How far could a £250,000 pension pot go?

If your pension pot totalled £250,000, would that be enough for you to live on? The answer to that apparently simple question is complex as it depends on several factors: your age, health, life expectancy, existing debts, property situation, dependents and previous lifestyle, among others.

We cannot answer all those questions here, but what we can do is consider some of the initial options you have with a total pension that’s worth £250,000.

There are three main options, which are shown below in the flowchart. Each is looked at in the text below.

Let us assume that you have accrued a total pension pot of £250,000 and you are old enough to draw money from it. At the time of writing, UK legislation generally allows you to withdraw money from your pension once you are 55 years of age (1).

With this in mind you have three broad options:

1. Leave the money where it is

2. Withdraw all of the money at once

3. Withdraw all of the money piece by piece over time.

Let us consider these in turn.

Option 1: Do not withdraw

This deserves serious consideration.

Once you have gone through the other options and got an idea of how much income £250,000 could pay, you might be very tempted to leave your money where it is for a while longer.

This leaves your money invested where it has the potential to grow (or fall) in value.

Importantly, though, you can also keep contributing to your pension pot, which would allow you to continue to benefit from the tax incentives set up to encourage investments in pensions.

The broad tax rules that apply to pension contributions at the time of writing are shown below.

Now let us find out what the other main options are, so you can see if they make more sense for you.

Option 2: Withdraw all the money at once

There are three ways in which you can withdraw all of the money:

• Withdraw all the money as cash

• Withdraw some as cash and use the rest to buy an annuity, which provides a guaranteed income in exchange for a lump sum upfront payment

• Withdraw all of the money and use 100 per cent of it to buy an annuity.

The first 25 per cent of your £250,000 pension pot can be withdrawn without having to pay any tax on it. This amounts to £62,500, leaving £187,500, which is taxable. The following is a hypothetical example to give you an idea of how taxes might be applied on the remaining £187,500.

If you were to pay zero per cent on the first £12,570, 20 per cent tax on the next £37,700 pounds, 40 per cent on the next £99,730, and 45 per cent on the remaining £37,500, then your total tax bill would be £64,307. Take that off the original £250,000, and you are left with £185,693.

IMPORTANT: This is a hypothetical example using the 2022/23 personal tax bands (2), but we note that the additional rate tax threshold will fall from £150,000 to £125,140 from April 2023 (3). The amount of tax you would pay is dependent on your personal circumstances.

Withdraw some as cash and use the rest to buy an annuity

You can withdraw up to 25 per cent as cash (which is tax-free) and use the rest to buy an annuity, which is a guaranteed income. Annuities fell out of favour in recent years, due to the low rates (income levels) on offer. But these rates have recently increased (4), making them a potentially more viable option for people seeking retirement income.

The government encourages annuity purchases by not taxing money you use to buy them, instead the income from an annuity is taxed as earnings (5). So you could take up to £62,500 tax-free, and then use the entire remaining £187,500 to buy an annuity.

Withdraw all of the money and use 100 per cent of it to buy an annuity.

Finally, you could withdraw the entire pension pot and use 100 per cent of it to buy an annuity. Again, there is no tax liability on this when you buy the annuity, but the money you receive from annuity payments will be subject to tax. What will an annuity pay?

This depends on a range of factors including these:

• Is it a lifetime annuity or just for a fixed number of years?

• Is it for one person or a couple?

• Is it index-linked so that it rises with inflation?

• Do you want money from it to be passed on after you die?

• Do you want to take out insurance on it so that you can pass on some money should you die very early on in the life of the annuity?

Not the most pleasant of thoughts, but reality places them upon us.

To get an idea of what an annuity might pay, let’s look at two illustrative examples based on the full £250,000 being used to buy an annuity.

The following quotes and numbers were taken from the moneyhelper.org.uk website in February 2023. MoneyHelper is part of the Money and Pensions Service (MaPS), a non-profit organisation set up by the UK government. It provides broad guidance but, obviously, cannot allow for the myriad of variations that apply across individuals.

For illustrative purposes only

Option 3: Withdraw the money piece by piece over time

This is where you could, for example, potentially set up regular payments (drawdowns) from your pension pot.

If you draw down £1,000 every month, £250 of that would be tax-free, while the remaining £750 would be taxable.

This could be beneficial in two ways. First, by taking smaller amounts, you might stay within a lower tax bracket. Second, it enables you to leave money in investments, which can continue to offer potential growth.

Always remember that stocks can, of course, go down as well as up, so there is no guarantee that your pension pot will grow during this or any other period.

Assuming that your pension pot neither grows nor shrinks during the subsequent months, such a drawdown schedule would give you 250 months of payments. This equates to 20 years and one month, taking you up to the age of 80. But, at Schroders Personal Wealth, we often plan for people living to the age of 100.

Moreover inflation is rarely ever zero or below and in December 2022 it was 10.5 per cent. This means the value of that monthly payment could buy less and less with each passing year.

In addition, many people like to be very active during the first 10 to 15 years of retirement. In this period, you may want to spend more money, take lots of holidays, and make the most of your years of vigorous health. Consequently you could need more money in your sixties and seventies than in your eighties, when your lifestyle might be slowing down.

Your main concern for your nineties might be to have stability and comfort. You might also want to prepare for the possibility of later life costs in nursing homes or domestic care in your own home. So funding needs could potentially rise again.

Care home costs

Care home costs alone are a serious consideration that could quickly eat into that £1,000 a month before tax.

According to Age UK, the cost for a care home averages around £600 a week, while that for a nursing home is more than £800 a week (7). This is a national average, so there are areas of the country where the costs can be higher.

Once a person’s total net worth falls below £23,250, the local authority might step in to assist, but it will have an upper limit on what it will pay.

In other words, you might have to contribute to healthcare costs from your own pocket if your preferred care provider costs more than your local authority is prepared to pay.

Other considerations

If you thought that was a little bewildering, there is more. Some of the further considerations that you have to bear in mind include:

• Other income sources that you might have (e.g. employment or rental income)

• Where you are single or part of a couple and what your circumstances are

• How much, if anything, you would like to leave by way of inheritance

• Where you want to live in the world

• Whether or not you have to meet mortgage or rental payments

• Any debt or assets you have.

There is clearly a great deal to think about and some serious choices to be made. A good financial adviser can help you make these choices.

Sources:

(1) www.gov.uk, ‘Personal pensions’, 6 February 2023.

(2) www.gov.uk, ‘Rates and thresholds for employers 2022 to 2023’, 8 December 2022.

(3) www.gov.uk, ‘Income tax additional rate threshold from 6 April 2023’, 21 November 2022.

(4) www.ft.com, ‘Savers look to pension annuities as rates soar’, 6 January 2023.

(5) www.moneyhelper.org.uk, ‘Guaranteed retirement income (annuities) explained’, 6 February 2022.

(6) www.ons.gov.uk, ‘Consumer price inflation, UK: December 2022’, 18 January 2023.

(7) www.ageuk.org.uk, ‘Paying for residential care’, 2 December 2022.