As the cost-of-living crisis continues and inflation soars, some people will be more inclined to take out extra funds from their pension. Even those who are still working may begin taking an income from their pot sooner than they had planned. While this may temporarily cover immediate costs, it comes with the risk of having much less money in the future.
The disadvantages of withdrawing too early
A landmark point which caused households to seriously assess how inflation would impact them was the April 1st increase in the energy price cap.
2015 reforms made it so that savers could easily access their retirement money once they reached the age of 55. This means that people are no longer limited to a lump sum of 25%. Instead, they can take as much from their fund as they want. HMRC reports show that a combined £2.69 billion was withdrawn from the personal pension savings of 428,000 people in the final 3 months of 2021.
If you have £100,000 in your pot by the age of 55 and you decide to stop paying into it, your funds can still increase by almost £65,000 by the time you are 65. (This is based on 5% annual growth.) However, if you were to take £25,000 out of the pot at 55, it may only increase by £48,000.
Of course, the purpose of pensions is to ensure that your finances are sufficient to fund your years in retirement. But if you withdraw sums too early, your future may be threatened because there will no longer be opportunity for potential growth.
Tax relief and the Money Purchase Annual Allowance
While 25% of the cash lump sum over-55s take out will be tax-free, any funds accessed afterwards will be taxed normally as income for the year. Additionally, if you would like to continue paying into a defined contribution pot, withdrawing money too early may have an impact on the amount you may use to top it up.
Current rules allow for tax relief on contributions up to £40,000 that you pay into a pension.
It is important to note that if you continuously take out lump sums from your pension, this can activate the Money Purchase Annual Allowance (MPAA). The MPAA results in a reduction in the amount that can be paid into your pension pot with tax relief to £4,000. Other scenarios, such as taking out an entire pension fund as a lump sum, will also activate the MPAA.
Some have argued for the MPAA to be increased. This would allow for over-55s to get more tax breaks on the pensions they have accessed if they are continuing to contribute more money into the fund.
This would put pensions in a good position for when the person eventually retires.
Of course, many people have already retired and have planned their retirement around consistently drawing from their pension. However, if you withdraw your money more quickly to grapple with the increases in your daily bills, you will not be able to continue doing this into old age. Therefore, it is important to assess the ways in which you can avoid drawing from your pension pots too early.
Inflation and potential solutions
Many are calling for the state pension to be increased. For those who are struggling to afford their energy and grocery bills, waiting until the next budget is impossible.
Pensioners with a low income may be eligible for pension credit. It tops up the pensions of low-income pensioners and can greatly help with regular bills like mortgage interest, council tax, and utility bills. Unfortunately, this benefit is largely underclaimed. Many fail to apply for pension credit because there is a pervasive belief that if you own a home or have savings, then you don’t qualify. This is not true, and it is worth a check to see if you are eligible.
Pension annuities are another viable solution. However, fixed-income annuities will be impacted by inflation. Even annuities that do account for inflation are not bought by many who need them, as they are too expensive. Additionally, pension schemes that increase annually to account for inflation are sometimes capped at 5%. This 5% is not sufficient when inflation is high, so the pension scheme essentially acts as a fixed liability instead. This issue requires schemes to revise their hedging strategy and ensure it is providing the protection it was intended to.
Speak to an expert about how to protect against inflation
At the beginning of 2022, inflation reached its highest level in decades. Inflationary pressures may persist for a longer period than what is predicted, so it is crucial for pension schemes to plan ahead. Waiting too long for the perfect solution will result in a loss.
This means that you must take practical and timely action. Keeping your endgame strategy on course is necessary, especially during a time of particularly volatile market conditions. A qualified professional will put a framework in place that promptly and effectively addresses these issues.
If you have any questions about how you can make the most of your pensions and account for rising inflation, contact us today.