Managing your money in retirement – 4 golden rules to avoid a shortfall

Managing your money in retirement comes with significant challenges, including the risk of overspending and running out of funds in old age. Cost-of-living pressures have only made things more difficult in recent years.

A comfortable retirement now costs a single person £43,900 per year, according to figures from trade association Pensions UK. This has risen from £33,000 in 2019, before the pandemic sparked the highest level of inflation in a generation.

These figures do not include housing costs, so anyone still renting or paying a mortgage in retirement could face even higher outgoings.

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With this in mind, it is unsurprising that one in five adults worry their pension won’t provide enough income in retirement, according to research from Nottingham Building Society. This rises to more than one in four among over-60s (28%).

Some use their pension savings to buy an annuity, giving them a guaranteed income for life (depending on the product you buy). However, the amount you qualify for depends on the size of your pension pot.

Others opt for pension drawdown in the hope it will give them better value for money – but the risk is that they could outlive their savings.

“It is crucial anyone entering drawdown has a clear plan for making their pension last, which means you need to regularly review your retirement strategy and withdrawals to make sure they remain sustainable,” said Rachel Vahey, head of public policy at investment platform AJ Bell.

“If you aren’t sure how to go about this, it’s worth considering employing a regulated financial adviser to help you navigate what can be complex choices.”

The lottery effect – overspending early on in retirement

Poor financial planning can create problems for those who opt for drawdown, with some retirees overspending early on in retirement and leaving themselves short towards the end – a time when outgoings can shoot up thanks to care costs.

Last year, a study by Legal & General (L&G) found that some retirees were at risk of emptying their pension pot a decade early, after taking large cash lump sums and withdrawing too much in monthly income.

Savers generally expect their pension pot to last 22 years from age 60, according to L&G’s analysis, taking them to around 82. But for those who may not have other sources of income, such as property wealth or a defined benefit pension, it typically runs out by age 77. Both fall short of the average life expectancy, which is 86 for those who are currently age 60.

“For most people, their pension pot is the largest sum of money they’ll have access to, and after decades of hard work and saving, it’s natural to view it as a well-deserved reward,” said Katharine Photiou, managing director of workplace savings at L&G.

“However, our research shows the sudden financial freedom can trigger ‘The Lottery Effect’ for some savers, which can lead to unsustainable spending.”

Golden rules to avoid retirement shortfall

1. Make a plan before taking your tax-free cash

Once you turn 55, you can access your pension and are entitled to take 25% of your savings as tax-free cash. Some rush to withdraw this straightaway as one lump sum, but that can be a mistake.

When you withdraw money from your pension, you take it out of a tax-efficient environment and move it into one where a tax bill may be generated – for example on savings interest, or dividends and capital gains if you decide to reinvest the money.

Withdrawing your tax-free cash and sticking it in a savings account also means you miss out on the potential for future investment growth.

It is better to have a plan for what you are going to do with the money. Some use it to pay off their mortgage, for example, so they can retire debt-free. Everyone’s personal circumstances are different, so it is worth seeking financial guidance or advice.

Remember: you don’t need to take all of your tax-free cash in one go. You can take it in instalments if you prefer. This means the money remains invested for longer and can hopefully continue to grow.

2. Build up your emergency savings

Everyone should have an emergency savings pot to cover unforeseen costs. Those who are working should have enough to cover one-to-three months’ worth of essential expenses, but this rises to one-to-three years among retirees. It is generally advisable to keep this in an easy-access account.

If you haven’t got enough in emergency cash savings as you head into retirement, should you use your pension tax-free cash to top it up? Helen Morrissey, head of retirement analysis at investment platform Hargreaves Lansdown, says it depends on your circumstances.

She told MoneyWeek: “If someone is in drawdown and needs a buffer to help them maintain income during periods of market volatility, then they could look at having 1-3 years’ worth of emergency savings.”

If they also have income from an annuity or a defined benefit pension, they might be able to keep less in their emergency cash reserve, leaving more invested in their pension.

“The decision to take tax-free cash to top up emergency funds will also depend on wider issues such as access to other assets, size of estate given the upcoming inclusion of pensions as part of people’s estate for inheritance tax, as well as wider planning issues,” Morrissey said. “If in doubt, people should seek financial advice.”

3. Think about how much income you need

A cash management strategy is important. How much income do you need to live on, and is your pension pot big enough to sustain you for as long as you might live? Some people adopt the 4% pension rule – a guideline that can be used to help you draw a sustainable retirement income for around 30 years.

This rule suggests you can withdraw 4% of your pension in your first year of retirement. In all subsequent years, you can withdraw the same amount but adjust for inflation. If you had a £500,000 pension, this would mean taking £20,000 in the first year. If inflation was around 2%, you would then take £20,400 out the second year, £20,808 out the third year, and so on.

There are pros and cons to the rule, as we explore in a separate piece. If you are in a position to seek tailored financial advice, that is usually the best approach, as a financial adviser will be able to help with cash-flow modelling.

4. Consider combining drawdown with an annuity

Pension drawdown is a more popular option than buying an annuity, based on FCA data. While the idea of guaranteed income is appealing, many dislike the idea that an insurer will profit from their life’s savings if they die shortly after purchasing the annuity contract. Meanwhile, your loved ones can inherit any unused pension savings.

That said, annuity rates currently look attractive and can give you peace of mind, offering guaranteed income until you die. Recent data from Hargreaves Lansdown’s annuity search engine shows a 65-year-old with a £100,000 pension can get up to £7,793 per year from a single-life level annuity with a five-year guarantee.

Savers don’t need to choose between the two approaches. A combination of the two can be a good strategy. “This mix and match approach means you can secure the income you absolutely need from an annuity, and also keep some invested for growth in a drawdown plan which provides a more variable, flexible income,” said Laith Khalaf, head of investment analysis at AJ Bell.