This article was last updated on 26/06/2023
After a lifetime of pension saving, I need to get to grips with spending it. Now I’ve sailed into my fifties, suddenly the point when I can tap into my pension, from 55, doesn’t seem so far away.
It turns out building a pension pot is the easy part, thanks to the Direct Debits that divert money into my pension plan every month. As I’m self-employed, I also chuck in random sums from time to time, if I’m feeling particularly flush, or particularly panicked about retirement.
So pension accumulation - tick.
But pension decumulation, the process of spending it? That’s looking a whole lot trickier.
Moving from saving to spending
Nowadays, only a lucky few have the luxury of defined benefit or ‘final salary’ pensions, where your pension income’s based on your salary and the number of years you’ve worked for your employer, rather than the amount of money you’ve contributed to the pension.
The rest of us with defined contribution pensions have to decide what to withdraw when. Spend too much, and we risk running out of money. Spend too little, and we face a less enjoyable retirement.
Planning how to transform a pension pot into retirement income involves balancing a whole load of different factors. Just to make things more difficult, several of the factors, such as life expectancy, stock market performance and inflation, are beyond my control. I can plan how to cope with them, but I can’t avoid them entirely. Plus, after all these years of stashing cash in my pension pot, it’s a big mindset shift to start spending those precious pounds.
Back in 2014 when the government ripped up the pension rules, the Pensions Minister at the time, Sir Steve Webb, made a crack about giving people the freedom to spend their retirement savings on a Lamborghini. But surprise, surprise, dedicated savers, after decades building their pension funds, didn’t suddenly change their personalities and blow their retirement cash on a luxury car.
If I want to overcome my fear of running out of money and enjoy the results of my saving, I need to come up with a decumulation plan.
Decumulation: where to get started
Here are some of the main factors to consider - and some suggestions about where to seek further information.
1. Money for retirement
I’ve started by working out how much money I have saved towards retirement. For my husband and I, that means totting up a hotchpotch of workplace pensions, private pensions and State Pensions, which kick in at different ages. Check what you’ll get as a State Pension and when on gov.uk.
We’re also lucky enough to have some money outside pensions, in savings and Individual Savings Accounts (ISAs) invested in the stock market, plus the rent from a buy-to-let property. As we own our house, we could potentially either downsize or use equity release to tap into some of the value of our home.
2. Retirement date
The earlier you start retirement, the longer you’ll need to stretch your retirement savings. Right now, I’m happily self-employed, and don’t see myself quitting at 55. However, I’m not sure I want to work full tilt until my State Pension starts at 67. Hopefully, if I build a big enough pension pot, I can afford to retire somewhere in between, potentially after working part-time for a while.
3. Life expectancy
Do you know when you’re going to die? No, me neither.
It’s hard planning decumulation, when you can only guess how long your pension money needs to last. Luckily, the Office for National Statistics (ONS) has a life expectancy calculator. Pop in your age and gender, and it will let you know your average life expectancy, and the chances of reaching older ages. So for example, I’m expected to live until 87, with a one in four chance of reaching 97, a one in 10 chance of hitting 99, and a seven in 100 chance of passing 100. Even though it looks like a limited chance I’ll reach triple figures, I’m still intending to plan on lasting that long.
4. Desired income
The general rule of thumb is to aim for a retirement income that’s two thirds of your current salary, but with my erratic freelance income I find it hard to imagine exactly how much I’ll need in retirement.
Fortunately, the Retirement Living Standards created by the Pensions and Lifetime Savings Association (PLSA), estimate what a minimum, moderate and comfortable retirement might cost. Check out my post about the Retirement Living Standards and how they can help.
If you want to put together a budget based on your own bills, MoneyHelper also has a useful budget planner.
5. Potential income
Whatever income I’d like to live on in my dream retirement, the reality will be driven by how much money I’ve saved, and how long it needs to last, between my retirement and popping my clogs. Luckily I can use the PensionBee pension calculator to plug in my current pension pot and contributions, and then toggle between different retirement ages and income, to see if my savings are likely to run out before the age of 100.
In practice, how you tap into your pension cash can have big implications for the future. It therefore pays to consider your options for accessing pension cash, tax, inheritance and any further pension contributions.
1. Income tax
Klaxon alert: withdrawing money from a pension isn’t the same as whipping cash out of a savings account. Only 25% of a pension can be withdrawn tax free – and the rest gets taxed as income. I really don’t want to whip out a large sum and see the tax man take 45%.
If I spread withdrawals over several years instead, I’m likely to pay less income tax. Funding retirement from different accounts can also help cut tax. In contrast to pensions, withdrawals from ISAs are completely tax-free.This means I could potentially take some income from my pensions, and top it up with money from my ISAs, to stay in a lower tax bracket.
2. Accessing pension cash
I face six different options for taking money out of my defined contributions pensions, once I hit 55 (rising to the age of 57 from 2028):
- Delay taking my pension pot and leave it invested.
- Withdraw the whole lot, of which 25% is tax-free. As explained above, that could land me with a large tax bill. Plus if I just stick the remainder in a savings account, the value will be eaten away by inflation.
- Use the money to buy an annuity, which pays a guaranteed income for as long as I live or for a fixed term, with the option of taking 25% of my pension pot tax-free. Annuity rates have been of poor value for ages, but they have risen recently and can provide peace of mind for some pension savers when they think about living out their retirement.
- Leave the money invested, via pension drawdown, and take a flexible income, also with the option of taking 25% of my pension pot tax-free. On the plus side, this dangles the potential for higher growth, and the chance to leave anything left over to my kids. On the downside, I risk running out of money if I spend too much, too fast.
- Leave the money invested and take it as a number of lump sums, where 25% of each amount is tax-free and the rest is taxable. These have the snappy title of Uncrystallized Funds Pension Lump Sums (UFPLS), and involve the same risks as pension drawdown. If you don’t need to release a chunk of money when starting your retirement, this can be a good way to reduce tax on your income.
- A mix of the above. So I could, for example, withdraw my 25% tax-free lump sum to keep as cash savings, use part of my remaining pension pot to buy an annuity to cover essential bills, then move the rest into a drawdown to use when needed.
3. Future pension contributions
If I decide to go part-time before retiring completely, I need to take care before touching my pension cash. Withdraw too much, and it will restrict the amount I can pay into pensions in future.
Anyone who takes any income from their pension, apart from the 25% tax free chunk, will see the amount they can put in a pension each year slashed from a maximum of £60,000 to just £10,000. This is known as the Money Purchase Annual Allowance, or MPAA.
If you want to keep snapping up free money in tax relief and employer pension payments, plan your decumulation carefully.
Spare a thought for your children. If you’re lucky enough to have any money left in your pension pot when you die, it won’t be counted when calculating inheritance tax, unlike other assets such as property and savings. Even ISAs get hit by inheritance tax, if they aren’t left to spouses or civil partners.
So if inheritance tax is likely to be an issue, it’s worth spending down savings and ISAs before using up pension cash.
Decumulation: potential problems
As part of my decumulation plan, I also need to allow for the gremlins that can throw a spanner in the works. Just to make things fun, these are mostly factors that I can’t control.
As we’ve all discovered recently, prices and bills can soar. So I need to allow for rising income, if I want to continue covering my costs in the years ahead. The PensionBee pension calculator is based on 2.5% inflation each year, and is the rate used by the Financial Conduct Authority (FCA). But if prices rise far more, I’ll be forced to make larger withdrawals to cover the higher costs.
2. Spending patterns
Income needs can change a lot during retirement. With all that free time, I’d love to spend more on hobbies and holidays while I still can. I’m expecting that spending to drop when health problems start, and also fear I might need loads more money in later life, for care costs or nursing home fees.
So I need a plan that allows for more disposable income in the early years, with a back up plan for long-term care later on.
3. Market movements
I’m intending to use drawdown to fund my retirement, where I leave a big chunk of my pension pot invested in the stock market. This dangles the tempting prospect of higher growth over the long term. However, the stock market doesn’t grow in a straight line, but can go up, down and sideways.
I can try to allow for the vagaries of stock market slumps by moving some of my investments into less risky assets and assuming moderate rather than super high growth. The PensionBee pension calculator shows an income line after inflation based on investment growth of 5% a year, but also shows the range of income on either side, based on low growth of 3% a year right up to high growth of 8% a year.
I’m also intending to keep a chunk of money in cash, so I can still pay essential bills when markets drop, and am not forced to sell investments when prices are low.
Where to get help
Personally, the sheer range of factors to consider with decumulation makes my head hurt. Luckily, there are places to get help.
If you’re over 50 and want more guidance on your pension options, you can book a free appointment with Pension Wise. The FCA is so keen on this impartial government service that it wants pension companies to ‘nudge’ their customers more strongly into making appointments, before digging into their pensions. I’ve previously written about how useful I found a Pension Wise appointment.
Your pension company will also normally provide a pensions toolkit, with materials about how to access your pension cash. However, if you want specific suggestions based on your own situation, you’ll need to pay for independent financial advice. You can search sites such as Unbiased.co.uk or VouchedFor.co.uk to find qualified local advisers. It could well be the best money you ever spend, to avoid expensive mistakes with your pension savings.
Faith Archer is a Personal Finance Journalist and Money Blogger at Much More With Less.
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.