How to turn your pension into retirement income: A five-step guide to sorting it out

When it’s time to stop work and enjoy the freedom of retirement, you will want to make the most of the money you have saved.

That means turning your pension funds into an income that can replace your salary in your younger pension years and into old age.

There are a number of different ways you can do this, and what suits you best will depend on the type of pensions you have, what you have saved up so far, and how much time you want to devote to keeping an eye on your funds during retirement.

You will also need to think about what you might like to do in the early years of retirement, along with how long you might live and how things will change as the years pass. Unless you are in poor health, it is wise to plan for the long term. 

Celebration time: Retirement brings freedom but also important financial decisions 

If you have a partner, you should certainly consider whether they will have enough to live on if they survive you.

You typically have the option of taking up to one quarter of your money as tax-free cash, and using the remainder to secure an income for the rest of your life.

But you do not necessarily have to take your tax-free lump sum, or anyway not all at once, and if you are sufficiently wealthy you might want to plan to leave some of your pension pots as an inheritance.

Here’s our guide to ensuring you get retirement off to the best possible start. 

1. What pensions do you have

You will need to work out what pensions you have, how much they are worth and what income they might generate to see you through retirement.

A key question here is who will take responsibility for this income? 

If you have a defined benefit pension from an employer, it is their responsibility to meet their promises of retirement income. If you have a defined contribution scheme, you will have been investing to build a pot and need to turn it into income yourself.

This is also the time to look at your financial assets more broadly – savings and investments and so on – and to get a state pension forecast so you can add these to your calculations.

Defined contribution pensions: These take contributions from both employer and employee and invest them to provide a pot of money at retirement.

Unless you work in the public sector, defined contribution schemes have now mostly replaced more generous gold-plated defined benefit – often final salary – pensions, which provide a guaranteed income after retirement until you die.

Defined contribution pensions are stingier and savers bear the investment risk, rather than employers.

You need to ask schemes the current fund values, and if there are any valuable guarantees attached to the pension – for instance, a guaranteed annuity rate.

Many people nearing retirement age may have a mix of defined contribution and defined benefit pensions. 

Taking a tax-free sum from your pension pot is a popular perk at retirement. However, you can still get 25 per cent of your pension pot tax-free if you opt to withdraw it gradually in chunks.

By not taking the whole lump sum out at once, if your pot grows in future you will have more tax-free cash available to take in the longer run.

Defined benefit salary-related pensions: Final salary or career average defined benefit pensions provide a guaranteed income after retirement for the rest of your life. They typically also come with benefits for a spouse or civil partner should they survive you.

Unless you work in the public sector, defined benefit schemes are mostly closed to new contributions. However, you might have some old ones which are now dormant but remain very valuable assets.

Having a guaranteed income from a final salary pension and a state pension could potentially cover essential bills while you take some investment risk with the rest of your savings.

The amount you are paid after retirement is usually based on:

– How long you have been a part of the scheme, known as pensionable service;

– What you earned prior to retirement, or over the course of your employment, known as pensionable salary;

– The scheme’s accrual rate. This is the proportion of your salary received for each year of service.

Your options for a 25 per cent lump sum vary according to the generosity of the terms and conditions of your scheme.

Our columnist Steve Webb has explained how defined benefit pension lump sums work and how to work out if they are good value.

State pension: You need to have made at least 10 years of National Insurance contributions or have equivalent annual credits for caring work, unemployment, disability or other reasons to qualify for a state pension from age 66.

At present the full state pension is worth £221.20 a week or £11,500 a year. People who have contracted out of S2P and Serps over the years and retire after April 2016 might get less than the full state pension.

You can check your state pension forecast here. If you have gaps in your record due to unpaid and or underpaid National Insurance in previous years, you can buy voluntary state pension top-ups for extra qualifying years.

Everyone gets the option of deferring their state pension to get more in their later years.

Missing pensions: If you have lost track of old pots, the Government’s free pension tracing service is here.

Take care if you do an online search for the Pension Tracing Service as many companies using similar names will pop up in the results.

These will also offer to look for your pension, but try to charge or flog you other services, and could be fraudulent.

> This is Money guide to tracking down old pensions

2. Work out what you are likely to spend

You can work out your income, spending and bills using a budgeting tool. Many are available online, and you can find This is Money’s budget calculator here.

The influential Retirement Living Standards report lays bare what annual incomes people need for a minimum, moderate or comfortable retirement.

The Pensions and Lifetime Savings Association measure is based on different baskets of goods and services like food and drink, transport, holidays, clothes and social outings – but it excludes tax, housing and care costs.

See below for what income an individual and a couple might require Bear in mind you are likely to spend more during more active early years of retirement. However, in later years you might require costly nursing and residential care.

3. How will you generate an income

If you have defined contribution pensions, you will need to generate your own retirement income. 

This means looking at buying an annuity (a product that provides a guaranteed income) or staying invested via an income drawdown plan, or some version of the two in combination.

Salary related defined benefit pensions pay out an income according to the terms of the individual scheme and any flexible options it has available. It is possible to transfer them to a drawdown plan to invest your savings instead, though not necessarily advisable due to what you are giving up.

Income drawdown: Pension freedom reforms in 2015 gave over-55s greater power over how they spend, save or invest their retirement pots.

They gave access to invest-and-drawdown schemes previously restricted to wealthier savers, and most people now opt to put their funds in such schemes to generate an income and hopefully a bit of growth.

Those who are novices to the world of stocks, bonds and funds might find the whole business something of a challenge, and struggle to manage their investments successfully enough to enjoy a comfortable old age.

Frequent bouts of market turmoil since 2015, most recently due to inflation and the subsequent run of interest rate hikes, could put off some retirees altogether.

Financial market volatility can leave people who entered drawdown facing losses, and also in a quandary because taking an income from shrinking investments early on can do disproportionate and irrecoverable damage to a portfolio.

This is Money has a starters’ guide to investing your pension and living off it here. This includes a checklist of what you need to think about and plan ahead for at the outset of your retirement if you want to keep your fund invested.

You have the option of transferring a final salary pension into a drawdown plan, although financial experts say this is rarely a good idea and the Government has placed safeguards against people giving up valuable pension benefits without realising.

However, some people are willing to give up a comfortable final salary pension and invest the money in an income drawdown scheme instead because at present anything left over can be inherited by other loved ones aside from your spouse.

Beneficiaries either pay no tax if the owner dies before age 75, or income tax at their marginal rate if the person who dies and leaves the pension was over 75.

If your final salary pension is worth more than £30,000, it is compulsory to take paid-for financial advice before giving it up.

Annuities: Despite offering the advantage of a guaranteed income until you die, annuities have been shunned for years due to poor rates and restrictive conditions.

But the recent run of interest rate hikes mean providers can afford to fund much more attractive deals, including if you want options like joint life – giving a survivor’s pension to a spouse – and inflation protection.

Sales of annuities have been at their highest since 2015, the year when pension freedom reforms opened up the alternative option of keeping retirement savings invested to all retirees.

You should bear the following in mind if you are considering buying an annuity.

– You might be able to get an ‘enhanced’ rate if you wait to buy until you are older and your health has worsened.

– You can think again about your invest-and-drawdown strategy, and buy an annuity in tandem or as a replacement source of income later, but you can’t get out of an annuity once it is purchased.

– If you are healthy, the best rates are on single life, no inflation-link ‘level’ annuities, but the current cost of living pressures highlight how important it is to get some protection against rising prices.

– If you buy a single, not a joint, life annuity there will be nothing for your spouse if you die first, so consider what they will have to live on and discuss it with them before making a decision. Many widows and widowers discover their partner’s annuity choice has left them with no income after their bereavement, forcing them to live on meagre state benefits.

– Consider buying an annuity with a ‘guarantee period’, which protects against the loss of all or most of your purchase money if you die shortly afterwards.

– You should shop around for the best deals. The free Government-backed Money Helper service has an independent annuity comparison tool here.

Combining drawdown and annuities: The dilemma for people considering an annuity is that rates could easily head even higher, and buying now could lock you into a lower income than you could get in just a few months’ time.

But you are under no obligation to annuitise your pension in one go, and you can phase your purchases, and use annuities in combination with an invested drawdown pot.

We have previously explored how people can combine drawdown and annuities in various ways to maximise retirement income.

> Do you want investment growth AND a guaranteed pension? Find out how here

4. Make sure you don’t overpay tax

No one wants to save up all their working life for a decent retirement only to get stuck with an avoidable tax bill.

Unfortunately, there are many tax traps for the unwary when it comes to pensions.

It’s especially important to find out about them if you don’t get financial advice when you start tapping your fund. 

Here are a couple of the most common.

– When you start tapping a defined contribution pension pot for any amount over and above your 25 per cent tax free lump sum, you are only able to put away £10,000 a year and still automatically qualify for valuable tax relief from then onward.

This new and permanent limit is known in industry jargon as the ‘money purchase annual allowance’.

– When you reach retirement, it is very important to plan your income carefully in the first year to avoid HMRC levying ’emergency tax’.

HMRC slaps extra tax on any initial sum taken from a fund on the assumption it could be ‘month one’ of a series over the rest of a tax year.

More than a billion pounds has been repaid to people overtaxed on their withdrawals since pension freedoms were launched in 2015.

> How to defend your pension from the taxman: Read our full guide here

5. Where to get help

Pay for personal advice: This is Money recommends talking to a financial adviser to help you maximise your income when deciding on your options.

They can help you with financial forecasting and cash flow modelling for retirement, minimising your tax bills and inheritance planning, among many other tasks you might struggle to do alone.

Recommendations from friends and family can be a good way to find a financial adviser, but make sure you question them carefully on their experiences.

If you do go down the route of financial advice, it is important to make sure that the adviser is right for you before signing up to any fees. Most offer free initial meetings and should explain to you what they offer, how they work, how they can help you and what they will charge.

If you aren’t happy with any of the above or they don’t explain things in a clear and simple way that you can understand, then they may not be the right adviser for you.

It can be tricky finding an adviser, so we have partnered with Flying Colours to help people find an adviser. It specialises in financial lifestyle planning and helping people to find high quality trustworthy advice from local IFAs.

Get free guidance on your options: Over-50s with defined contribution pensions can have a one-hour phone or face-to-face appointment with the Government’s free Pension Wise service.

If you’re under 50 or only have final salary pensions you can still get help from the Government’s MoneyHelper service. Call free on 0800 011 3797