Investing A Pension Lump Sum: Considerations And Your Options

New pension freedom rules mean that from the age of 55, anyone that holds a pension can, should they wish, take out lump sums as cash. If you decide to do so, and it’s a decision that should only be made after careful consideration, what are your options? You have any number and we’ll cover the main investment options available to you here. But first, let’s explain the tax considerations you should take into consideration before opting to take a lump sum out of your pension. And also the other factors to keep in mind before reaching a definite decision.

How Are Pension Lump Sums Taxed?

Pension income is taxable after the personal pre-tax income of £12,500 we can all receive annually. Income from employment, investments (after capital gains tax allowance) and most other forms of income that are not covered by exemptions all count towards that personal allowance.

Thankfully, there are tax allowances that apply to income from pension funds that can significantly reduce the tax you will owe on any pension funds you take as cash. The first 25% of pension cash taken as a lump sum, or via smaller chunks, is tax free. So if you chose to take a £100,000 lump sum from your pension to invest elsewhere, £25,000 of that would be tax free. The remaining £75,000 would be subject to income tax. That income would also be charged at the higher 40% rate (income over £50,000). If the taxable portion of your lump sum is at least £150,000, a whole 50% would be lost to the tax man.

That’s an important consideration. Taking a lump sum out of your pension that is enough to be taxed at 40% or 50% may make little sense. If, when any other sources of income are taken into consideration, the taxable portion of your lump sum will still be taxed at the lower 20% rate (up to £50,000), you might come to the conclusion that makes sense. But weigh up the tax hit carefully.

But investing an entire pension lump sum tax free is also possible. That can be achieved by drawing down your entire pension but only taking 25%, your tax free portion, as cash. You can then invest an annuity which offers a guaranteed income for as long as you live (though there are also options that give you a guaranteed income for a set period of 10, 20 or 30 years. But that option runs the risk of you still being alive and well and in need of an income after your fixed term annuity income expires). The second option is to invest your remaining 25% in an adjustable income investment product that offers flexi-access drawdown you can make use of if and when you need to.

It is important to note that the income you receive from either a guaranteed income annuity, or an adjustable income product, will still be taxable above your personal £12,500 allowance (because you’ve already used up your 25% tax free allowance on the cash lump sum). But unless it takes your annual taxable income above £50,000, it will at least be taxed at the 20% rate.

We’ll take a closer look at annuities and adjustable income investment products a little later.

Why Choose To Invest A Pension Lump Sum? Isn’t It Already Invested Through My Pension?

Pensions are almost always mainly invested rather than held as cash. Especially in the super-low interest environment of the past decade. Holding a pension in cash would mean its value being eroded by inflation – the rate of which has run ahead of the interest rates on offer for cash savings balances for some time now. And if a pension is already invested in funds, why bother taking out a lump-sum to re-invest elsewhere?

There are a number of reasons why such a move might be justified:

Existing Pension Funds Not Performing Well – Inexperienced investors often opt for whatever pension product was put in front of them at the time, both when it comes to workplace and private pensions. However, on review years down the line it can also, unfortunately, be the case that product has not performed well ie. returns have fallen behind market benchmarks.

That can especially be the case with pension products taken out pre-2013, when the Retail Distribution Review (RDR) came into force. RDR banned Independent Financial Advisors (IFAs) from earning commissions on products they advised investors to buy in an attempt to cut out the opportunity for conflicts of interest in the advice they gave. Instead, IFAs were now obliged to charge clients an hourly rate.

Pre-RDR, the business model of IFAs, who often worked directly for banks advising retail customers, was earning commissions on the investment products their clients bought into. Those commissions were also usually trailing, so IFAs would continue to earn as long as their clients were contributing to the pension products they had been steered towards.

IFAs often didn’t charge anything for the advice they gave, instead earning their living from commissions. An unfortunate repercussion of that model was that many retail investors were steered towards pension and other investment funds based on the level of commission they paid out to IFAs, rather than positive qualities in the interests of investors. Being able to pay out high commissions also often meant the fees charged by such funds were expensive and significantly eroded investment returns.

And while RDR meant that model came to an end, the new rules were enforced for new investments only. That means that there is still a huge volume of UK retail investment capital tied up in expensive and poorly performing funds that are still paying out trailing commissions to IFAs. This November (2019), the Financial Times put the amount of UK-based retail investment capital, much of it in pension products, tied up in such funds at £184 billion.

For anyone with pension products dating back to before 2013, which is most people approaching or already having reached retirement, there is a significant chance that the funds the money is invested in are not providing returns as good as the benchmark index.

It makes sense to review the performance of pension investments. And if they have not been as good as they should be, drawing down a pension lump sum and re-investing it elsewhere, more cheaply, could make sense.

Diversification – Another reason an investor might decide on investing a pension lump sum differently to where it has been held to date is the desire for increased portfolio diversification. For example, if an entire pension fund is based in UK-based assets, an investor might decide it’s in their best interests to add more international exposure to diversify geographical and currency risk.

Or, if a pension portfolio is invested in products that focus on growth, the decision might be made to invest more in income-generating assets such as stocks that pay good dividends or fixed income investments such as bonds. That’s a typical strategy as retirement edges closer and the investor has less time to ride out any stock market downturn if and when it eventuates. Income stocks, particularly those in more ‘defensive’ sectors such as utilities and other products and services we still pay for regardless of the economic environment, tend to suffer less during a stock market downturn.

Investment grade bonds and higher class junk bonds also offer both income and are uncorrelated to stock market downturns. Rather, they see their exchange values increase as investors seek shelter. Once retirement approaches, or pension funds are already being relied on to provide an income, the classic portfolio will be rebalanced more towards lower risk assets.

Or, an investment portfolio might have been set up with a very low risk, low return profile to start with. In that case an investor might decide to draw down and invest a pension lump sum in higher risk, higher return profile investments in order to spur growth while there is still the window of opportunity to do so.

Investing A Pension Lump Sum – Your Options

When it comes to investing a pension lump sum there are a wide range of options. These can be divided into investment options which are open to any investor and others which are specifically pension investments. As always, these options come with varying risk profiles so it is important to understand what your pension investment needs, targets and risk profile is and assess their suitability within that context. If in any doubt whether or not an investment is suitable for you and your personal financial situation, always speak with a qualified and regulated professional investment advisor.

Annuity

An annuity is a pension product that offers a guaranteed income, usually for life. There are annuities that offer a guaranteed income for a set number of years, such as 10 or 20, but those should be considered carefully as you may need a pension income for longer than you expect.

The most traditional kind of annuity product offers you a guaranteed fixed income for life. For example, if you buy a £100,000 annuity, you might expect an income of between £3000 and £5000 per year from it. But it could be less or more depending on the age, and health, of the investor when the annuity is purchased. Younger investors and those in good health will receive less as the annuity provider will expect to have to make the payments for longer.

There are other kinds of annuity that offer variable income or inflation-linked income. You should carefully explore your options and compare the options available to you for suitability for your personal situation.

As guaranteed income products, annuities, predictably, represent a modest return on investment capital. That’s the trade-off for security. However, they have the advantage of being tax efficient. Annuity income is, after your 25% tax free drawdown, still taxable. But unless you have other sources of income, or purchase a particularly large annuity (and if you have that big a pension pot there’s a strong argument that there are better options than putting it all towards an annuity), there’s a good chance your annuity income will not exceed your annual £12,500 personal allowance before income tax begins to be charged.

Flexible Income Pension Drawdown Products

Another option is to invest in an income drawdown product that will offer you a flexible income as and when you need it. Most commonly, a pension pot holder would take their 25% tax-free lump sum and then invest the rest of their pot into a pension drawdown product. This allows the holder to manage their pension drawdown income for tax efficiency and making sure pension income doesn’t qualify for the higher income tax bands.

Unlike annuities, pension drawdown products don’t offer guaranteed income or income for life. The holder has to manage their investments and how much is drawn down monthly or annually in a way that is sustainable and tax efficient. How much income is generated by a drawdown product will also rely on financial markets performance at any given time. So it’s advisable to also have cash and fixed income investments on hand so assets don’t need to be sold at unattractive prices during market downturns.

Flexible drawdown pension products can be complicated so it might make sense to consult with a professional investment advisor before choosing one.

Pensioner Bonds – Fixed Savings Rate Bonds For Over-65s

In 2015, the UK government launched its Pensioners Guaranteed Income Bonds and Capital Bonds scheme. Unfortunately, these bonds are no longer on sale and it is unclear if there will be another similar bond issue in the future.

However, there are plenty of other investment grade and higher risk-higher reward bonds and bond funds on the market that could provide a fixed income from investing a pension lump sum. Investment grade government bonds such as Gilts issued by the UK, are very low risk (the UK government would have to default on its debt – something that has never happened and would be a very unexpected turn of events for the foreseeable future). But these low risk bonds also pay modest coupons that often run below inflation.

If the focus is purely capital preservation then low-risk, low-return investment grade bonds could be a good solution for investing a pension lump sum. But if the investor also wishes to draw down an income, without gradually depleting pension capital or doing so only slowly, a little more risk will have to be taken on. This can be achieved by investing some of the pension cash in bonds that offer higher returns, for example 5%-7%, at a higher risk profile.

This can be achieved with moderate risk exposure by investing in ‘junk bonds’. These are bonds issued by companies with a credit rating and debt management history that falls just short of investment grade. Companies with a B or double B credit rating, for example, offer higher bond coupons but also relatively rarely default. Default rates at the high end of the junk bond market are in the low single figures. So as long as investment capital is well risk diversified through either a bond fund, or a selection of several or more hand-picked junk bonds at the higher end of possible credit ratings, it could be a good investment choice for pension funds.

Just be careful not to be attracted by higher returns offered by junk bond issuers with lower credit ratings, because at the lower end of the scale default rates can jump to up to around 20% during severe economic downturns. Or, if your pension pot is large enough, you could always set aside 10% or so to invest in higher risk, higher return bonds. That will drive returns if things work out well and won’t badly impact your pension pot if you do unfortunately suffer from an issuer defaulting.

EIS Investments/VCTs

Making investments through the government-supported EIS scheme, or investing in a Venture Capital Trust, which is basically an actively-managed EIS fund, offer a high risk to high reward way for higher net worth investors with a pension lump sum to offset much of the tax that would otherwise be due.

EIS investments are equity stakes in private companies. When an investment is made in an EIS-qualifying company (EIS companies should hold intellectual property and be defined as ‘innovative’) you receive back a tax credit compensating you for the income tax paid on the capital invested. So if you were hit by a 40% tax charge on a pension lump sum, it would be returned if the money was then invested in an EIS-qualifying company. Other tax breaks include no capital gains tax being paid if the investment proves successful. And further tax credits also go some way to mitigating losses if the investment isn’t successful.

Another way to approach an EIS investment is to reinvest taxable capital gains from other investments. Capital gains liability is reduced by 50% if returns are reinvested via the EIS scheme.

VCTs, but only if newly issued shares are purchased, also offer income tax relief. A VCT is also a good way to diversify risk as these closed-ended venture capital funds also come with income tax relief on cash invested.

The downside to EIS, and to a lesser extent, VCT investments, is that they are illiquid. Shares in private companies cannot be sold on an exchange like publically traded stocks. So an investor is locked in until the company is either sold, has an IPO, the company launches a share buyback, a new big investor offers to buy shares from existing earlier investors or another private investor is willing to buy them.

VCT shares can be sold on the secondary market but there is no guarantee what price they will fetch. It will depend on the performance of the trust. Investments in private companies, especially younger private companies, is also inherently risky. Shares in both EIS and VCT investments have to be held for a minimum of 3 years or tax credits are refundable.

These options for investing a pension lump sum are only suited to high net worth and sophisticated investors able to take on more risk with some of their capital.

So there you have it. While the options listed above are not the only possible choices when it comes to investing a pension lump sum, they do cover many of the most popular mainstream and alternative ‘hands off’ investment options available. And we hope they offer a good starting point to your decision making process.