How to turn your savings into the perfect pension

The reforms will help people who are retiring, as well as savers, says David Prosser

April's pension reforms should make life easier for people coming up to retirement, particularly those who want to carry on doing at least some paid work after retirement age. The idea is to address one of the problems that many people say puts them off starting a pension - that there are so many restrictions on what you can do with the money.

From next month, whatever type of private pension you have, you will be able to take a quarter of your savings as a tax-free cash lump sum when you reach age 50 (rising to age 55 from 2010). You'll be able to use this cash for anything you like, whether or not you're retiring, and you don't have to cash in the rest of your fund. You can even take the money and continue working while saving more in the same scheme.

Some people will use the cash to pay off their mortgages, while others may want to help children with the cost of university, or even a first home. Currently, it is not possible to draw a pension from your employer's occupational scheme and continue working at the same company. But from April, this restriction will no longer apply, which will make it easier for people to move to part-time work before they retire completely.

A second reform will also help people with smaller pensions. Anyone with total savings of £15,000 or less - across all their pension plans - will be allowed to take the money in cash, rather than having to use it to buy a tiny annual income. A quarter of the fund will be tax-free, with income tax to pay on the rest.

John Jory, of B&CE Pension Consultants, says: "Far more people will be able to take a taxed lump sum rather than have to buy an annuity." For now, only those with funds worth less than £2,500 have this option.

The rules on how you draw a pension are also changing next month. Currently, the vast majority of people convert pension savings into a regular income by buying an annuity, a contract from an insurance company that guarantees to pay out a regular income until you die.

If you have a final salary pension, your employer arranges this contract for you in order to provide the income it has promised, but everyone else has to take their chances in the annuity market. As annuity rates have fallen sharply in recent years, many people have had to accept much smaller pensions than they had anticipated. And once you've converted your savings into an annuity, the money is gone, even if you die the following day.

From next month, your options will be more attractive. You'll still be able to take a conventional annuity, if that suits you, but you could instead choose to take out a five-year plan with some of your pension fund. These "limited period annuities" are likely to offer you a higher initial income while allowing you to leave the rest of your pension fund invested.

Though there is a risk these investments will not perform, there is also the potential for long-term gain which could boost your purchasing power when the initial five-year term ends.

"Value protected annuities" will be another option. David Elms, of IFA Promotion, explains: "Roughly speaking, if on death, the money used to purchase the annuity has not been used up by an individual and they are under 75, the balance can be paid to the policyholder's estate after a tax charge of 35 per cent."

The idea of this initiative is to appease people concerned that thousands of pension savings disappear into annuities. However, Elms warns: "This potential benefit will be reflected in the rates for protected value annuities, which could be notably lower."

The final option for savers is an "alternatively secured pension", which simply means taking an income directly from your pension fund, rather than bothering with an annuity at all. There will be limits on how much income you can take - broadly, you'll be allowed about as much as an annuity would offer - but your pension fund can remain invested.

This will be a risky option for anyone who is relying solely on their pension fund in retirement - the fund could fall in value and hit your income, for example - but the upside is that you will be able to leave any unspent savings to your heirs.

The money will have to be used to provide your dependents with an income, or if there are none, it can be bequeathed to anyone you see fit, though there may be inheritance tax to pay. Don't encourage your heirs to expect a windfall, however. The money must be bequeathed to their pension funds, so they won't be free to simply spend the cash.

Two action points that can't wait

Every time the Government overhauls the pensions system, there are people who lose out following the changes. Two groups are at risk next month.

The first potential danger lies in the new rule that all pension savers will be entitled to take up to 25 per cent of their funds as a tax-free cash lump sum once they reach retirement age.

While this simple rule is good news for most people, some savers are currently entitled to take more than this, in which case they could be losers.

Those most likely to be affected are people on high salaries and those who have been members of a pension scheme since before 1987. If you think you might be caught by the rule, check with your pension provider. You can get an exemption, but only if you register your right to more than 25 per cent in advance with HM Revenue & Customs.

Second, from 6 April, there will be a lifetime limit on pension fund savings. Anyone with a pension fund worth more than £1.5m will face punishing tax charges on the excess savings, potentially losing up to 55 per cent of the money to the Treasury.

This cap will be increased each year, probably in line with inflation, but a surprising number of savers could be caught out. A pension fund worth £1.5m roughly translates into an annual retirement income of £83,000 for the typical pensioner couple and the charge applies whatever type of pension fund you have.

If your pension savings already exceed £1.5m, you can protect the money from the tax by registering it with the Revenue. In some circumstances, there may still be tax to pay, particularly if you want to continue contributing to a pension plan, but you will at least be able to reduce the final bill.