FOOL'S EYE VIEW
The Dangers Of Unlocking Your Pension

By James Carlisle
July 17, 2003

If you have your Fool boots properly fitted, then you'll know that the time to become very suspicious of something is when people seem to be trying extra hard to persuade you to do it. It almost certainly means there's more in it for them than there is for you. So it is various advisers springing up proposing schemes to 'release cash from your pension'. Typically advisers might aim to take between 1% and 3% of your pension fund in return for organising you to get some money out of it 'early'. If that sounds like a recipe for disaster, then that's probably because it is.

Early Retirement

The most important thing to recognise about this is that there is no magic to it. There can't be. The law surrounding pensions is so tight that the poor things virtually suffocate anyway, never mind allowing you to 'unlock their value' or 'release their cash' willy nilly. 'Pension release schemes', if you want to call them that, are nothing more than early retirement.

'Retirement', in terms of a pension, is really the act of taking benefits -- of converting your pension pot into a lump sum and an annuity. It doesn't necessarily mean that you have to stop working although company schemes may not actually become payable until you leave the company (more about this in a moment). The law says you can take benefits from a personal pension from the age of 50 (or younger if your career has a normal retirement age below that or if you become incapacitated), so you can 'unlock your pension' any time after that, if you choose to.

How it works

When you take benefits from a personal pension, you get to take up to 25% of your fund as a tax free-lump sum. The remaining 75% has to be used to buy an annuity.

However, under a thing called income drawdown, you can delay buying the annuity until you're 75. In the meantime, the remaining 75% of your pension fund stays invested and hopefully keeps growing, but you must take an income out of it each year -- amounting to between 35% and 100% of what you would have got if you had bought an annuity (according to rates set by the Government Actuaries Department -- called GAD rates).

The situation for company pensions may be more complicated, in that they might need to be transferred to a personal pension to start with. In doing so, the transfer value is designed to reflect the benefits that the company pension could have been expected to provide. But there may be charges to take away from the money that gets moved across and the personal pension would be more risky than a final salary company pension, if you didn't take all the benefits right away. One other point is that, if your pension is written as lots of smaller ones (which they often are, even though it may not appear so), then it might be possible to take some of your pension now and leave the rest until later -- something called phased retirement.

Anyway, the best way to see how all this might work is by taking a simple example. We'll use a single female aged 55, with a personal pension fund worth £100,000. I shall call her Janet.

Taking benefits early

If Janet wanted to take benefits now, then she'd stand to get an immediate, tax-free, cash lump sum of £25,000.

With the other £75,000, she could buy an index-linked annuity of around £2,600 per year at current rates, which are about 3.5% for a typical 55-year old single female.

Alternatively, she could use 'income drawdown' and take a minimum of 35% of the annuity income according to the GAD rates. These don't take account of index linking, so the implied annuity rate ends up being a bit higher -- 6.2% in this case. So, under income drawdown, she'd have to take a minimum of 35% of 6.2% -- that is about 2.2% -- of her remaining pension fund each year, or about £1,600 to start with.

Meanwhile, the £75,000 remaining in the pension fund will continue to grow. Assuming stock market growth, after costs, of 7% per year and taking 2% off for the income you take out each year, you might expect the fund to grow at approximately 5% per year. That might increase Janet's £75,000 fund to about £120,000 by the time she reaches 65. If annuity rates stay the same, she might then use that £120,000 to buy an index-linked annuity of around £6,000 per year (the rate for a typical 65-year old single female is 5% - it's higher than for a 55-year old because her life expectancy is lower).

To summarise, taking benefits at 55 would give Janet £25,000 up front, plus either (a) a cast-iron £2,700 per year, rising with inflation, for life or (b) £1,600 growing with the stock market for 10 years, followed by £6,000 per year, rising with inflation, for life -- assuming stock market growth to be 7% per year after costs. Option (b) clearly looks the better, despite some stock market risk, and it's all because most of the pension fund has had an extra 10 years to grow in the stock market.

Taking benefits later

So, if keeping your pension fund invested in the stock market for longer is a good idea, it follows that the best bet of all is to delay taking your benefits until you really need to. If Janet waited until she was 65 to take her benefits, for example, then the £100,000 pension fund that she had at 55 might have doubled to just under £200,000, using the same 7% growth rate that we used above.

That would be enough for a lump sum of £50,000, plus an index-linked annuity income of £7,500 per year (using the same 5% annuity rate for a single 65-year old woman). If she were able, Janet could still take the income drawdown option at age 65, delaying the purchase of an annuity until 75. Depending on the stock market producing the goods, she'd then hopefully be able to buy an even better income at that point.

The bottom line

The bottom line is that pensions are going to struggle to finance our increasingly long retirements in any event, and you really don't improve matters by taking your benefits early. The stock market involves risks, but the evidence is that over the long term, it's the best place for your pension fund to be invested. The longer you can keep it there, the better off you're likely to be.

If you still decide that you might want to 'release some cash' from your pension ahead of events, even though you know it's probably a bad idea, then, if it's a company scheme, start by talking to the human resource people at work about it. If it's a personal pension, start by writing and asking for an illustration of what your benefits might be now and if you waited.

If it all makes about as much sense as ancient Greek, and you're absolutely sure you want to investigate the options further, then it will make sense to get advice. But you'll want to make sure that the adviser doesn't have an incentive to persuade you one way or the other. Generally that will mean paying by an agreed fee whatever you decide rather than a commission based on a particular outcome.

More: The Fool's Pension Centre

A version of this article was originally published in December 2002.