Tax-Efficient Pension Choices in the UK

Paul Sweeting

The special tax treatment of UK pensions means that the decision on how to use
pensions assets is more involved than in other tax jurisdictions. In particular, the
ability to take up to 25% of pensions 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 riskfree
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.

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