Investors reaching retirement are making some unwise decisions when it comes to taking a tax-free lump sum. Jenny Lowe looks at the consequences...

Rising living costs and rampant inflation are having a dramatic impact on the income available to those in retirement – that much is obvious – but what many retirees don’t expect is the value of their tax-free lump sum taking a hit.
Sorry to be the bearer of bad news. The ongoing economic turmoil has seen the average lump-sum payout at retirement plummet by more than 10 per cent to £21,500 since the financial crisis took hold in 2008.
A tax-free lump sum on retirement has long been one of the most attractive benefits of a pension, and one that is utilised by almost 80 per cent of retirees.

It is understandable that pensioners would want to enjoy the money that they have worked hard to earn, but the disadvantage of taking a lump sum is that monthly income could be dramatically reduced if it is not invested wisely.
At present you can take up to 25 per cent of the fund as a tax-free lump sum. The remainder is then used to either purchase an annuity – a form of investment that pays you an income for the rest of your life – or draw payments directly from the scheme as a ‘drawdown pension’.

Regrets? They have a few…
According to a recent survey by Prudential, some pensioners are beginning to regret the way they used the tax-free cash, with at least 10 per cent claiming that they had not fully understood the long-term impact that taking the tax-free amount would have on their retirement income.

Those retirees that use their tax-free cash to clear debts – 19 per cent paid off some or all of their mortgage or cleared credit cards or loans – have the right idea.

What is slightly more worrying, however, is the increasing number of people who are spending the money on luxuries and DIY, or even giving it away, potentially reducing the monthly income they get from their pension fund dramatically.

The days of buying a shiny new car or going on a once-in-a-lifetime holiday are definitely gone, replaced by making savings and investments with the lump sum to supplement the income that pensioners need to live comfortably during retirement – particularly when you consider that a personal pension pot of £80,000 could potentially be used up within the first seven years of retirement, depending on the household circumstances.

High inflation
Inflation as it impacts on pensioners is significantly higher than the average household, as their personalised ‘basket of goods’ includes many items that have increased more rapidly, such as food and fuel costs.

As many as two in five pensioners admit to living a ‘cautious’ retirement because they are worried about having sufficient long-term income. More than half of the 79 per cent who have taken a lump sum so far this year have put some of the money into a savings account, and just over a quarter invested in stocks, shares or investment trusts.
There does, of course, need to be a balance, and unsurprisingly many people actually want to spend their at-retirement lump sum in a way they have looked forward to for many years.

As is the case with the majority of things in life, there is no one-size-fits-all solution. For example, spending the money from a tax-free lump sum and taking a level annuity with the balance of your fund will effectively fix the level of your retirement income – and for some this may provide the stability that they need.

Others may wish to explore more flexible retirement products that take into account the effects of inflation. One thing, however, is abundantly clear – forget your dreams of how to spend that 25 per cent windfall for now and ask a financial adviser what options are currently on offer.

Jenny Lowe is a journalist with the Financial Times Group