Retire at 65 and lose £15,000

We look at the pros and cons of cashing in your pension pot early.

Today I'm going to try to tackle just part of a very complex subject, which is when to take benefits from your retirement pot. To avoid War and Peace word-count situations, I must focus exclusively on annuities and defined-contribution (aka money purchase) pensions. This is certainly not to recommend those products over others, but that debate is kicked off in other articles and isn't the topic here.

For those who don't know, an annuity is a guaranteed income until you die and it's a popular choice for people who cash in their pension pots. Once you buy an annuity there's no reversing the decision and you can't get your pot back, so it's a decision you want to get right.

The potential benefit of cashing in early

I'll start with some examples of how much you might get if you retired today at different ages. To keep it simple I'll assume your spouse is the same age as you, you're non-smokers with no health problems, you want a level annuity (i.e. your monthly payment doesn't rise each year) and you want your spouse to keep getting the same annuity if you die first. You have a £100,000 pension pot, so you take £25,000 as a tax-free cash lump sum, and annuitise £75,000. This is what the annuity will pay you:

Age and annual annuity	Total after tax benefits if you live till 80
55 years old and £3,680pa	£69,000
65 years old and £4,225pa	£54,000
74 years old and £5,250pa	£27,000

This assumes you pay 40% income tax till 65 and then, for simplicity, a 15% tax rate thereafter.

In the above example, a 55-year-old buying an annuity today will get back £69,000 by the time he's 80, which is £15,000 more than a 65-year-old and a staggering £42,000 more than a 74-year-old. This is despite receiving a significantly smaller annual annuity. A 65-year-old would eventually catch up with the 55-year-old, but only if he or his wife can live long enough. Based on my tax assumptions that's well over 100 years old.

This tip is absolutely vital to know if you want to make the most of your pension pot at retirement.

If you die earlier, the difference will be even greater and, depending on how early you die, you may not receive the benefit of your patient retirement planning at all. Here's a spanner though: after you've annuitised your dependants generally get nothing or relatively little from your pot when you die, even if you had a big pot and have received just a few thousand in annuity payments. (Although, if you've have provided spouse's benefits as part of your annuity, your husband or wife will benefit from continuing annuity income after your death). This is a potential negative point for annuitising early. In contrast, your beneficiaries will normally see a good portion of your retirement pot if you die before annuitising.

But everything changes

It gets more complicated.

All of the above assumes that nothing changes over time, but it does. At present, a £100,000 pot might get you an annuity of around £6,000 or £7,000 (or an annuity rate of 6% - 7%) per year if you only provide an income for yourslef, and not your spouse after your death. If you choose to buy later, what you get may rise or fall depending on how annuity rates change.

What's more, you may choose when you're 55 to keep some or all of your pension pot invested, which means it could move with the stock market. If after 10 years annuity rates were to go up 50% and the stock market 20%, a 65-year-old who annuitises will have done a little bit better than the 55-year-old by the time he's 80 and will outpace him swiftly thereafter – assuming he lives that long. If annuity rates halve or the stock market stumbles, you might never catch up with the 55-year-old, no matter how long you live.

Annuity rates are affected by increasing life expectancy, interest rates, quantitative easing, changing solvency legislation, your health, and other factors. The debate about whether rates will fall or rise in the future is tight and vicious, but forecasts always are. Forecasts are always varied and the only thing we can say with total accuracy is that they're 100% uncertain.

You have flexibility

Just because you decide to take an annuity, it doesn't mean you have to do so with all your pensions at once. You can continue with (or start) other retirement savings plans and investing in the stock market. (That's why I didn't factor further retirement savings into my figures earlier in the article, as you can do that regardless of whether you annuitise early.) You can also continue to work. It's not a matter of “That's it! I'm now annuitised and superannuated.”

If you decide not to cash in any of your pension pots early, you don't have to keep all or any of it in the stock market if that's frightening you. There are safer investments you can transfer your money to, although the stock market has a good history of outperforming over ten years or more – usually!

How to decide what to do

It's not easy to decide, but there are two ways of looking at it. Most people who comment at the bottom of pension articles try to find what course of action will give them the biggest profit and beat the pension companies. That's fine, as long as they realise that by trying that they may end up taking more risks too.

Another way is to forget trying to win and think about what you need and being satisfied that you can live within your means. How big a pot do you reckon you need? How much must you save to get there? Once you're there, since you're not thinking about squeezing out maximum profit, it'll be time to stop taking risks and be happy with what you've got.

More changes

The government intends to make pensions more flexible so you might want to wait for the details before making any decisions. We also have many options that I've not covered in this piece that might be more suitable for you, such as income drawdown and other retirement saving schemes, so do your research.

More: 10 reasons wealthy people have all the money | Does NS&I have a hidden agenda?

Get a better return for your money by switching savings accounts.