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The sixty and seventy-somethings portrayed in the film The Best Exotic Marigold Hotel believed they had found the ideal solution to the problem of funding a retirement - escape to lower-cost India. After all, what could go wrong? Quite a lot as it turns out.
For most of us the idea of moving halfway around the world is not part of our retirement plan. If you do not want to find yourself in the same dire financial straits as Judi Dench’s character Evelyn, you cannot leave things to chance.
The first step to getting a successful retirement plan on track is to understand how our pension system works and how to make the most of it.
How much money will I need in retirement?
As early as your 40s you should ask yourself how much income you will need in retirement and work out whether you are on course to meet that goal. You should then make a reassessment regularly.
Assessing your income needs involves guesswork, but there are pointers that can give you a plausible answer.
The most sensible approach is to establish the minimum amount you need to live a comfortable life. Start with your current income and expenditure and think about how your lifestyle might change. Once you have established your essential expenses you can work out how much any luxuries, like extra holidays, might cost. As a rule of thumb retirement experts say that you should aim for about two-thirds of your pre-retirement income.1 The Money Advice Service has a pension calculator to help athttps://www.moneyadviceservice.org.uk/en/tools/pension-calculator.
You should include the State Pension in your calculations. You can get a State Pension forecast from the Department for Work and Pensions at www.gov.uk/state-pension-statement.
Remember that you cannot take money out of a private pension until you reach 55 (or 57 from 2028).
What will my pension buy me at retirement?
That depends on several factors including what type of pension you hold. Final-salary pensions, also known as defined benefit schemes, pay out an income in retirement linked to length of service and earnings before you stop working. If you have a final salary plan and are unsure about the income and benefits it will pay in retirement, ask your pension department for help.
For savers with money purchase or defined contribution plans life is much more uncertain. In these schemes each individual has a pension pot and payouts depend on the amount you and your employer contribute, charges and the performance of financial markets.
Until recently the majority of those with money purchase pensions would exercise their right to take 25% of their pension as a tax-free lump sum. They would then use the rest of their pension pot to buy an annuity- a type of insurance that promises a regular sum for the rest of your life.
That changed on 6 April 2015 when the restrictions that forced people to purchase annuities were swept away. Under the new system you have the right to save, invest or spend a money purchase pension pot in retirement as you please. This flexibility makes it more difficult to say for sure what your pension will buy at retirement. However, there are a few benchmarks that can help your calculations depending on how you use your pension pot.
There are four main options:
1. Buy a guaranteed income for life using an annuity
You can choose to take up to 25% of your pot as a one-off tax free lump sum before converting the rest into an annuity, which will give you a regular income for the rest of your life. How much you get from your annuity will depend on factors including your age, your health, and whether you opt for a guaranteed amount or for an investment-linked or inflation-linked annuity.
A 60-year old with a £100,000 pot would receive around £5,770 of income a year from a basic single life, level annuity, according to the Money Advice Service’s annuity calculator (https://www.moneyadviceservice.org.uk).2
2. Use your pot to provide a flexible retirement income - flexi-access drawdown
With this option you can take up to 25% of your pension as a tax-free lump sum. The remainder of your pension savings stay invested and you can take an income monthly, quarterly, annually - whenever suits you. You set the income you want though you may have to adjust it from time to time depending on the performance of your investments. Your income is not guaranteed so you must manage your investments carefully.
One benchmark to consider when setting your income is the dividend yield on the FTSE 100. This reflects the income paid out on a regular basis to shareholders by companies listed on the UK’s stock market index and is currently around 4%. If you based your income on this measure you would be able to withdraw £4,000 of income a year from a £100,000 pension pot.
3. Take small cash sums from your pot
You can take cash as and when you need it directly from your pension fund. Any funds left in your pension after the cash has been paid out will remain invested for you to take further money in the future. Each time you make a withdrawal, 25% will be tax free and the rest taxed as income.
4. Take your whole pot as cash
While this might seem an attractive option remember that you need to ensure that you will have enough to live on for the rest of your life. Also anything above the 25% that you are entitled to tax-free is taxed. Withdrawing large sums from your pension could trigger a huge tax bill.
Mix it up
You do not have to choose just one of these options. You can divide your pension into segments and treat each segment differently. You can also leave your pension fund untouched, allowing it to remain invested and hopefully continue to grow: though remember that while it is invested your pension fund could fall in value as well as go up.
Where to get help
If you are 50 or over you can use Pension Wise, a free government-backed service that provides guidance online, on the phone and face-to-face (https://www.pensionwise.gov.uk).
If you need to speak to a financial adviser the Money Advice Service’s Retirement adviser directory can point you in the direction of an FCA registered adviser who specialises in retirement planning (https://directory.moneyadviceservice.org.uk/en).
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Money Means is a news and information series written by independent financial and consumer journalists and experts. FSCS launched Money Means in 2016 to help give people clear and useful information about personal finance, to increase their understanding and confidence when dealing with money.