You may choose to just take money from your defined contribution pension, whenever you need to, from the age of 55. You can do this in a few ways, with different tax implications for each.
Income drawdown allows you to take 25% of your pension tax-free as either one lump sum or in instalments. We took an in-depth look at income drawdown in a previous issue of Thinking Ahead. Reading this is a good way to understand how this option works.
It’s possible to get a better income from income drawdown than from an annuity, but this would normally entail investing a substantial amount of your pension fund in riskier investments such as equities and/or commercial property funds.
If you invest your income drawdown pension fund predominantly in bonds and your main goal is to provide a regular income, you may be better off buying an annuity instead.
The problem with opting for riskier investments is that they can go down in value, sometimes quite significantly, as well as up. If most of your fund is held in riskier investments and the value falls shortly before your planned retirement date, this could throw your plans into disarray.
Under such circumstances, pressing ahead with retirement and drawing income from a fund that is still falling in value will do lasting damage to your savings… to such an extent that your savings might run out before you do!
For this reason, preparing your investments in advance makes a lot of sense.
Holding cash alongside investments
A common method of overcoming the volatility that comes with investing in equities and commercial property is to hold cash alongside these investments. This can either be a cash bank account within your pension, if you have a self-invested personal pension, or a cash fund if you have a normal personal pension or money purchase pension.
Some investors aim to hold two to three years’ worth of planned retirement income in cash in advance of retirement. If you decide to do this and plan to take, say, £5,000 a year in income from your pension, aim to hold cash of at least £10,000 and ideally £15,000.
This means that you don’t have to put off your retirement plans, even if the market has fallen, because you can draw your regular income from the cash you have set aside within your pension, allowing your riskier investments time to recover. Then if your riskier investments rise in value, you could take income from those and replenish your rainy day cash at the same time.
You could aim to build up this rainy-day cash around five years before retirement, by gradually switching other investments into either the cash bank account within your pension or a cash fund. For example, if you wanted to set aside £15,000, switching £3,000 a year in each of the five years before retirement would allow you to reach your target.
Moving investments to minimise risk
By moving investments gradually over a longer period, such as five years, you minimise the risk of mistiming market movements. Instead, you are effectively cashing in your other investments at a broadly average value over that five-year period.
In addition to moving some investments into cash to act as rainy day money post-retirement, remember that you can also take a quarter of your savings as a tax-free cash lump sum at retirement.
So, as well as gradually switching some savings for rainy-day money post-retirement, you should also look at gradually switching any amount you plan to take as a tax-free lump sum.
You might also be interested in these retirement income options….
Retirement on the horizon? Find out what your options are.
Use our tool to find out what your pension might be worth when you retire.
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