Key Decisions For A Better Retirement

By Neil Faulkner (TMFVertigo)
May 25, 2006

Irish woman: Whenever they decided to move to Ireland it was because they thought Ireland would be warm. I swear to God! And then they got here and it was freezing so they went to...Where did you go?

Rodrigo: Denmark.

Irish woman [very amused]: Denmark.

As Mexican guitar duo Rodrigo y Gabriela will testify, we sometimes make uninformed decisions that don't work out. When it comes to pensions, these decisions can be rather more costly, and somewhat less humorous than Mexicans looking for scorching sunshine in Dublin. The government's White Paper on pensions is due out today, which will shift the pensions landscape for many people. But while the fine print of this is being digested, here are four decisions you can make now regarding your pension.

1. The state second pension - Contract in or out?

The government pays everyone a basic state pension when they retire. There's also a second state pension (S2P, formerly SERPS), which is based on the amount of National Insurance contributions you pay. You can contract out of the scheme so that, sometime after each tax year, you get part of your NI contributions back as a rebate that goes straight into a personal pension. You have to decide whether to contract out, stay in or contract back in again.

Which? the consumer group, is a strong opponent of contracting out. It reckons that contracting out may be the next mis-selling scandal. £35bn of taxpayers' money has gone to fund managers. Not only have the returns been poorer than expected, but £3bn of this has gone to the pensions industry and financial advisors in charges. Which? estimates that 4.5m people who contracted out look likely to get less than they would if they'd remained in.

You must decide whether to stay contracted out or not. Do you rely on the government, and future governments, to keep their promises? Just like they always do! Or do you believe that trusting a random and probably expensive fund manager to invest your money is a safer bet? Indeed, today's White Paper on pensions could see the value of S2P cut dramatically for higher earners, muddying the waters still further on this complex issue.

There are some things we can be more sure about. If you're a woman over 54 or a man over 60, you almost certainly will lose if you contract out. The same goes if you expect to rely on the government when you retire. If you have contracted out, review this decision each year, as your circumstances can change.

Gabriela: We got that disease. What's that disease? Sad? Syndrome of sadness or something. [laughs] When you get really depressed because it's dark. Our landlord was laughing 'Ah ha ha! Mexicans and they don't have a heater!'

2. Combining your pensions

If you've got lots of pensions, it may be advantageous to combine them. Firstly, you cut down on the paperwork. Secondly, it's easier to manage and to judge overall performance, and therefore to take appropriate action if it's unsatisfactory. Thirdly, you can cut the funds that charge too much, which eats heavily into your pension.

There are reasons to leave them where they are as well. You might like the diversity it provides and the fact it spreads the risk amongst different fund managers. You also won't be hit by hidden charges when you leave. At present, it's possible to combine your pensions when you retire and to purchase an annuity (a monthly pension income), so there's no rush if you're happy with the current paperwork, charges, and performance of your funds.

Gabriela: The first time we arrived it was summer and I saw the fireplace and thought 'that's funny'. And then in winter time we didn't know what to do and we said 'Where, help?' because at that time our English was ten times worse.

Rodrigo: It was worser.

3. Claiming your pension earlier... or later!

It's tough to get your personal pension early. The law states that your pension scheme must receive evidence from a doctor that you're permanently unable to work. Also, it's up to your pension scheme whether they allow it.

Defined benefit schemes are less likely to pay out early than defined contribution schemes and you'll probably receive a greatly reduced pension.

It might pay off if you defer your state pension. If you don't claim it for a year, you might get about an extra £100 for each £1,000 of state pension. However, you will have given up a year's worth of state pension, so it would take a few years to show a profit. If you deferred for five years, it would probably take about ten years to show a profit, so you're gambling that you'll live that long.

If after the five years you feel less confident of your future, you could take the money the government should have paid you as a lump sum. They'll add interest too, which is fixed at 2% above the Bank of England's rate.

Gabriela: And I went to this shop and said hhhhhhhow [with extended Spanish ch sound at the start], hhhhhhhow can I turn the fireplaaaace? [in exaggerated plaintive fashion!]

4. Taking a lump sum

When you retire, you're able to claim up to 25% of your pension pot as a tax-free lump sum. Or, if your pensions all add up to less than £15,000, you're allowed to take the whole lot tax-free. You could use this to pay off your mortgage, go on holiday, or whatever you want.

One attractive option for a lump sum is to buy a 'life annuity'. This is just like a pension annuity in that it will pay you a monthly income. You can read more here.

If you don't intend to buy an annuity or reinvest your lump sum, it could have dire consequences. When you take out a lump sum, your monthly pension income is often disproportionately small, particularly if you're in a final salary scheme.

Even if it isn't disproportionate, your monthly pension will be a lot smaller than if you hadn't taken the cash. Remember that you'll probably rely on your pension income and government handouts for the rest of your life, so you want it to be as high as possible.

Gabriela: And we're still freezing. I'm actually freezing here!

> Don't freeze, do something! Make informed decisions by visiting our Pensions centre for more information.