Top five considerations before employees cash in their pension

Over half (53%) of retirees who accessed their defined contribution (DC) pensions chose to withdraw their entire pension pots, according to the Financial Conduct Authority’s (FCA) interim findings of its ‘Retirement Outcomes Review’.

Of these fully withdrawn pensions, 52% had been transferred into other savings or investments, thereby losing the valuable tax benefits available in the pension scheme which can’t be replicated for example in deposit accounts.

According to the FCA, accessing pension pots early has become ‘the new norm’ with almost three quarters (72%) of pensions being accessed by individuals under age 65, and with most choosing to take lump sums rather than a regular income.

It may be tempting for employees to take advantage of the pension freedoms and cash in their pension, but have they really thought through what’s involved?

WEALTH at work, a leading provider of financial education, guidance and advice in the workplace, has outlined the top 5 considerations for employees before cashing in their pension.

1 Do employees understand the tax implications?
Tax planning should be at the heart of any pension transaction. Only the first 25% of the amount that is drawdown from a pension pot is tax-free and the remaining 75% is taxed as earned income.  If individuals cash in a pension during a tax year when they are still working, 75% of the sum withdrawn will be added to their earnings for that tax year and may push them into a higher tax bracket.  Employees may, therefore, want to consider withdrawing smaller amounts from their pot.  

An option could be for employees to take ‘partial’ or ‘phased’ income drawdown. This would enable them to drawdown small amounts of their pension pot while keeping the majority of their savings invested, allowing them to benefit from any future investment growth that it enjoys. Of course, growth isn’t guaranteed and the value of a pension could fall instead.

Another important point for employees to note is that if they withdraw any cash simply to add to their savings, the money withdrawn will form part of their estate for inheritance tax purposes.  If left in the pension scheme this would not be the case.

Ultimately, it’s crucial for employees not to forget that a pension remains one of the most tax efficient saving vehicles available.

2 Do employees understand how long they will need to make their retirement saving last?
Before taking the cash, it is crucial for employees to think about if they will have enough money to last the duration of their retirement. For example, a 65-year old man now has a 50% chance of living to 87 and a woman of the same age has the same chance of living until she’s 90, so making retirement savings last is key. It’s advisable that employees regularly review their choices throughout retirement as their needs evolve.

For example, income requirements are widely believed to follow a ‘u shape’ in retirement with the first ‘active’ phase being the most expensive. Spending seems to fall after a while in what is known as the ‘passive’ phase, as people become a little less active and perhaps cut back on areas such as travelling. But costs then may go up later in retirement in the ‘supported’ phase, if extra care and support is required.

3 Do employees understand the risks around pension transfers?
Since the pension changes we have seen a rise in employees wanting to transfer their defined benefit (DB) pension scheme into a DC pension to access the cash.

However, pension transfers are complex – there are many things employees should consider before they make any decisions, including if the transfer value being offered represents good value.  Transferring from a DB pension scheme can mean that employees will be giving up valuable guaranteed benefits and they might find themselves worse off.

To protect consumers it is now a legal requirement for individuals to take regulated financial advice for transfers on DB schemes valued at £30,000 or more.  This advice is a highly specialised area and only certain advisers hold the relevant qualifications and permissions to help.  Employees should be aware that the Financial Conduct Authority’s (FCA) current view is that a transfer will not be suitable unless it can be proved to be in their best interests.

4 Are employees switched onto pension scams?
Employees getting scammed out of their retirement savings is a real issue. The problem is many of these scams look perfectly legitimate so are not easy to spot. Others offer investment returns which are too good to be true but people easily get sucked in. They often have very professional looking websites and literature.

Whatever employees are planning to do with their retirement savings, they should check before doing anything that the company is registered with the FCA. They can also visit the FCA’s ScamSmart website which includes a warning list of companies operating without authorisation or running scams.

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5 Do employees realise that financial advice can be better value than no advice?
Many employees don’t realise that when they buy retirement products such as annuities, through for example online brokers, there are charges deducted which can cost just as much, if not more, than getting advice.  A financial adviser will look at an individual’s personal circumstance, objectives and attitude to risk and then, after considering all of the retirement income options available, will make a specific recommendation to address their needs; they will then have the benefit of consumer protection for the advice given. After all, according to research by Unbiased, UK savers who take advice save on average £98 more every month and receive an additional income of £3,654 every year of their retirement, based upon a pension pot of £100,000.

Jonathan Watts-Lay, Director, WEALTH at work comments: “Whilst the pension changes offer a great deal of flexibility they also carry many pitfalls and risks. It is good to see that employers are starting to recognise this and putting in place financial education, guidance and advice from specialist workplace providers. This approach helps both the employer and the employee by ensuring the retirement process and the options available are well understood, therefore leading to better outcomes. ”