Pensions are an important factor for financial independence but can sometimes be confusing. For younger people like myself there's much guesswork we try to do in terms of what the right choices are when it comes to how much we should put in, and where we should keep it for the long term. For those approaching the retirement age, choices need to be made on how you want to take that pension.
Should you buy an annuity to guarantee some level of income for the rest of your life?
Or is it better to take it all in one taxable lump sum, and try to manage the money yourself going forward?
There are cost benefit implications for both approaches so it's understandable for someone to feel a bit overwhelmed when needing to make a choice.
This was the dilemma faced by someone close to me. They ultimately took the lump sum but I figured it was an interesting case to work through, to try and see if that choice would pay off ultimately.
The numbers and options available
So that we're all on the same page I need to set the scene a little.
What's on the table is a defined contribution pension that has reached maturity on a 60th birthday, and was valued at around £26,142.13. Not a huge amount for a pension I know, but that's what we're working with. At least the tax bill will be low!
Leading up to that 60th birthday the pension provider sent a letter with some information on the various options that could be taken with regards to the money. The options were:
Taking all of the pension savings in one go as a taxable lump sum.
Buying a guaranteed income for life (annuity).
Taking the pension savings as a number of lump sums.
Choosing more than one option and mixing them.
Transferring the pension savings to another pension provider.
Keeping the pensions savings where they are.
As the intent was to start taking money from the pension, we can pretty much focus on the first 3 options only. Furthermore, since the pension pot wasn't a huge amount the third option was decidedly not attractive.
That leaves the first two, take a lump sum all in one go or buy an annuity for life which would pay an amount each month.
With the annuity there were a couple of different options available, notably:
These were just the examples given in the letter by the pension provider and I'm sure more could have been obtained if the options needed to be explored further. But these are enough for us to work through in this article.
One of the key questions when it comes to spending your pension is "how long should I try to make it last?". This is a tough one as you never know what tomorrow brings, but one will hope that there are at least a number of decades still to come once retirement age has been reached.
Therefore I will look at how the numbers play out for timeframes of 15 years, 20 years, 25 years and 30 years in the upcoming scenarios.
Annuity option 1: £2,150.16 with no yearly increase
With this option there is no lump sum amount and everything saved up in the pension is traded in for some amount of income each year.
Using our stated timeframes the total amounts received would be as follows:
On the surface of things this looks like a great result as the initial pension amount was only £26,142.13. So even after just 15 years the amount received from annuities would've exceeded the amount traded in.
However, when you think about the effects of inflation the numbers may not look as attractive anymore.
The annuity received in the 2nd year would only be worth the equivalent of £2,108.00 in the first year, and the annuity received in the 15th year would only be worth the equivalent of £1,597.60.
It would still be "£2,150.16" each year that is received, but the real value of that money would deteriorate over time.
This is known as calculating the "present value" of money where you figure out what that future money would be worth in today's value, after accounting for inflation which is assumed to be 2% each year on average.
What this ultimately means is that the headline figures we see in the above table are not as valuable as they appear, due to the purchasing power of that future money being less than it would be in today's terms.
When the present value of money is taken into account the total amounts received would look more like the following:
This table shows the real value of the money received in today's money.
While there's still a "profit" after 15 years, notice how the real value of that total is actually much lower than in the previous table.
Furthermore, I added a second row to the table to show how much the annuity of £2,150.16 would actually be worth in the future. In short, the guaranteed income you've purchased for life is getting you less and less each year.
Annuity option 2: £1,612.56 with no yearly increase
The second option allows us to take a tax free lump sum of £6,535.54 and use the remainder of the pension, now worth £19,606.59, to purchase an annuity for life which would give us £1,612.56 each year.
Here's what we're going to do.
We're going to put the tax free lump sum into a stocks and shares ISA and invest it into an index fund that returns 7% on average, not accounting for inflation. This can be considered a conservative assumption as the standard 7% annual return typically takes into account inflation.
Then we're going to withdraw 4% each year from those investments as "spending money", and add it on top of the £1,612.56 being received from the annuity.
This will give us the following total amounts received over the years:
So right off the bat we might consider this option as being worse than the first, as simply looking at the total amounts received we can see that they are lower across the board. It isn't much, but lower is still lower.
Now let's look at the adjusted figures:
Again, lower across the board when compared to option 1's adjusted figures.
At this point we might summarise as follows: After 30 years of withdrawing money and receiving an annuity using option 2 we would have received £44,645.89. This is good considering the pension was originally only valued at £26,142.13 but it's still shy of the £48,155.96 that we would've got using option 1.
Now take a look at the table below:
If you recall, we invested £6,535.54 after taking it as a lump sum. We've been spending 4% of the returns each year, but the principle is still there and growing. This table shows the value of that principle in both non-adjusted and adjusted terms.
By adding the value of the investment account to the total amount of income received you will now find that your "total spending power" will surpass option 1. Using the 30th year column as an example you can add £44,645.89 to £8,070.99, giving you a total amount of £52,716.88.
This is more than the £48,115.96 you would've gotten from option 1 by the 30th year.
Suddenly option 2 may not appear as bad as it did originally...
Annuity option 3: £981.48 with a 3% yearly increase
The third and final annuity option also allows us to take a tax free lump sum of £6,535.54 and use the remainder of the pension to purchase an annuity, which will start at £981.48.
The difference with this option however is that the annuity will increase by 3% each year, meaning each year there will be more and more money being received.
From the description we might consider this option to potentially be a smarter long term play, especially if we're assuming the average inflation rate to be at 2% each year. Essentially it means that the annuity being received will maintain its real value over time, unlike in option 1 where we saw it decreasing in real value as the years passed by.
With the tax free lump sum we're going to do the same thing as we did in option 2, invest it into an index fund within a stocks and shares ISA, and use the same assumptions. This also means the value of the investment account will be taken into account for final valuations.
Here's how the figures play out with the non-adjusted calculations for the annuity:
Not taking into account the investment account value at the moment, it looks as though the amount of income received falls shy of both option 1 and option 2. The 3% increase each year sounded good, but perhaps too much annuity needed to be sacrificed in exchange for it.
Here's the adjusted figures after calculating the present value of each payment:
At a total of £41,902.64 after 30 years this option is 6.15% worse than option 2, and a whopping 13% worse than option 1 when only considering the amount of spending money received each year.
That honestly sounds like quite a hit to take.
Let's bring the investment account back into the picture, which would be the same as in option 2 since the invested amount was the same. Here's a reminder:
Again, using the 30th year column as an example you will calculate that the total spending power is £49,973.63.
This is also more than the £48,115.96 you would've gotten from option 1 by the 30th year.
But we should be careful here. The total spending power is only realised if everything in the investment account is liquidated and spent. In order to have gotten to this point you would've had to have had much lower spending money for 30 years.
Being frugal when you're very young might make sense, but in this situation you'd have already reached retirement and will be knocking on your 90th birthday.
You don't really have the luxury to wait any longer for compounding returns...
Real Life Option: Take it all and invest it into an index fund
Originally for this article I was also going to dive into a number of different investment options to see how those played out; things like high dividend funds, 50/50 splits between equities and bonds, and so forth.
But I think that would make things a bit too confusing.
So I'm only going to go through the example that was taken in real life - take the whole £26,142.13 from the pension and invest it into an index fund within a stocks and shares ISA.
For clarity this was done in two lump sums across two financial years to stay within the £20,000 ISA limit, and there was a little bit of tax to be paid which dropped the total amount received down to around £24,722.13.
We're going to make the same assumptions with the index fund as in option 2 and option 3; an average of 7% growth each year and 4% being withdrawn as spending money.
Here's how that looks in non-adjusted figures:
I kept the total annuity line in there for clarity purposes, but since no annuity was purchased the amount received will be nothing right the way through. Every penny received comes from the 4% withdrawal from investments.
It's not looking that great in terms of spending money when compared to the first 3 options, especially since we haven't taken into account the value of the investment account yet.
Here's the numbers when adjusted
Comparatively speaking this option comes in last place if having spending money is your primary concern, which would make sense since you're now spending your pension.
Let's bring those investment account numbers back in. Remember, since we invested the full amount of £24,722.13 at the start the account will be worth considerably more than in option 2 and option 3.
The headline will tell you that this option is the best in terms of total value, because if you add the £30,530.30 from the 30th year onto the £32,267.60 from 4% withdrawal, you would have a total of £62,797.90.
This is far more than what you would've had with the other 3 options.
But while this may be the case, the shrewdest of readers will have quickly realised that much of that value is actually locked away in order to keep getting the 4% withdrawal.
And they may ask "what's the point in having all that money, if it cannot even be spent in retirement?"
Spending money or generational wealth?
Now that we've laid out all the options and worked through them there are two tables I want you to see.
The first table is the total amounts for each option when you take into account the annuity income, 4% withdrawal income, and the investment account values:
The second table is the average amount of annual spending money you would've had from each option. Basically it's the annuity income and the 4% withdrawal income:
I wanted to show these two tables because it lays everything out for us to see from two perspectives; one, in terms of actual spending money, and two, in terms of wealth that could potentially be carried forward.
With annuity option 1 there is the most spending money on average. Even with the annuity amounts decreasing in real value over time it still stays ahead of all the other options in the timeframe that we're looking at. The trade-off is that you leave nothing behind from your pension, which isn't necessarily a bad thing.
Annuity option 2 gives you a little more in total, thanks to your investments growing over time. But it does lock away some of your wealth meaning you get less to spend on average. This option may appear attractive to someone who's thinking ahead a little further as it means there's a small sum left behind to handle your affairs after you've gone.
Annuity option 3 only sounds good on paper in my opinion. You get a lot less to spend on average compared to the first two options, and the amount you leave behind is the same as in option 2. Basically there isn't enough time for the 3% growth to compound and catch up with what you need to sacrifice in terms of income in order to make it worth it. All around, option 2 is superior to this one.
Finally, the "take it all and invest it" option is basically the opposite side of the spectrum from the first option. You get the least amount to spend on average but you will leave behind a potentially sizeable sum of money. If you're someone looking to help your kids or grandkids after you've left, this might be the option you find most attractive.
So the person close to me mentioned at the start of this article is my mother, and in light of the article's calculations it looks as though the ones who will benefit the most from her decision are her children or grandchildren.
I'm fortunate enough to be in a position where I can support my mother financially, and have done so since my very first pay check at the age of 18. Financially speaking, not that much will change for us. I could even increase the amount I send her each month to give her more financial flexibility if she wanted it.
But not everyone has this ability or fortune.
By working through the examples I wanted to take a deeper look at the various pension withdrawal options available, and see if I could peel back the complexity a little.
Honestly, when the stack of documents first came through from the pension provider it was quite intimidating and confusing. But now I feel more confident in the option that we went with.
Were the amounts being considered even larger, let's say a pension pot that was ten times the size, I'm sure that the thinking process would've had to have been different in some aspects. Imagine the tax considerations!
But the message I wanted to deliver from this article is that there are a number of things to consider; and depending on what you want, certain options that appear attractive to others may not necessarily be the one for you.
Hopefully this article helps you come to your own decision!