Lump Sum conversion calculations

islandcat

Hi
I am in the Local Govt Pension Scheme and have just taken flexible retirement.

My benefits notification letter came today and I can't work out their calculations and would appreciate any help.

My standard benefits ( No conversion) are
Pension £13685 Lump Sum £35411

The letter goes on to state that I can convert sum of my pension to lump sum, £12 tax free cash for every £1 a year of pension that I surrender.
The max tax free lump sum is 25% of my "personal fund".
This personal fund is calculated by multiplying my annual pension by 20 and then add the standard lump sum payable from the scheme.

I have worked this out as max lump sum of £77278 with a reduction in my annual pension.

The council say this is wrong as the original (standard) figures have changed and you have to go through the whole calculation again.
their figures are £ 10694 pension and £71297 lump sum and the formulae they use is:
Max TFC=[((Standard TFC/12)+Standard Pension)x20]/[3+(20/12)]

where 12 is the conversion factor.

The conversion details in the letter seem quite straighforward to me but I am at a loss to understand their formula.

Any help appreciated as I will have to give notice of my intentions in the next few days

thanks

Zelazny

The complication is that the law says that you cannot take more than 25% of the "value" of your benefits as cash, and they count each pound of pension as being worth £20 of cash. The thing is, your scheme values it differently and allows you to get £12 of cash for every £1 of pension that you give up.

If you did things your way, you'd get:
Total fund value: 13685x20 + 35411 = 309111
25% of fund value = £77,277.75
Which means lump sum of 35411 and commuted pension to get a further 41866.75.
This means commuting 41866.75/12 = 3488.90 of your pension
This leaves a pension of: 10196.10
But when we check this, the pension "value" is 203922 and the cash sum is 77277.75. In this case, the lump sum is 27.48% of the total, which means that part of the tax free cash would be an unauthorised payment, and subject to tax at 55% (in addition to the scheme facing a scheme sanction charge).

The derivation is a little complex, but the formula that they give should give you a 25% tax free cash sum.

Checking: 10694 x 20 + 71297 = 285177
cash as %: 71297 / 285177 = 25.001%

Which is fairly close (and likely closer if we had more exact figures - I'm assuming there's a few pence involved as well).

Zelazny

Derivation is as follows:

terms used:
Max cash that can be taken = cash
addn_cash = lump sum in addition to your benefits
Full unreduced pension = full_pen
Pension to be commuted to provide cash = comm_pen
Remaining pension after commutation = resid_pen
(so: full_pen = comm_pen + resid_pen)
Commutation factor = CF
so: cash = addn_cash + (comm_pen x CF)

what we want is for the residual pension "value" to be 3 times as much as the cash "value", so:
20 x resid_pen = 3 x cash

but resid_pen = full_pen - comm_pen
and comm_pen = (cash - addn_cash)/CF (from rearranging the equation above)
so:
20 x (full_pen - [(cash - addn_cash)/CF]) = 3 x cash
expanding and rearranging gives:
[20] x (full_pen + [addn_cash/CF] - [cash/CF]) = 3xcash
divide both sides by 3 and move the cash over to the right:
[20/3] x (full_pen + [addn_cash/CF]) = cash x (1 + [20/(3xCF)])
so:

cash = ([full_pen + (addn_cash/CF)] x 20) / (3 + [20/CF])

as listed in your original post.

islandcat

I knew it wasn't going to be simple !!

Many thanks for taking the time to explain it all to me, no wonder the layman (me) has difficulty understanding it all.

I can now move forward with this.

Kind regards

Zelazny

Calculating the benefits available to people on retirement used to be a fairly large part of my job - it's no trouble :-)

RichandJ

islandcat wrote: »

I knew it wasn't going to be simple !!

Many thanks for taking the time to explain it all to me, no wonder the layman (me) has difficulty understanding it all.

I can now move forward with this.

Kind regards

Believe me, there are some pension administrators who have difficulty with it as well. This calc was part of the last governments pensions "simplification" regulations.

Thanks to Zelazny for laying it all out.

Cash-Cow_3

Am I right in thinking that a 1 in 12 conversion rate is really, really bad?

Linton

Yes - if you invested the cash in a commercially available inflation linked annuity you would need something like a 1 to 30 conversion rate to get an equivalent income.

Zelazny

Cash-Cow wrote: »

Am I right in thinking that a 1 in 12 conversion rate is really, really bad?

Depends how you mean. In terms of comparison with an annuity, then perhaps (to buy an annuity you'd be looking at spending a lot more than £12 per £1 of pension - so selling it back at that rate does seem less than ideal), but compared with other pension schemes it's not that unusual. Also bear in mind that you're not usually reducing the spouse pension by taking cash - that's normally based on the full pre-commutation pension.

The scheme actuary will base these figures on the long term projections of the scheme funding. In theory the cash should be about equivalent in value to the pension, based on the assumptions that they've used.

Looking at the value of returns, if your investment return is 7% per year and your pension increases at 3% per year, the pension is only better after about 15 years (assuming pension is invested as it's received, and comparing the situation with the cash all being invested) - so it's not actually that bad. It gives people a lot of freedom to pay off mortgages, treat themselves to a holiday or whatever - and a good 95% of people seem to take the maximum cash, from what I've seen.

I'm not saying that it's better to take the cash, mind - just saying it's not as bad an option as the 12:1 immediately makes you think.

islandcat

I will have to state my intentions to the Council's pension dept on Monday.

From speaking to colleagues and close friends who have retired, and my bank, they suggest that it is best to take the maximum in tax free that is possible.

that would let me pay off my mortgage and would then be debt free apart from daily living expenses. I have no spouse.
I will be investing the bulk of the remainder and planning my forecasts on a 4.5% return. I will max on ISAS and also leave an emergency pot of about £10k.

As I am still working 50% I have worked out with my pension, salary and return on investment, I should be about £200 better off each month than when I was working full time.

Hope my calcs work out.

Many thanks all for the commentary.

Regards

jem16

islandcat wrote: »

From speaking to colleagues and close friends who have retired, and my bank, they suggest that it is best to take the maximum in tax free that is possible.

I think nowadays that depends on what you intend to use the cash for.

that would let me pay off my mortgage and would then be debt free apart from daily living expenses. I have no spouse.
I will be investing the bulk of the remainder and planning my forecasts on a 4.5% return. I will max on ISAS and also leave an emergency pot of about £10k.

Have you considered just taking enough cash to pay off the mortgage and give you an emergency pot?

As I am still working 50% I have worked out with my pension, salary and return on investment, I should be about £200 better off each month than when I was working full time.

Are you needing the extra income from the investment returns? If so you would require a return of 8.33% to match what you are giving up pension wise.