Don’t cash your pension lump sum until you’ve read this

A lot of people are giving a lot of thought to whether they should take tax-free cash from their pensions ahead of the November Budget. I think this may not be the best use of their time.

Back in 1998, Richard Carlson wrote a wildly popular self-help book called Don’t Sweat the Small Stuff. The success of the book relieved him of the need to worry about trivial things in his own life. For the rest of us, too, it was a useful guide to putting life into perspective - including our financial plans.

I’m not dismissing the concern that many people have about the impact of the Budget on their retirement planning. And I think it is unhelpful that the door has been left open for so long to rumour and speculation. But I suspect that the focus on a pension raid is a distraction from bigger issues on which investors would be better to focus their attention.

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There might be merit in pre-empting the Budget in a few specific circumstances. For example, if you already had plans to use your tax-free cash to pay off debt, to help out family members, to bridge a gap between early retirement and the state pension age, or to pass money to a spouse. If you were going to take the cash anyway, then you might think it makes sense to do so before the possible removal of the opportunity.

But pensions are a very tax-efficient savings vehicle, so taking money out without a plan would not be sensible. At the least you should be recycling unused money into an ISA as fast as possible to retain the tax benefit. Worse still would be to conflate concerns you may have about the level of the market with the tax-free cash question. If you simply want to de-risk your portfolio, then this is easily achieved within a pension by moving money into cash or a money market fund.

There is absolutely no certainty that Rachel Reeves will target tax-free pension cash in the Budget. A retrospective raid on retirement savings may be a political risk she is prepared to take. But it would be damaging. I wouldn’t do it, but I’m not the Chancellor.

• Read: What can we expect in the Autumn Budget?

Let’s assume that the need for cash justifies the political gamble. Then we need to consider the likely scale of the attack. One possibility doing the rounds is a reduction in the maximum amount anyone can take tax-free from their pension from the current £268,275 to £100,000. Let’s work with that.

For most people this will make no difference at all. The average pension pot for people aged 55-74, according to the Office for National Statistics, is about £140,000. Perhaps the fact that you would need a pension pot of more than £400,000 to be affected by the mooted reduction makes it more, not less, likely.

If you do have a pension pot above this level, you need to decide whether the potential cost in terms of extra tax is worth acting on. At the upper end of the range, if you are lucky enough to have a pension pot worth £1.1m or more, the amount of tax-free cash that you might be able to take would be reduced by £170,000. On the assumption that you will try to manage your income in retirement to minimise your tax liability, the cost to you of any raid could be a fifth of this, or £34,000.

That’s not an insignificant amount of money but if you are in the fortunate situation of having a million-pound pension pot, it is possibly not the most likely way that you could be relieved of that sort of sum. Last Friday’s 2.7% dip in the S&P 500 index, after President Trump rekindled the smouldering US-China trade war, might have single-handedly wiped almost as much from an undiversified pension pot of that size.

I would argue that the more pressing imperative for an investor with a big pension is not to second guess an unpredictable political decision but to ensure that their investments are future proofed against market risk. A bear market would have a much bigger impact on the value of your retirement savings than tinkering by a cash-strapped government.

As investors, we have a tendency to equate big with important. We should avoid this. Any piece of information can be judged in two ways - its strength and its weight. Confusing the two can easily force us into either over- or under-reaction. For example, investors might attach little importance to a company cutting its dividend. The news has little strength, but it has more weight than the market assumes. Boards don’t change their dividend policy lightly.

Viewing a dividend cut in the way most investors do leads to an under-reaction. In the same way, a focus on a big, but in market terms unimportant, event like a regional war (or even a Budget) might lead to an over-reaction. Strength but no weight.

This is just one example of how investors tend to misjudge the significance of events. A related behavioural bias is over-emphasising the visible over the invisible, the tangible over the intangible. Inflation will probably cause more damage to your investments over time than any market correction. But you almost certainly spend less time worrying about it, because its delayed impact is harder to grasp today.

For the same reason, we have a tendency to overweight the importance of what is close to hand, in space and time. This leads to home bias in our investments and to an extrapolation of recent trends. Something to think about as the S&P 500 and the gold price hit new highs. Getting the big calls right, not sweating the small stuff, is what counts.

This article was originally published in The Telegraph.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.