Taking money from your pension? A raid for the short-term should be ‘last resort’

What do you need to consider before dipping into your life savings to meet short-term needs? Steve Webb explains.

According to a report by the UK Financial Capability Strategy, 17.5 million people of working age have less than £500 in readily accessible savings. Unfortunately, the current crisis means that for many people savings will quickly run out. But many millions of people also have money set aside in pensions, and those aged 55 or over can now, in principle, get their hands on that money. A key question is whether this is a good idea or not.

In an ideal world, we would not even be having this conversation. But if people are facing urgent bills, it is understandable if they choose to explore whether using some of their pension savings could help them get by. So, what should people bear in mind if they are thinking about accessing their pensions earlier than planned?

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‘Pot of money’ pensions

It is worth thinking separately about the two main types of pensions – ‘defined benefit’ (DB or final salary) and ‘defined contribution’ (DC) pensions – as the issues are rather different in each case.

Modern DC pensions are essentially a pot of money that is invested and can be drawn on once you reach the age of 55. A quarter of any pot can usually be taken tax-free and the rest is subject to income tax. There are a few things to think about before accessing your DC pension, including the importance of talking things through with the impartial PensionWise service before you make a final decision.

The first is the issue of tax. Apart from the tax-free lump sum, the rest of your pension withdrawals are taxed, and HMRC will often take a surprisingly high amount in tax. This is because it assumes you are going to make a lot of withdrawals during the year and as a result may end up as a higher-rate taxpayer. To be on the safe side, it therefore takes a big chunk of tax upfront and then expects you to claim back the excess.

This process can take well over a month, and in the meantime you will have less of the money you took out than you might have expected.

A related point on tax is to do with making ‘lumpy’ withdrawals from your pension. The taxable part of your withdrawal is counted in full as income in the year in which you take it. There is a risk that a large one-off withdrawal could take you into a higher tax bracket, with the result that you pay more tax than if you spread the withdrawal over two or more tax years. If possible, therefore, you should try to phase any withdrawals rather than taking everything in one go.

Many DC pensions have also suffered from the slump in the stock market in the first part of 2020. For many people their DC pot will now be substantially lower than it was at the start of the year. If you decide to access your pot now, you will effectively be ‘locking in’ these losses, rather than leaving time for your investments to recover.

Of course, no one can predict the market with any certainty and there is still a chance that the value of your investment could fall further. But it is worth bearing in mind that those who sold immediately after the sudden market crash of a couple of months ago have done much worse than those who held on just a few weeks more and saw some measure of recovery.

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DB access a bigger decision

Deciding to access a DB pension is in many ways a much bigger decision. Once you transfer out of a final salary pension scheme you cannot change your mind, and only a minority of schemes will allow you to transfer out just part of your rights. You are giving up a guaranteed income, often with inflation-linked increases and with a pension for a surviving spouse or partner.

You will need to spend a significant sum on financial advice and will need to beware the risk of scammers who encourage you to transfer your final salary pension into an alternative arrangement. The Pension Regulator has recently instructed pension fund trustees to issue a letter to members thinking about a transfer, warning about the danger of scams and stressing the advantages of staying where you are.

Since 2015, pension freedoms have helped many to flex their retirement savings. But the challenge now is to ensure that those who are under financial pressure are able to make well-informed and measured decisions about whether accessing their long-term savings for short-term needs is the best thing to do.

Steve Webb is a partner at pensions consultants Lane Clark & Peacock.

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