This year’s pension reforms will give most people much more freedom to decide how they use their savings to pay for retirement. But this increased choice also has the potential to lead to problems: some people will inevitably make poor decisions about what they do with their money, for example by making excessively risky investments.
There is also the opportunity for unscrupulous companies to market dubious “get rich quick” schemes to retirees who suddenly find themselves with a large sum of cash.
So if you are approaching retirement, what are the biggest financial dangers you face?
Risk 1: Your money will run out
Under the pre-April 2015 system, most people would get a guaranteed income from their pension when they retired, either as a condition of a company final-salary scheme, or by using their own pension savings to buy an annuity. Annuities turn cash into a monthly income for the rest of the customer’s life.
The new freedoms mean that most people will no longer have to buy an annuity: instead, the money can be kept invested in the stock market under a drawdown scheme, which will allow a regular income to be taken. Or it can be cashed in, with the proceeds used for other types of investment or spending.
But if none of your pension is used to buy a guaranteed income, there is a chance it will run out and you’ll have nothing left to live on apart from the state pension (assuming you are entitled to it).
If you invest your pension cash and take regular income from it, you have to make sure you don’t take too much income as well as hoping your investments grow sufficiently, so that the money does not run out during your lifetime.
This involves making predictions about investment growth rates and your own life expectancy.
To reduce the risk you could use part of your fund to buy a small annuity which, when added to the state pension, would give you enough to live on – albeit not in any great luxury.
Risk 2. Inflation will erode your income
Even after April’s changes come into effect, many people will still choose an annuity to provide their retirement income. But although annuities guarantee payments for the rest of customers’ lives, they are not infallible.
If your annuity pays the same amount year after year, the spending power of this income could fall significantly as the result of inflation.
For example, if your annuity pays out £10,000 a year, after 15 years of inflation at two per cent (the current Bank of England target) this sum would be worth just under £7,400 in today’s prices.
If you were to live for 20 or 30 years past retirement, the effects could be much more dramatic – as they could if the country suffers periods of higher inflation.
To reduce the risk and protect against inflation, you can opt for a rising or inflation-linked annuity which pays out a higher level of income every year. But the bad news is that the income you get from this type will be lower than a standard annuity in the early years.
Risk 3. Fraudsters will target your cash
There have been repeated warnings from consumer groups and investment experts that the new pension freedoms will encourage unscrupulous firms as well as out-and-out fraudsters to target new retirees.
It will be much easier to take money out of a pension and invest in, say, buy-to-let property or even fine wine and classic cars.
Extreme caution needs to be exercised if you are presented with an investment opportunity that claims to offer particularly high returns – especially if these are said to be “guaranteed”. If you invest through a company which is regulated by the Financial Conduct Authority, you will be able to claim compensation if your investment was misrepresented or if any important information was withheld.
To reduce the risk, see the FCA’s register of regulated firms.
Risk 4. You’ll pay too much tax
If you take money out of your pension, a quarter of any withdrawal will be tax-free. The rest will be subject to income tax at your marginal rate. This could be zero, 20, 40 or 45 per cent depending on what other income you have in the financial year in question.
Consider, for example, someone with a pension pot of £100,000 who decides to take the whole amount in cash as soon as they retire in March 2016.
This person has already earned £50,000 from their job in the 2015-16 tax year, so their marginal tax rate is 40 per cent. As a result, the first £25,000 of their pension is tax-free, but the remaining £75,000 is taxed at 40 per cent to produce a bill of £30,000.
Had they waited until after 6 April 2016 and a new tax year, part of the £75,000 would be taxed at zero per cent, part at 20 per cent and part at 40 per cent because the individual had no other income in 2016-17. This would have cut the total tax bill on the withdrawal to less than £20,000.
To reduce the risk, be very careful how much money you take out and when you take it out.
Risk 5. Your money won’t grow fast enough
While there is a danger of investments failing to grow sufficiently, or of collapsing entirely, a low-risk approach can also be dangerous.
If you simply take money out of a pension and stick it in the bank, your returns are likely to be low, for the foreseeable future at least. Interest rates on savings accounts and cash Isas are as miserly as they have ever been, and most do not grow fast enough to beat inflation and tax.
If you also need to make regular withdrawals to provide you with an income to live on, your money may not last long enough in a savings account.
To reduce the risk, an annuity could be a better bet if you want a low-risk approach where your money is guaranteed not to run out.