Lets look at how to make your pension last. You may need more than you think.

Whilst reading this page and using the modeler, you should remember that the spending power of your pension will diminish over the course of 25 years due to the effects of inflation. If prices increase by an average of 3% a year, a reasonable assumption, then in 25 years a pound will buy less than half of what it buys today.

If you don't buy a life annuity (a guaranteed income for life which may include annual increases and a spouse and/or dependents pension on your death) with your pension fund then you will probably choose to benefit from your pension fund using one of five strategies:

1. Withdraw the entire fund in one go. If you plan to do this, then you may as well go straight to the tax page and see why this isn't a good idea if the sum of the taxable 75% of your pension fund + your income in the tax year of withdrawal is greater than £50,270!

2. Withdraw a percentage of your fund each year, that is, a percentage of the fund value as it stands when you make the withdrawal. This will give you a fluctuating income dependent upon the percentage drawn and investment returns - your income could rise each year or fall each year, but the fund will never deplete completely as you will only ever draw a proportion of what is left.

3. Withdraw a fixed sum each year, that is, the same sum of money each year. This will give you a fixed income (but take no account of inflation), but the fund may eventually run out.

4. Withdraw a fixed sum each year and increase it, that is, the same sum of money each year, but increasing to offset the effects of inflation. This will give you an increasing income, but the fund may eventually run out.

5. Withdraw the investment income each year, that is draw the increase in your fund value of the course of the year, leaving your capital intact. The potential downside to this is that sometimes your fund will lose value over the course of a year (the value of shares can go down as well us up), leaving you with no income (or a reduction of capital to make up for it). Remember also that the worth of your capital will be eroded by inflation as the years go by.

Before we look at the example tables, lets look at YOUR situation. Below is a modeler for strategies 2, 3 & 4, above. Strategy one doesn't need modeling as the outcome is set - you'll have no fund left and strategy five isn't really suitable for modeling as the outcome is a fixed fund with fluctuating levels of income in years that the value of your fund increases, and a reduced fund and no income in years that the value of your fund decreases.

To use the modeler, enter the value of your pension fund, the level of income that you would like at outset and the percentage by which you would like to increase your pension each year to offset the effects of inflation (3% is often used in long term predictions). The modeler will then display possible outcomes for you using both strategies 2 and 3. Withdrawal values will be rounded DOWN to complete pounds.

£ Value of your Pension Fund
 
£ Amount to be withdrawn at outset
 
% Annual increase to your pension (Used in outcome 3)
 
Show possible outcomes  

Below are some tables to help demonstrate the effect of drawing from your pension. They show the level of your fund and what you might draw from it for up to 25 years after your retirement. The figures are based on various levels of withdrawal and an annual investment return on your remaining fund of 3%, 5% and 7%. remember that your fund may not increase at these levels (or may exceed them). The investment returns are for illustrative purposes only. All sets of projections assume a fund of £100,000 at the point at which you start drawing. I have not included an increasing pension set as to give a broad outlook using different increase rates would require lots of space. Please use the modeler, above, to demonstrate the effects of different increase rates on your own pension fund.

Ahead of the tables, I provide quick summary of the data shown on them to highlight how your fund might last and guide you through what the data means. Remember that 75% of your withdrawal is taxable! See the tax page for more details about how your pension withdrawal might be taxed.

1. Withdrawing a percentage of the remaining fund each year (that is, the same sum of money each year. This will give you a fixed income (but takes no account of inflation), but the fund may eventually run out).

Even if you withdraw just 5% of your fund each year, you will need a fairly decent investment return to maintain your income. A return of 7% a year will enable you to have a 'pay rise' of around 1.65% each year whilst increasing your capital by the same amount. This is a pretty high return and is unlikely to be maintained in the long term. A more realistic investment return of 5% (and even that is by no means guaranteed) will see your income decrease from £5,000 in year one to £4,696.40 after 25 years. Using a long term inflation assumption of 3% per annum, this will only have the buying power in todays money of around £2,300 meaning your income will have halved in real terms. On an investment return of just 3% the outlook is even worse - an income of £2,900 a year which will be worth less than £1,400 in todays money!

On a more extreme example, taking a closer look at the equivalents of the 5% withdrawal example, what will happen if you decided that you will draw 20% of your fund each year? You might be starting off with a tidy, and tempting, £20,000 a year, but this will decrease rapidly. Even with a return of 7% a year you will be drawing £17,120 after 1 year and after 25 years your fund will only have just over £2,000 remaining, giving an annual income of £410 - Less than £200 a YEAR in todays money! With a 5% investment return your annual income will be just £255 (£122 in todays money) and a 3% return will leave you with just £158 (£75 in todays money) a year to live on!

2. Withdrawing a fixed amount from your fund each year (that is, you withdraw a fixed sum each year and continue).

The first obvious downside of this is that you don't get a pay rise (though you can include an annual increase of your choosing on the modeler, above), so by the time 25 years have passed, you have an income that is worth less than half what it was at outset. Of course, you have full control of your money so you may decide to give yourself a small (or large!) pay rise each year, but this isn't without risk. The second, possibly not so obvious, downside to this is that your fund may well run out. If you withdraw a sum that is greater the funds investment returns, it will eventually run out.

Lets have a look at the same scenarios that we did for strategy one.

Withdrawing £5,000 a year (5% of your initial fund) will mean that, even on an investment return of 3%, you will still be getting £5,000 a year after 25 years, but your fund will only be worth £21,600. That means that after 30 years, there will more than likely be nothing left. With an investment return of 7%, you will still be drawing £5,000, but your fund value will have more than doubled!

So far so good, but what if you elect to withdraw £10,000 a year? After 11 years, you will have just £6,500 left if you get a return of 3%. You'll get to 15 years before your money runs out if you achieve 7%

With the more extreme example of a £20,000 (20%) withdrawal, you'll get just 5 years of £20,000 and then a final year of £6,559 at 3%. Even at 7% you only get five full years, with a final payment of £17,189. If you have taken this option after, for example, a redundancy at age 60, then by the age of 66 you will have run out of money!

This demonstrates the importance of doing your math's and not getting carried away because you suddenly have access to a large sum of money. There is a very strong argument to limit your withdrawals to an amount which will leave your capital intact, or even leave your capital with a small amount of growth.

You may choose to achieve this by withdrawing a fixed percentage that produces an increasing income, based on realistic long term investment return assumptions, for example, taking 3.5% of your fund each year with an investment return of 5% gives an income that will increase by 1.325% a year, but this relies on investment returns being a constant 5% over the course of your retirement. Alternatively, you may choose to withdraw only the investment income each year. This has the potential pitfall that sometimes your fund will lose value over the course of a year (the value of shares can go down as well us up), leaving you with no income. Remember also that the worth of your capital will be eroded by inflation as the years go by.

My preferred choice would be to take a fixed percentage each year - probably something between 3% and 3.5% based on what has been explained above and demonstrated below, but with one eye on investment returns to enable me to alter that percentage if necessary.

There is also a strong argument for staying on the annuity path if you expect to live to a ripe old age. With effective compulsion to buy removed, some much better products should appear on the market and everyone should still give consideration to whether a lifetime guaranteed annuity is the best way to secure their future.

To view the full projections, click to view each example table

Withdraw 5% of remaining fund each year
Withdraw 10% of remaining fund each year
Withdraw 15% of remaining fund each year
Withdraw 20% of remaining fund each year

Withdraw £5,000 each year
Withdraw £10,000 each year
Withdraw £15,000 each year
Withdraw £20,000 each year