Millions of households risk falling short of essential retirement costs due to a common financial decision: withdrawing the tax-free lump sum from their pension early, according to a report by Oxford Economics commissioned by Hargreaves Lansdown.
Forecasting suggests that 92% of households can cover their essential retirement expenses, largely due to the state pension. However, this figure drops significantly for those who take their tax-free lump sum and do not reinvest it to generate income. The proportion of households able to maintain their lifestyle in retirement is eight percentage points lower for those who take this lump sum compared to the overall average.
The tax-free lump sum allows individuals to withdraw up to 25% of their pension pot, capped at £268,275, from age 55 (rising to 57 in 2028). This is a popular perk, with 83% of people accessing defined contribution pensions since 2015 taking a lump sum from at least one of their pots. Many use these funds for immediate needs or desires, such as paying off debt, clearing mortgages, or funding holidays and home improvements.
However, experts warn that this immediate benefit can have long-term financial consequences. Helen Morrissey, retirement specialist at Hargreaves Lansdown, stated that people should carefully consider the impact on their retirement income before withdrawing the lump sum. She noted that some individuals deposit the money into savings accounts with low returns, where it could potentially earn more if left invested within the pension.
This trend of lump sum withdrawals has been substantial. Savers withdrew approximately £3.9 billion in pension lump sums in the 12 months leading up to October, an 81% increase compared to the same period in 2022/23. This surge occurred amid speculation ahead of the Autumn Budget that the government might reduce this tax perk.
The report highlights that higher earners are disproportionately affected because their personal pension, from which the tax-free portion is extracted, often constitutes a larger part of their overall retirement wealth.
To illustrate the financial implications, consider a £400,000 pension pot. If 25% (£100,000) is withdrawn tax-free and placed in a savings account earning 3% annually, it could grow to about £134,000 over ten years. If the remaining pot grew at 5% annually, it would reach £448,688 in the same period, resulting in a combined value of £582,688. In contrast, leaving the entire £400,000 invested for ten years, assuming a 5% annual growth, could result in a pot of £651,558. This would allow for a tax-free lump sum of £162,889, offering a substantially larger amount for retirement spending.