Pensions: When should you raid the pot?

However, it’s a road paved with pitfalls: do it for the wrong reasons or at the wrong time and there may be costly consequences further down the line.

The opportunity to access pension cash before retirement arises from HM Revenue & Customs rules allowing savers to take up to 25 per cent of their pension pot tax-free at the age of 55. The squeeze on household finances has driven a marked increase over the past two years in the number of people exercising their right to access their pension cash early, advisers say, despite the risk of being left with a shortfall in retirement.

So when is taking your tax-free cash a sensible move, and when should you leave it untouched? “Everyone’s situation is different,” said Graeme Mitchell, managing director of Lowland Financial in Galashiels. “The main factors include marital status, health, the other assets and sources of income you have, your appetite for risk, type of pension, capacity for loss and your tax position, for example.”

While it’s a decision based on individual circumstances, however, there are some situations in which the risk may be worth taking and some where it isn’t.

Here we run through a few examples.

Why you shouldn’t access your pension savings early

Pension investors may have a legal right to take tax-free pension cash from the age of 55, but the risks are numerous, said Hazel Brown, pensions director at Carbon Financial Partners.

“Your retirement income will be reduced; you may be hit by exit penalties for releasing your pension early; you could lose guaranteed benefits or annuity rates and you could lose any benefits you might receive in the event of ill health.”

The impact on your eventual retirement income is perhaps the key consideration. If you take up to 25 per cent of your pension pot before retirement, you are left with a smaller fund with which to buy an annuity.

If you opt instead for a capped drawdown arrangement – where you leave your fund invested in retirement and take income from it in tranches – the ongoing costs will generally increase.

“This will cause greater erosion on your remaining fund or require you to take a higher investment risk to try to match the deductions,” said Brown. “If markets turn sour, you could lose far more of the fund.”

The risks of pension unlocking are magnified for members of final salary pension schemes, given the greater value of the benefits at retirement.

Mitchell warned against taking anything out of a final salary scheme unless there’s a specific purpose. One might be to repay an interest-only mortgage, for example, if there’s no other way of clearing the loan.

Working out if it’s worth taking tax-free cash from a final salary pension is also more complex because schemes use several different ways of calculating how the withdrawal of a tax-free sum will reduce an individual’s retirement income.

When it may be an option

There are two scenarios in which it can make sense for members of defined contribution (or money purchase) schemes to take their tax-free cash early, according to Mitchell.

One is on the approach to retirement. Mitchell gives the example of a risk-averse saver two years from retirement and with a pension fund of £100,000. They are entitled to ask the question as to whether their fund will be worth any more in two years’ time, said Mitchell.

“Investing in shares or other asset-backed funds is too risky. Even if they continue to work, I think there is a case for taking benefits now,” said Mitchell.

There are several options. Up to £25,000 can be taken from their £100,000 fund now, buying a level annuity paying £4,000 a year (based on an annuity rate of 5.33 per cent).

Alternatively, they can wait until retirement when the fund may be worth a little more, albeit only marginally as much of it is already in cash.

But even if the fund is left for two years and grows to £102,000, that’s only an extra £500 in tax-free cash on retirement. If, in the meantime, the annuity rate offered rises to 5.5 per cent, the remaining fund of £76,500 buys an annuity income of an extra £207 a year, but they have lost out on £4,000 a year of annuity income by not taking it two years earlier. “They gain absolute certainty of income for life, but the death benefit is significantly less and tax will have an impact,” said Mitchell.

Another scenario where there may be a case for taking the 25 per cent tax-free cash early would involve the pension fund being left in deferred drawdown (where no income is taken from it). “Securing the bird in the hand arguably frees up the investment choice for the remaining fund,” said  Mitchell.

“You can invest with a much longer term perspective as in future any variation in the fund can only affect future income and hopefully you have potential for more growth in the fund, which translates to  income.”

There’s a potential sting in the tail in the form of a tax hit and the loss of some death benefits, however, while there’s also the need to ensure the invested fund is on the right track.

“The remaining fund needs to be monitored regularly to ensure that the growth rate achieved matches the deductions and inflation, or you’ll have a lower fund with which to buy an income at retirement,” said Brown.

On balance

The starting point should always be to defer taking the tax-free cash for as long as possible.

“If there is a case based on personal circumstances for taking the cash early, check all implications and consequences – preferably with the assistance of an adviser – before jumping in eyes wide open,” said Mitchell.

Brown agreed: “You may think that capital from your pension scheme would be great to have now but it may be prudent to also consider the situation when you have no opportunity to accumulate any further income in retirement and what you intend to live off then if you have no other source available,” she said.