Make the most of . . . a £500,000 pension pot

Imagine if you had £500,000 built up within your pension fund. Would your priority be a comfortable retirement for yourself? Or would it be ensuring that your heirs also benefited from your wealth?

A pension pot of that size would be enough to deliver an annuity income of about £26,000 per year, but could also produce a reasonable inheritance through careful planning.

FT Money gets the views of the experts on three different courses of action.

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I want to maximise my income now

Billy Burrows, director, Better Retirement Group: At first sight it might seem relatively simple to maximise income from a defined contribution pension pot, but in practice it is more difficult. The first step is to be clear what maximising income actually means.

Does it mean getting the most income at the outset, or does it mean maximising income over the lifetime of the annuity by trying to achieve income growth? There are three other considerations; how much risk can be taken, what about inflation and what about tax?

In the past, some clients with large pension pots have chosen to maximise income by simply investing in either a level or inflation-linked annuity, usually on a joint life basis.

Someone aged 60, with a husband or wife of the same age, could receive more than £23,000 per annum gross from a pot of £500,000 for a joint life, level annuity and £12,057 from an inflation-linked annuity. This might seem too simple, but the justification has been that they want no risk with their pension, because any risk should be taken with non-pension assets.

This strategy is much rarer today, though, because annuity rates are so low and inflation-linked annuities are so expensive.

The other obvious way is to take pension drawdown, where the maximum income at the outset is currently £28,000 (120 per cent of GAD) for capped drawdown and no limit for those who qualify for flexible drawdown. In my experience, few investors with large pension pots take the maximum income because it may not be sustainable unless a high-risk high-return investment strategy is adopted. It is more usual to see withdrawal limits of between 3 per cent and 5 per cent of the fund.

Another popular approach is to consider investment-linked annuities, which can pay a high starting income, similar to 120 per cent of GAD, with the potential for future income growth.

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I want some income, but also to pass on my wealth to my heirs

Matt Hawkins, chartered financial planner, Rathbone Pension & Advisory Services: Phased drawdown is an option for those where there is no immediate need for the full tax-free cash amount, and where they have a desire to maximise death benefits.

Under this approach, a pension is divided into multiple segments at the outset, depending upon the amount needed, and the required number of segments is encashed. From each, 25 per cent is deemed tax-free cash; the remainder provides taxable income through annuity purchase or capped or flexible income drawdown. Segments not encashed are "uncrystallised" benefits; those where any tax-free cash or income have been generated are "crystallised" benefits.

Staggering payments from a pension pot until "full" retirement can be highly tax efficient. Tax-free cash can be taken from the age of 55 and, taken as 25 per cent lump sum of a £500,000 pension fund, would equate to £125,000. However, taking "slices" of income, until full retirement, could provide an additional annual tax-free income of £41,666. At retirement, income can be structured using any remaining tax-free cash, along with the desired annuity or drawdown income route to generate the most efficient net income strategy using available tax rates and allowances.

The pension fund may remain invested, potentially increasing its value and the amount of tax free cash available until the entitlement is exhausted. The remaining fund will continue to grow without liability to income or capital gains taxes (with the exception of the 10 per cent withholding tax).

Phased retirement is also an effective inheritance tax (IHT) planning tool as any uncrystallised benefits can be passed on to nominated beneficiaries, through a trust structure free of IHT and without using an individual's nil rate band. Crystallised benefits follow the death benefit rules applicable to annuity purchase or income drawdown. Where any lump sum is available, crystallised benefits are taxable at 55 per cent.

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I want to preserve my wealth

Adrian Walker, retirement planning manager, Skandia: Not touching a pension at all - not even to access the tax-free cash - is a tax-efficient means of passing on wealth to beneficiaries should the pension holder die before the age of 75. On death before the age of 75, any untouched pension fund within the lifetime allowance can pass to beneficiaries free of any tax. if the pension holder dies after the age of 75, the entire pension fund, if paid as a lump sum, is subject to a 55 per cent tax on death, regardless of whether the fund has been touched or not.

If the client continues to work, maximising contributions to build more wealth for retirement will be a key driver. If the client moves to part-time work, savings may need to be used to supplement income. Use of other forms of savings - such as Isas - to provide retirement income can be tax-effective. Judicious use of the annual capital gains tax (CGT) allowance can also deliver tax-free retirement income.

Accessing the pension savings on a gradual basis to meet income needs as they arise will preserve the unused savings for longer, maximising the value that can be passed on to beneficiaries if the client dies before reaching age 75. The remaining pension saving will continue to benefit from any investment growth, increasing the amount of tax-free cash that can be taken later in retirement.

Taking this approach will allow the client to preserve as much of their wealth as possible while using other investments or capped drawdown to provide for any immediate income needs. Minimising investment risk will also help to preserve a client's wealth. Reviewing the underlying investment holdings and moving into less volatile assets will help reduce the risk of capital erosion.

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