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Tax-Efficient Pension Choices in the UK

Published online by Cambridge University Press:  10 May 2011

Paul Sweeting
Paul Sweeting
Affiliation:
School of Mathematics, Statistics and Actuarial Science, University of Kent, Canterbury, Kent, CT2 7NZ. :, Email: p.j.sweeting@kent.ac.uk
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Abstract

The special tax treatment of United Kingdom pensions means that the decision on how to use pension assets is particularly involved. In particular, the ability to take up to 25% of pension assets as a tax-free cash lump sum at retirement, offers retirees opportunities to enhance their pension above that possible through the purchase of a compulsory purchase annuity (“CPA”). The tax-free cash lump sum can be used to buy a tax-efficient purchased life annuity (“PLA”), or in a phased retirement strategy. Income withdrawal can also be used to defer the purchase of an annuity until age 75 and, potentially, to generate a higher income. In this paper I compare the options available to retirees using stochastic modelling. I compare the expected excess pension and expected shortfall, both relative to the alternative risk-free pension available, to assess the various options. I find that if the maximum amount of tax-free cash is available to be used to enhance retirement income, then phased retirement offers the best risk/reward trade off. The advantage is greatest for higher-rate tax payers. As the level of tax-free cash falls, income withdrawal becomes more attractive to those wishing to take greater risks.

Keywords

PensionsCompulsory Purchase AnnuityPurchased Life AnnuityStochastic ModellingIncome TaxIncome DrawdownPhased Retirement
Type
Papers
Information
Annals of Actuarial Science , Volume 4 , Issue 2 , September 2009 , pp. 177 - 197
Copyright
Copyright © Institute and Faculty of Actuaries 2009

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