3 June 2013

Should I ... take my pension lump sum?

Most pensions will provide the option of a tax-free lump sum when you start to take some benefits from it. And this is one of the more significant questions for someone approaching retirement.
 
There are pros and cons, of course, which will be different for each person. And in a short blog we can only really list the things to consider. Let's look at Defined Contribution (money purchase) and Defined Benefit (final salary) pensions separately.

Defined Contribution

Most pension plans will offer you the standard 25% tax-free lump sum when you take some pension benefits.
 
Here are the pros...
  • you get a tax-free lump sum to spend
  • you could invest it and potentially get a higher income than you might by buying an annuity (depending on a range of factors)
  • you could invest it and withdraw lump sums when required - it's good to have flexibility
  • you could invest it and buy a better rate of annuity later in life (perhaps when you are less healthy)
  • it's in your control
And some cons...
  • you get less income from your pension

Defined Benefit

Here the decision is rather different. It largely comes down to how much pension you are giving up by taking a lump sum, and that's down to the "commutation factor" which the employer offers - that's the level of tax-free lump sum which you get for every £1000 of annual income foregone. A typical commutation factor would be 15 - you give up £1,000 of annual pension income to get £15,000 of lump sum. The lower the factor is, the worse the deal on offer is.
 
So here's some pros...
  • you get a tax-free lump sum to spend
  • you may (just) be able to get a better income by investing it or buying an ill health annuity later in life - it depends on the commutation factor, but it's pretty unlikely
  • it's in your control
And the cons...
  • you get less income from your pension - in particular with a Defined Benefit pension you are likely to be losing out on inflation-linked increases in the income
There will always be non-financial considerations like how badly you want that world cruise, or the new conservatory, but one way of looking at the financial aspects is to do a simple spreadsheet of income received year on year by using each option.
 
... or you could always contact us to help you decide!

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