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Retirement beckons. How will you create an income for your retirement? Should you be taking a pension commencement lump sum (PCLS) and if you do, should you spend it on that round the world cruise or rather invest it to boost your regular income?

So you're about to retire; no more daily grind in the rush hour, no more stress on daily commute because of the wrong kind of trains on the track, etc., etc., etc. What do you have to look forward to in financial terms? Will you be sailing off into a golden sunset or will you be stuck in a gloomy twilight?

Throughout your working life you will have been paying National Insurance contributions. Your state pension is reliant on your NI contributions record. Similarly your contributions to occupational pension or personal pension schemes will, largely, dictate what kind of income you may expect to get.

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How to take your lumps and like it

The rules governing the size of the pension commencement lump sum have been simplified following the A Day changes to the pensions' regime. At the same time, the name became more complicated. Pension commencement lump sum (PCLS) is the mouthful replacing what we used to call tax free cash. Don't get nervous about the name change. It is still tax free (for now anyway).

The maximum PCLS under defined benefit (final salary) pension schemes is no longer determined by salary and length of service. In fact, there is no direct link between the amount of pension and the amount of PCLS that may be taken. However, simplification only goes so far. Members of defined benefit (DB) final salary pension schemes may take a PCLS of a maximum of 25% of the lifetime allowance. However, the formulae that work out exactly how much you would be entitled to remain complex and, to the layman, confusing!

If you have a defined contribution (money purchase) occupational pension or any kind of personal pension scheme the maximum tax-free lump sum you may take is 25% of the value of your pension fund. Exactly what that means in cash terms is, of course, impossible to calculate until you come to retirement because it will depend on the size of your fund at that time.

Taking a lump sum out of your pension fund and giving up a proportion of pension income is known as "commutation".

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Why you would take a PCLS

There are many reasons why you may wish to consider taking out a pension commencement lump sum (tax free cash as was) from your pension fund. The world cruise, perhaps, or a new car might spring to mind first but they aren't necessarily the right reasons! Many people may find themselves with a mortgage that still has a few years left to run when they reach retirement. Taking a PCLS out of your pension fund to pay off the mortgage immediately would save on interest charges and could actually increase your disposable income in retirement.

Alternatively, you could use the lump sum itself to boost your income in retirement by investing it. Remember that your pension benefits are potentially taxable. Therefore, you may wish to use the tax-free lump sum to buy a purchased life annuity that offers tax advantages over a standard pension annuity. With the former, most of the income is treated as a return of capital and, therefore, is tax free with the remaining interest portion being taxed as savings income at 20% only. However, if the annuitant is a higher rate taxpayer, there will be an additional 20% tax liability, non-taxpayers can reclaim the tax deducted at source and 10% taxpayers can reclaim the tax overpaid.

This key difference in the taxation of pension annuities and purchased life annuities means that it may make sense to take the PCLS and use it to buy a purchased life annuity in order to maximise income at retirement.

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How you pay tax on your pension

Any contributions that you pay into your pension scheme during your working life receive tax relief at your marginal or highest rate of income tax. Unfortunately, the government's largesse does not extend to pensions in payment. When you come to retire and take your pension, your pension income is taxable as "earned income".

Defined benefit occupational pensions are paid with basic rate tax deducted at source. Your personal tax allowance rises at age 65 and again at age 75, allowing you to keep more of your money. However, some pensioners still end up having to tackle self-assessment tax returns and pay higher rate tax on their pensions. Retirement annuities are also paid net of basic rate tax. However, if you are a non-taxpayer (because your income is lower than your tax allowance, for example), you can arrange to have your retirement annuities paid with no tax deducted by filling in form R89 or form R86 if the annuities are held jointly. These forms are available from your local tax office. You may also access form R86 via the HM Revenue & Customs website.

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Getting the best annuity you can buy

If you have a defined contribution (DC) money purchase company pension or any kind of personal pension, then once you have taken whatever PCLS you intend to take from your pension fund, you may purchase an annuity on retirement but are not obliged to do so. Such an annuity will provide you with an income for life, which is paid by an insurance company in return for handing over your pension fund.

Annuities may be taken in different forms: on a single life, joint life, escalating (increasing with earnings) or inflation-linked basis (rising in line with the Retail Price Index or Consumer Price Index.) Plan carefully, because the decision to purchase an annuity is not easily reversible - once you have bought an annuity, it is for life and you may not change your mind and switch to a different provider later. The level of income you receive will depend on a number of factors including: your age, sex, life expectancy, state of health, where you live and prevailing annuity rates.

Annuity rates are generally quoted as percentages. Thus an annuity offering a rate of 7% would mean that to create an annual income of £7,000 you would need to have a pension fund worth £100,000. The income you will receive from your annuity will be based on the return available from gilts (government bonds). The problem for potential annuity purchasers is that when interest rates and inflation are low, gilt yields tend to be low too.

You may be able to put off purchasing an annuity but even if you can't or won't or don't want to, that doesn't mean you cannot get the best deal you possibly can. You are not obliged to purchase your annuity from the institution that has managed your pension funds. You may shop around by using what is called "the open market option". This allows you to take your pension fund to any annuity provider in the market to get a better deal for yourself.

Annuity rates change from week to week and certain individuals can get better rates because of special factors. For example, if you have a life reducing medical condition, you can get better rates by buying an "impaired life annuity" because of your shortened life expectancy. The same applies to smokers, the seriously obese, and even those who have worked in a manual occupation and lived in the North of the UK all their lives.

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Why you may not want an annuity yet

You may defer annuity purchase providing you have other assets to live on or are able to draw income from your fund gradually, for instance, by using income drawdown or phased retirement. These are flexible ways of taking your pension in stages while leaving your pension fund invested on the stock market so that it can grow. Both these arrangements are relatively high risk and should only be undertaken after you have taken independent financial advice. They are generally not recommended for those with pension funds smaller than £250,000.

Under the pensions' regime which came into effect in 2006, you are no longer forced to purchase an annuity at age 75 but you are required to use your pension savings to create a guaranteed income by the time you reach the age of 75. This alternative is called Alternatively Secured Income and is available to those with what the HM Revenue & Customs calls principled objections to the pooling of mortality risk. However, the absence of any lump sum death benefit as part of this arrangement may make this option unattractive to most people.

You will also need expert advice on investing your pension fund as it will need to grow to cover the costs of the plan. The principal risks are that your pension fund might drop in value because of poor investment returns and/or that annuity rates might fall further.

Using an unsecured pension - the post A Day form of income draw down - you may take up to 25% of your fund as a PCLS and leave the balance invested. You may then take an income, if you wish each year, of between zero and 120% of what a level, standard annuity would pay to someone of your age. The crucial difference between an unsecured pension and the previous income draw down rules is that you are no longer obliged to take any income each year.

After age 75, you may continue doing a more restricted form of income draw down, called taking an alternatively secured pension or ASP. This allows you to take an annual income of between zero and 70% of what a standard level annuity would pay a 75 year old, however old you are. This means that your income will not rise in line with your age.

In phased retirement, also known as "staggered vesting", instead of buying one single annuity contract with your pension fund, each year you buy one or more small policies. Some phased retirement plans may include several hundred small annuity contracts. In this way your pension fund is turned into annuity income over a period of time.

You maintain your income in phased retirement by reducing the amount of cash taken directly from your pension fund each year as income from the annuities you have purchased rises over time. Phased retirement offers almost similar flexibility to income drawdown and is also not generally recommended for those with pension funds of less than £250,000.

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How you can guard against inflation

Inflation has been the great enemy of pensioners. Many suffered in the 1970s when inflation soared to 25% because while prices rocketed, their income remained fixed. Nowadays, company pensions are required, at least in part, to be increased each year but few (with the exception of public sector schemes) provide full index-linking because this is extremely expensive.

You may purchase an index-linked annuity although this is expensive and will result in your initial income being around one third less than an ordinary, level annuity. Alternatively, you can arrange for your annuity to increase by a set percentage each year - say, by 3% or 5%. Again, this will reduce your initial income substantially.

Other options are to take a with-profits or unit-linked annuity. In common with annuity deferral, these schemes expose your pension funds to market risk. You are counting on your pension annuity to grow over the years so that you can look forward to a rising income over time. However, if the underlying investments do not perform as expected, you could see a drop in income. There will be a minimum limit below which your annuity income cannot fall. What you will actually get will be dependent on the return from the underlying investments. Investment-linked annuities should only be considered after taking independent financial advice and only by those people who have other assets to live on, in case the annuity income drops.

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18 June 2007 © Moneyextra.com

 

Our senior editor Robin Amlôt recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.