is taxed just like a salary and at your highest marginal rate of income tax. Under the rules for the current tax year, you get a personal allowance of £12,570 where no tax is due. On income between £12,571 and £50,270 you’ll pay a basic rate of 20pc. For income between £50,271 and £125,140 you’ll pay 40pc – and anything over will be taxed at 45pc.
It’s worth bearing these bands in mind and taking only what you need in a tax year to minimise your tax bill. Don’t forget to factor in what you get from the state pension, which is currently £10,600 a year if you get the full entitlement.
Now read: How to use your pension to avoid inheritance tax
The return of annuities
Buying an annuity is an option when the time comes to retire. It’s an income-generating insurance contract bought with money in a pension and in exchange pays a set income for life.
With rates at a 14-year high they are an attractive option again for those retiring. The beauty of an annuity is that it guarantees you will never run out of money because the payments are made for life.
At today's rates, a 65-year-old can secure £6,842 a year of income for £100,000. However, the payments would not increase with prices, so could become much worse value over time.
While drawdown offers much more flexibility, an annuity still may be the right choice for at least part of a pension pot to fix in stone a guaranteed amount which may be needed to cover a mortgage payment, for example.
Knowing a large portion of your bills will be covered can give you some comfort, while
retaining an invested element to help meet further expenses.
Remember you don’t need to choose either annuity or drawdown, a combination of the two may be the most suitable option.
Now read: How do pensions and annuities work?
