If you are nearing retirement, you’ll need to start thinking about your future income when you stop working. This article covers three steps you should take and five key questions you should ask before taking flexible pension payments, according to Hargreaves Lansdown.
Things to do beforehand
It’s a good idea to start planning your retirement at least two years before your retirement date. Before deciding on your pension drawdown method, there are three steps you should consider taking.
1. Put together an emergency fund
According to Nathan Long, senior analyst at Hargreaves Lansdown, it’s a good idea to have an emergency fund large enough to pay for one to three years worth of expenses in an easily accessible account.
This may seem like a large amount, but remember that you will be on a fixed income. It will be important to have some extra financial insurance just in case.
2. Make sure you understand your options
It is important that you understand how pension drawdown works. In addition, make sure you understand the alternative options available to you, such as buying an annuity.
If you are unsure about your options, it might be worth seeking financial advice. For more information on how to find a financial adviser, check out our step-by-step guide.
3. Know what you want from your retirement
Think about what you want from your retirement and how much it will cost. This might include living in a different area or taking up new hobbies.
It is important to think through your plans carefully because they will have an effect on your expenses. For further information, check out our article on tips for planning your retirement income.
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Five questions to ask before taking flexible pension payments
Before taking flexible pension payments, there are five questions you should consider.
1. How much do you need to live on?
The amount you will need to live on will be influenced by two basic types of expenses:
- Essential expenses – including housing, groceries, utilities, medication and local transport.
- Non-essential expenses – including holidays, socialising and hobbies.
It is likely that your expenses will change with retirement. For example, you won’t have any housing expenses if you’ve paid off your mortgage. Similarly, your transportation costs could fall if you are no longer doing the daily commute.
2. How can you make your pension last throughout retirement?
According to Hargreaves Lansdown, one common way to do this is to stick to spending the natural yield of your investments. If you only spend the natural yield, your pension pot will remain untouched and will continue to generate an income throughout your retirement.
A typical yield is around 3% to 4% of your pension pot every year. So if you have a pension pot worth £500,000, the maximum yield will be £20,000.
Be aware that if you decide to take larger flexible pension payments, there is a risk that you could run out of money. This is an even higher risk if the yield falls, which could happen during an economic downturn.
It is better to use an emergency fund as income during a market downturn instead of your pension.
3. Where should you invest the money?
If you have the right asset mix, your pension should be able to withstand any market volatility. Reviewing your portfolio every year will ensure you do not withdraw more than the natural yield.
Keep an eye on annuity rates as you get older. They tend to improve with age and you could decide to buy one later on.
You could adopt a blended approach, using an annuity for your essential expenses and flexible pension payments for non-essential expenses.
4. How should you take account of dividend fluctuations?
It is better to focus on the natural yield rather than changes in dividends. In any case, history shows that dividend payouts recover fairly quickly if they do fall. An emergency fund can be used to supplement any possible shortfall.
5. How should you take account of market movements?
If you have diversified your portfolio, this will protect you from extreme market volatility. If the market does fall, it is important to wait it out rather than panic sell. You can use your emergency fund in the meantime.
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Take home
With careful retirement planning, you will be prepared for any market uncertainty. You will be free to spend your retirement doing things you enjoy rather than worrying about your income.
