This week our reader wants to know the impact of early retirement on their finances.

Reader question:

I am considering taking early retirement this year – probably in April/May, depending on how quickly the pandemic comes under control: I’m hoping to do a lot of travelling in the early years of my retirement.

I’m age 63 so would be taking my pension three years earlier than I’d originally planned. I know I won’t get my state pension but would want to start taking my private pension.

Will starting it early make a big difference to how much income I’ll get from it?

Carl Lamb of Smith & Pinching responds:

The period just before you retire is a critical one: it’s when you must make some fundamental decisions about how you are going to fund your retirement and work out what you can afford to do.

It’s also a time when advice can make a huge difference.

Before being able to advise on your best way forward, I would need to know everything about your financial situation including the type and amount of pension entitlements you have built up.

Pensions come in two basic types.

A “defined contribution” (DC) pension is where you’ve built up your entitlements through contributions (including those from your employer, if it’s a workplace pension), tax relief and investment growth.

A “defined benefit” (DB) pension – such as you find in the public sector – is a workplace pension where your entitlements are calculated according to your salary and length of service.

If you have a DC pension, then you have choices about how you take your income. Broadly, speaking, you can buy an annuity or use income drawdown.

An annuity involves using the entire fund to buy a guaranteed income for life, but the terms cannot be changed and early retirement would indeed mean a lower income figure as your pot would need to stretch over more years.

Income drawdown lets you draw income directly from your fund, leaving the remainder invested for growth.

There are different ways of doing this but essentially direct withdrawals do allow you some flexibility in how much you take at a time, so enabling you to take more income in your early retirement years and less later.

However, the income is not guaranteed and, because the fund remains invested, the value can fall and so you must continually manage the investments to ensure the fund does not run out.

DB pensions may be less flexible: you would need to look at your scheme’s rules and ask for a pension forecast from your pension administrator to see the impact of taking your pension early.

This is very important, as the benefits available under a DB scheme tend to be very valuable and extremely costly to replicate.

If you are considering transferring out of your DB scheme, it is critical – and in fact required in most cases – to take advice.

In most cases, you will be entitled to take a portion of the fund or scheme benefits as a tax-free lump sum (“Pension Commencement Lump Sum”). It may be the case that this money could help fund your retirement plans before you start taking income.

If you take independent financial advice at this point, your adviser is likely to use lifetime cashflow planning to show the impact of different spending levels on your overall fund over time, using different growth assumptions. This is a really useful way of reaching an understanding of what your fund might be able to achieve.

Any opinions expressed in this article do not constitute advice. The value of your investment can go down as well as up and you may get back less than the amount invested.

The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.