Pension options at retirement

At retirement when we take our pension from a defined contribution scheme we have a number of options available to us.

• The open market option

• Tax free cash lump sum

• The frequency of payment

• Escalation in payments

• Spouses provisions

• Guarantee periods

Each of these options can be taken in conjunction with any other. However, some of the benefits will defray the initial amount of pension benefit that you would receive should you take a single life pension with no other provisions.

The Open Market Option

The Open Market Option (or OMO) was introduced as part of the 1975 United Kingdom Finance Act and allows someone approaching retirement to ‘shop around’ for a number of options to convert their pension pot into an annuity, rather than simply taking the default rate offered by their pension provider.

 The term OMO is now generally used to support a campaign, often led by the pensions industry and the media, to make sure people know the benefits of shopping around. The majority of people still don’t use the Open Market Option in large part because they don’t know they can or don’t realise the benefits of doing so. Retirees who don’t use the OMO and settle for the default deal offered by their pension provider, may be missing out on up to 20% more income from an annuity. This is especially important as retirees cannot change their annuity once it has been purchased.

 One of the main reasons that people can get more from an annuity if they shop around is that they may qualify for what is known as an Enhanced Annuity (sometimes known as an Impaired Life Annuity) which pays a higher income to people who suffer from a range of health conditions – anything from asthma to a serious heart condition. There are also other products available that may suit peoples retirement needs better than the default deal offered by a pension provider. One suggestion to make the most of the Open Market Option is to speak to an independent financial adviser who will explain the different options available at retirement.

Tax Free Cash Lump Sum

At retirement you are permitted to take 25% (a quarter) of your pension fund in as a Tax-Free Cash Lump Sum. In certain circumstances it could be more than this. The Tax-Free cash can be paid by the ceding scheme or the new scheme should you take advantage of your Open Market Option. The remainder will be considered as earned income by HMRC. The amount of tax you pay will depend on your prevailing tax status at the time that you take the pension.

Frequency of Payments

Most pension providers will allow you to take your pension at different Frequencies of Payments, such as annually, quarterly and monthly, sometimes in advance or arrears. Once you have made your decision that is generally how you will continue to receive your income for the rest of your pension annuity.

Escalation in Payment

You can elect to have your pension paid to you at a flat rate for the rest of your life or have it increase in different ways, through Escalation in Payment, typically by 5%, 7.5% etc. Should you choose this option then the initial pension you receive will be significantly reduced but at least you can ensure that your pension retains some degree of inflation proofing. 

Spouse’s Provisions

Typically people will purchase a single life annuity but you can elect to provide a pension for your spouse, through a Spouse's Provision should you wish to do so. This at least ensures that should you die in the short term your spouse will continue to benefit from your pension. Spouses pensions can generally be provided at different rates as a percentage of your own, for example 33%, 50% or even 100%. As with all other pension options its best to check what the pension provider is able to offer.

Again this particular option does reduce the amount of initial pension annuity because you are effectively buying two pensions from the same amount of money.

Guarantee Periods

At outset, as with all these options you can elect to take a guarantee period against the pension. 

A Guarantee Period can be of different duration, again typically 3, 5 or 10 years. This means that the pension will be paid out to your spouse (or in the event of your spouse predeceasing  you, your estate) for the remainder of the term should you die within the guarantee period. For example if you were to take a 10 year guarantee period and then die in year 6 your spouse (or estate) would continue to receive the pension for the remaining 4 year term, after which time, (unless you had provided for a spouses pension) the pension would cease and no other payments would be made.

These options are not offered at the outset of your pension plan as you have no indication at that time what your marital status may be at the time of vesting, the prevailing rates of inflation and your need for tax free cash. Nevertheless the decisions that you make in relation to these options are of great importance both to you and your family should you have one. Moreover once you have made your decisions they cannot be unwound, there are no “U turns”. It is therefore essential that you give consideration to taking professional financial advice at this pivotal and critical time in your financial planning.

Enhanced annuity

An enhanced annuity (also known as an impaired life annuity) can increase the income from your pension by as much as 27%. It pays you a higher income than a conventional annuity because of your health or lifestyle conditions.

What is an enhanced annuity?

If you were to take out life assurance you would usually be penalised for being in poor health and would have to pay a higher premium that what is known as the “standard risk”. But with annuities, a health condition can be beneficial to the rate at which the pension is paid.

Enhanced annuities work on the assumption that your life expectancy is reduced if you have certain medical or lifestyle conditions. Annuity providers see you as someone that they'll have to pay for less time than someone in a better state of health. Therefore they compensate you by paying you a higher income, essentially using up your pension pot more quickly. This higher income is paid for life, even if your health improves or you change your lifestyle!

Do you qualify for an enhanced annuity?

You don't have to be seriously ill to qualify; there are currently over 1,500 medical and lifestyle conditions which could increase your annuity income. Your life expectancy will be assessed based on health and lifestyle conditions to ascertain the seriousness of your impairment. Remember to be completely honest about the degree of your illness! The uplift you’ll get depends on the seriousness of the condition, but even If you smoke, are overweight, drink alcohol regularly or take any prescribed medication you could qualify for enhanced rates and more income.

If you or your partner answer “yes” to any of the following questions, you may qualify for an enhanced annuity.

• Do you smoke?

• Have you been diagnosed with high blood pressure, requiring ongoing medication?

• Have you suffered a heart attack requiring hospital admission?

• Have you been diagnosed with cancer (excluding skin cancer and benign tumours) requiring surgery, chemotherapy or radiotherapy?

• Have you been diagnosed with Parkinson's disease?

• Have you been diagnosed with Multiple Sclerosis?

• Have you taken early retirement on the grounds of ill health?

• Have you been diagnosed with diabetes, requiring insulin or tablet treatment?

• Have you suffered from a stroke (CVA), excluding mini-strokes (TIAs)?

Tips to get the best enhanced annuity

1. Be honest. Declare everything about your health and lifestyle – don’t hold back or you could lose out.

2. Declare everything about your partner’s health and lifestyle. You could still get an enhanced joint income even if you’re in fantastic health but your partner is in poor health or a smoker.

3. Shop the whole market. There isn't a single 'best' provider for everyone which is why we get quotes from every enhanced annuity provider in the market. These quotes can vary on a day by day basis.

Lifetime allowances

Breach may impact on more than a million workers

An estimated 1.25 million people are set to breach the current lifetime allowance (LTA) limit of £1.055 million for pension tax relief over the course of their working life, according to new research published.

The LTA is a limit on the amount of pension benefit that can be drawn from pension schemes – whether lump sums or retirement income – and can be paid without triggering an extra tax charge. It has been cut three times since 2010, and this research estimates that around 290,000 workers already have pension rights above the limit, and well over a million more people are at risk of breaching it by the time they retire.

Facing a tax charge of up to 55% on pension savings

Those who exceed the LTA could face a tax charge of up to 55% of their pension savings above this level at the time of testing. Around 290,000 non-retired people have already built up pension rights in excess of the LTA. Fewer than half of these are thought to have applied for ‘protection’ against past reductions in the LTA and so could face significant tax bills when they draw their pension. Worryingly, many may be unaware of this. Almost half of these people who are already over the LTA are continuing to add to their pension wealth, thereby storing up an even bigger tax charge with every passing year. Amongst non-retired people who are not currently over the LTA, an estimated 1.25 million can expect to breach the LTA by the time they retire.

Groups likely to breach the lifetime allowance

The two main groups likely to breach the LTA are relatively senior public sector workers with long service, whose Defined Benefit pension rights will exceed the LTA, especially as they now have to work to 65 or beyond rather than 60 as in the past, and relatively well-paid workers in a Defined Contribution pension arrangement where their employer makes a generous contribution into their pension pot.

Highest earners may be less affected by the lifetime cap

Typical salary levels of those affected are in the range of £60,000–£90,000 per year. But ironically, the very highest earners may be less affected by the Lifetime Cap because they are now heavily limited by the amount they can put into a pension each year. The data suggests that only a couple of thousand people exceeded the LTA in the latest year for which figures are available (2016/17). The number likely to face a tax charge could therefore increase more than a hundredfold, purely based on those who have yet to retire but who have already exceeded the LTA.

Workers who would not regard themselves as ‘rich’

The research finds that one of the reasons why so many people will exceed the LTA is that current policy is simply to increase it each year in line with price inflation (as measured by the CPI). By contrast, wages will tend to grow faster than inflation, and the money invested in pension pots should grow faster than inflation over the long term. This means that the LTA will ‘bite’ progressively more severely over time and will affect hundreds of thousands of workers who would not regard themselves as ‘rich.’ 

Source data:

Research conducted for Royal London is based on detailed analysis of data on more than 7,700 workers from Wave 1 and Wave 5 of the ‘Wealth and Assets Survey’ March 2019.

Should I transfer my defined benefit pension?

If you have a defined benefit (DB) pension, you may be offered the option to transfer it into the more common type of pension (defined contribution). But be careful as this is a “one-way street with no u-turns”. This is a big decision and an irreversible one, so it’s important to understand exactly what this means, and what the pros and cons for you might be.

What is a defined benefit pension scheme?

A DB pension (also known as a final salary pension or superannuation scheme) is an excellent type of workplace pension. Instead of building up a pension pot over time, it provides you with a guaranteed annual income for life, based on your final or average salary (hence the name).

DB pensions are often seen as more generous, because it would take an above-average defined contribution (DC) pot to be able to buy an annuity that pays you the same amount as a DB scheme.

So why would I transfer from a DB scheme?

Despite the attractions of a DB pension, in some ways it is not as flexible as a DC pension pot. You can’t vary the income you take from it, nor draw out larger lump sums (apart from the tax-free lump sum offered by some final salary schemes). Also, and more importantly to many, this kind of pension cannot be inherited by your beneficiaries.

Your pension’s ‘transfer value’ is the size of the pension pot you would receive in exchange for giving up your DB pension. Some providers will offer generous transfer values, and this may be seen as a strong incentive to switch (in so doing it reduces the employer’s financial commitment to the scheme). The choice you face is essentially this: having more money to spend now, versus having a guaranteed income for the rest of your life – which may work out as more money or less, depending on how long you live. Generally speaking none of us know the answer to how long we are going to live, which is why there is a risk involved in switching from a guaranteed income for life pension

Are all DB pensions transferable?

Not every DB pension is transferable. Private sector schemes, and some public sector ones, will be ‘funded’ – that is, supported by a central fund. This is the only kind from which you can transfer. Other public-sector schemes (such as the NHS pension) are ‘unfunded’, meaning they are supported directly by the taxpayer. You can’t transfer out of this kind of pension.

What are the possible benefits of transferring?

Transferring your DB pension to a DC pension pot means you can access your pension flexibly, and also pass on any unspent pension to your loved ones when you die. For smaller DB pensions with transfer value of just a few thousand, there may be a stronger argument for transferring them – as in such cases the guaranteed annual income may not be very much.

What are the risks?

If you transfer your pension you won’t be able to transfer it back, so tread carefully and do your sums before making your decision. You will expose yourself to the risk of your pension one day running out, or of failing to achieve as high an income as you would have received from the original scheme. Ultimately, you are trading certainty for uncertainty.

How to decide

Having money to spend now may be very appealing, especially if there is a pressing demand for it. However, if your pension’s transfer value is over £30,000, the law requires you to seek financial advice before the transfer can be made. Some providers further insist that you get advice on smaller transfer values as well, to protect themselves if you later decide you’ve made the wrong decision.

Get to know your pension

Saving for later life - pensions

Your retirement income is made up of the State Pension, your workplace or private pensions, plus any additional savings you may have. 

Get to know your pension and you can feel more secure about your future. 

State Pension 

The State Pension is a regular payment from the government that you can claim when you reach your State Pension age. Getting to know your State Pension can help you plan ahead for your retirement. 

The amount you receive is based on your National Insurance record. In 2019/2020 the full rate of new State Pension is £168.60 a week – that works out at over £8,750 a year – but not everyone will get the same amount. 

Visit www.gov.uk/check-state-pension to find out what you could receive, and the earliest you can claim it, under the current rules. This service also shows you your National Insurance record. You may be able to improve your forecast by filling gaps in your record. 

Your State Pension is a good foundation, but you should consider how much you need to save for the lifestyle you want when you retire, and think carefully about saving for your future. Find out more at www.yourpension.gov.uk 

State Pension age is regularly reviewed and can change, so it is important to check it. 

National Insurance Contributions and Credits 

Most people pay National Insurance contributions when they are in work. 

You can also get National Insurance credits if you are claiming certain benefits. You may be eligible if, for example, you receive disability benefits, are a carer or are bringing up children. 

Many of these are given to you automatically but others need to be applied for. 

For more details on how to apply, visit www.gov.uk/national- insurance-credits.

 Checking your State Pension can help you identify gaps in your record. If there are gaps, you may want to make voluntary National Insurance Contributions to fill them. 

Pension Credit 

Regardless of gender, if you’ve reached women’s State Pension age and your weekly income is less than £163.00 (for single people) or £248.80 (for couples)* you may be able to get extra income from Pension Credit. Visit www.gov.uk/pension-credit to check if you’re eligible and what you might receive. 

* These amounts may be higher for those who are severely disabled, have caring responsibilities or certain housing costs. 

Workplace Pension 

A workplace pension is an easy way to save for later life and the earlier you start, the more you’re likely to have when you retire. 

Whether the employer you work for is large or small, even if it is just you and your boss, you could benefit from a workplace pension. 

Get to know the benefits:

 1. Saving into a workplace pension is easy: if you are eligible you

don’t have to do anything as you will be automatically enrolled into a pension by your employer. 

2. When you pay in, your boss pays in too. 

If you don’t save into a workplace pension when you get the chance, or you choose to leave it, then you’re giving up this extra money from your employer. 

For more information visit www.workplacepensions.gov.uk 

Pension Wise 

Pension Wise is a free and impartial government service. It can help you understand the different ways you can take your pension pot. 

Your are eligible for a free guidance appointment if you are over 50 and have a defined contribution pension (not a final salary or career average pension). 

A defined contribution (DC) pension is a personal or workplace pension based on how much you, and possibly your employer, have paid into your pension pot. With this kind of pension you decide how to take your money out. 

You can have your appointment with a Pension Wise guidance specialist over the phone or face-to-face in hundreds of locations across the UK. All guidance is impartial – our specialists won’t recommend any products or companies and won’t tell you how to invest your money. 

Book your free appointment by calling 0800 138 3944 or go to www.pensionwise.gov.uk and get to know your options. 

How well do you know your pension? 

Is it worth saving into a pension? 

Most people can expect to get back more in retirement than they put into their pension. Most people saving into a workplace pension also benefit from contributions from their employer and the government in the form of tax relief (which means some of your money that you would have paid as income tax goes into your workplace pension instead). 

Will the State Pension be enough? 

The State Pension is the foundation of retirement savings and for many people, relying on this alone could mean a fall in income upon retirement. Saving into a workplace pension means people will have more money to continue doing the things that they enjoy when they retire. 

Retirement seems like a long way off - is it too early to start saving?

Although retirement might seem like a long way off, it’s never too early to start saving. Saving through a workplace pension is easy and, if you are eligible, you don’t actually have to do anything because your employer will enrol you. The earlier you start to save, the more money you are likely to have when you come to retire as your money has time to grow. 

Further information 

www.pensionwise.gov.uk 

You can get further information on pensions and savings from: 

www.moneyadviceservice.org.uk 

Information correct as of April 2019 

www.yourpension.gov.uk 

www.workplacepensions.gov.uk 

www.pensionsadvisoryservice.org.uk