A simple question but a complex answer, so I have listed below some key points to consider and some useful links that should help.
The first point to remember is to sit down and calculate what you already have in terms of future pension provision, to include your estimated State Pension when you reach normal retirement date (NRD), plus any current or previous Final Salary (DB) scheme entitlement. It should then be easy enough to ascertain what your future guaranteed pension will be. For example:
Fred (current age 56) will have >35 years of qualifying national insurance contributions and will therefore receive the full state pension at age 67 of £8,750 (in today’s money)
Fred also has a deferred DB scheme from a previous employer and after receiving his latest pension statement from this scheme he can see that he will get, (after taking his tax-free cash), £6,250 per year at his normal scheme retirement date (which in this example is 65). Fred could elect to take this pension early (any time after 55) with the consent of the scheme trustees but if he did so the starting pension (and tax-free cash) would be re-calculated and adjusted (and will be lower). Alternatively, Fred could elect to defer taking this pension until age 67 (to tie in with his state pension) and in this scenario Fred’s starting pension from this scheme is likely to be higher. Fred’s DB pension also increases each year in line with inflation so the £6,250 will increase each year at an amount set out in the scheme policy document.
Let’s assume then that Fred decides to retire at 65 – he can look forward to a pension (in today’s money) of £6,250 each year (from his DB scheme) and then at 67 he will also receive the state pension.
So, a nice straightforward (simplified) example. Fred has the benefit of a DB scheme that is guaranteed, will increase each year for life, provides a 50% widows pension on his death, plus he will (at 67) receive his state pension, which is also guaranteed and should increase each year subject to future increases to the State pension).
Unfortunately, most people won’t have the benefit of having a DB scheme and instead will have what’s known as a Defined Contribution scheme or personal pension. Just to recap the key differences are:
DB scheme – pays a pension based on your salary (pensionable pay) and length of time that you were a member of the scheme. These schemes do not have a cash value as such but are guaranteed and will often have additional benefits’ such as a widow’s pension and increases to the pension each year. DB schemes (usually confined to the public sector and large employers) are costly to run and as a result many employers no longer offer them – The risks lie with the employer.
DC scheme – The more common workplace pension where you pay contributions into the scheme and your employer also contributes. There are no guarantees with these schemes, and they will have a specific cash value, dependent on contribution levels and the underlying investment performance of the scheme. The objective is to grow your “pot” during your working life and then you have a number of options (Pension Freedoms) when you decide to retire (the earliest age currently being 55). The risks lie with the individual.
Let’s look at Fred’s example once again but this time let’s assume, he has worked all his life and contributed to a number of workplace DC schemes.
Fred has over 35 years qualifying NI contributions so will receive the full state pension of £8,750 at age 67.
Fred has combined all his previous DC schemes into a SIPP and the projected value at age 65 is £250k (Fred’s SIPP provider should be able to calculate the estimated future value of his fund).
Fred is also contributing to his workplace DC scheme and contributing £150 per month – his employer is also contributing £250 per month, and the estimated value of the fund at age 65 is £150k (Fred has obtained a pension forecast from his workplace pension scheme).
So, at age 65 Fred hopes to have a combined pension pot of £400k – it’s important to remember that this will not be guaranteed and will depend on the investment performance of the funds / assets he has invested in. Ultimately the final values could well be lower (or higher) than forecast.
Fred decides to take 25% tax-free cash at age 65 and this will leave Fred with an estimated pension pot of £300k. Fred now has a number of options available to him (Pension Freedoms) to generate a regular income from his pension pot.
He could purchase an annuity with the £300k which will provide him with a regular income for life and guaranteed.
He could elect to keep the £300k invested and just take the income that his investments generate – generally known as taking the natural yield.
He could elect to take a regular monthly drawdown from his pension pot.
He could elect to take a combination of the above (a mixed retirement strategy).
He could even draw the £300k out in cash – however this is not normally a sensible option as the £300k will be classed as income and will be subject to income tax (in this example) of 45%.
So, Fred decides that he will use the monthly drawdown option to provide an income (his pension) – but how much can he drawdown? Well, based on a monthly drawdown of £500 per month (£6,000 annual equivalent) and assuming he increases the amount at 2% each year to cover inflation, Fred’s underlying pension fund should remain intact for the rest of his life – once again, I stress there are no guarantees as this will depend on the underlying investment performance which may reduce or even deplete the fund completely during his lifetime.
If Fred decided to take 5% drawdown (£1250 per month), also increasing at 2% each year then it’s likely that Fred will run out of funds during his expected lifetime.
There is a great Pension Drawdown calculator on the Which website – you can access it here – give it a try, it’s easy to use and should get you thinking of your potential income in retirement.
My personal view (and nothing in my articles should be construed as advice or recommendations) would be to keep drawdown amounts to between 2 & 3% p.a, especially in the first few years of retirement. If, in the early years your investment returns exceed your drawdown you can always review your future drawdown, perhaps increasing the amount or taking an additional lump sum. So, a pension pot of £300k (after taking the tax-free cash) should provide a sustainable income of £500 per month (allowing for a 2% increase in the monthly income each year) which should (no guarantee of course) last you for the rest of your life. If the initial drawdown rate was 5% then, whilst this would provide an income of £1,250 per month (also increasing at 2% each year), this will however increase the risk that you may run out of cash in later life.
To highlight this point please refer to the simple example below showing the potential effect on the underlying fund value based on different drawdown rates - Hopefully this highlights my point that an initial drawdown rate of 3% or less (with a 2% increase each year in the monthly income) is a sensible starting position which can of course be reviewed in future years.
Remember – your pension pot sustainability is dependent on:
Underlying investment performance (and your attitude to risk)
Your age when you commence drawdown
How long you live after retirement (if you retire at 55 then this could be 40 years or longer)
The fund charges (this can have quite an impact on your fund value)
The amount you are drawing out each month / year (and future increases)
I will be discussing annuities, mix and match options and the natural yield strategy in future articles – in the meantime my suggested steps would be:
Read my article – Get to Grips with your Pension
Review your previous schemes and decide what action to take – here
Beware of Pension Scams
And if this is all confusing you should consider getting Professional Advice. Read my article here
Talking of getting help – The Team at Pensions Awareness Day #PAD19 are touring the UK in September 2019. This is a fantastic opportunity to get your pension questions answered by experts – The PAD19 link is here.
I need a coffee! - Until the next time.