Make this pension mistake and lose £18,415!

by Jane Baker on 02 February 2010  |  7 comments
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Make this mistake with your pension and it could have a devastating effect on your income in retirement.

The earliest age we're allowed to take an income from a pension is 50. But from 6 April this year, the minimum age will be hiked up to 55.

I'll admit there probably aren't masses of you who are planning on hanging up your boots the second you reach your 50th birthday anyway. But there are still a significant number of people for whom the change in this rule is crucial.

For example, some pension savers have seen the value of their pension plummet, and are very keen to get their money out at the earliest available opportunity before matters get even worse. Others, who still have debts later in life, are relying on their pensions to supplement their finances sooner rather than later.

Meanwhile a lucky few are wealthy enough to justify retiring early, and may be alarmed at the prospect of waiting another five years.

Whatever the reason, hordes of pension savers in their early fifties are cashing in their pensions before it's too late. But, unless you can really afford it, here's why I think that cashing in is a very big mistake.

Why should you wait?

Stock market investing can be a very bumpy ride at times. I can understand why savers may think now is a good time to get out. After all, the UK stock market has been surprisingly strong over the last year despite the recession. The FTSE 100 index grew almost 30% during this period which has undoubtedly had a positive impact on pension fund values. Surely, it would be sensible to capitalise on these returns now?  

Having said that, there's no getting away from the fact that the earlier you start taking benefits from your pension, the lower your income will be. By starting at 50, rather than waiting until 55, your pension will have to pay out for five years longer, and that will push your yearly income down.

On top of that, by leaving your pension invested for longer, there's a greater opportunity for capital growth which could improve the final value of your pot, and ultimately provide you with a higher income in retirement.

How much could you lose out on?

Let's assume you're 50 and you have amassed a pension pot worth £50,000. Let's find out what would happen to your pension income if you took benefits now or waited five years until 55:

Income figures are based on a standard annuity for a male, non-smoker. The annuity is level in payment and provides no spouse's benefits or guarantees. For simplicity the figures also assume no tax-free cash is taken, and the entire pension fund is used to buy an income.

At the age of 50 your £50,000 pension pot would buy you an annual income of £2,792. Over the next 30 years until you reach 80, you would have received a total payout of £83,760 from your pension.

However, if you left your pension invested for another five years, you pension pot would have grown to £60,708 (assuming a growth rate of 7% a year). This time, you'll get a higher pension income of £3,618 and a total payout of £90,450 over the next 25 years.

That means you'll get an extra £826 a year - £6,690 over the next 30 years - just for leaving your pension alone until your 55th birthday. It's true you'll be benefitting from five years' worth of extra income by taking benefits at 50, rather than 55. But that's still not enough to provide you with a greater total payout by the time you reach 80.

Even better, if you leave your pension where it is until you're 55 and you continue to contribute say, £100 a month, your pension value would have stepped up to £68,562. A pension pot of this size could provide you with a yearly income of £4,087 and a total payout by the time you reach 80 of £102,175.

This time that's an extra £18,415 compared with taking your pension at 50, and means you'll have an extra £1,295 a year, every year, in income.

So you can see there's potential for a much healthier pension income if you leave your pension invested for another five years. And, of course, the longer you leave it the greater the benefits could be.

What if you really need some cash now?

If your finances really are getting overstretched, dipping into your pension early might seem like a good solution. But I think you should consider taking some of your pension now, and leaving the rest invested in the hope that it grows in value over time. Under current pension rules, you're entitled to take 25% of your pension pot as tax-free cash. You could use that lump sum to boost your finances now, while drawing an income from the remainder years later.  

But there are two things you should remember: first, by taking tax-free cash now, you'll reduce the value of your pension which means a smaller income later on. And second, while stock market performance has been strong over the last year, it may not do so well in the future which could force the value of your pension down.

If you have a question about your finances later in life, why not ask the lovmoney.com community for help at Q&A. And join our Get ready to retire goal where we guide you through all the decisions you'll need to make as your retirement approaches.

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