Small Final Salary pension.

ed123_2

I have just had a forecast for a small final salary scheme ('87-'92 early retirement). £3800 full pension or £2600 reduced pension plus £17,636 tax free lump sum.
I have had previous estimates over the years which appear to drop quite considerable:- '92 £5905,'96 £6300, '99 £5808, '02 £5200,'07 £4,824, '10 £3894. My question is why is it decreasing ie I thought that a final pension was based on years of service and final salary? (although they state it can be affected by market conditions, annuity rates etc)
It would appear it better to take the pension now as the forecast decreases over time?
The cash lump sum /reduced pension appears to be the better alternative as the break even point is 15 years and the present day value of money now is greater now plus I intended to place the money in a five year savings account-4.52% gross).
Any ideas?....thanks ed (nb posted earlier in error but I don't know how to remove it!!)

PhishFood_2

Hi there

Most of the elements of a FPS pension are fixed when you leave service eg. the salary the benefits are based on, the normal retirement age, the length of service BUT there are elements that change during defferment (sp?), mainly the revaluation element.

Each year the government produce statutory revaluation factors and these vary with economic conditions (specially CPI and RPI index).

So each time you receive a projection of benefits they will have been revalued up to the quote date using the statutory factors and then from quote date to your retirement date using an estimate for future revaluation. The closer you get to your retirement date then the more accurate the projection will be as there will be a smaller element of estimated revaluation.

Hope that made sense?

With regards to taking lump sum over a higher pension, it really is a gamble. Most people take the lump sum as it appeals and it's nice to have a lump sum - personally if I were in good health in retirement and didn't need a lump sum then I would opt for the higher pension but then my grandparents both lived to 98 so thinking long term!!

jamesd

The commutation rate is 14.7:1, £14.7 Pounds of lump sum per Pound of ongoing income lost. Bad deals are 12 or lower, good are over 20. Yours is a pretty poor deal for taking more lump sum.

Your calculation for the break even time seems to be 17636 / 1200 = 14.7 years to break even. A better way to approach it is 1 / 14.7 commutation rate *100 = 6.8% interest plus inflation needed to match the increasing value of the income. Say 9-10% depending on inflation. That's because you need 6.8% interest on the 17636 to get the 1200 of income you're giving up to get the lump sum. Plus inflation to keep that value increasing over time as the pension payments will.

You're not going to get that say 9-10% from savings accounts and it's a bit high even if you were using investments. So it looks as though the lump sum isn't a good deal.

If you had a commutation rate of 20 you'd need 5% plus inflation. That's a lot closer to being doable.

If your health isn't normally good then the lump sum might still be a better idea.

An alternative to taking a lump sum from the pension is to increase a mortgage or increase its term. The cost of the mortgage interest is small compared to the 9-10% value of the income from not taking the lump sum. This would get you the lump sum and you'd also get 9 to 10% minus the mortgage interest rate and repayments as extra income. Since it's long ter you'd go with a 25 year mortgage to keep the repayment part as low as possible, so the long term increase int eh value of the pension comes into play.

HappySeagull

Taking the lump sum is a bit like taking out a loan.
You then gradually repay the loan, by taking a reduced monthly pension.
Unlike a fixed-term loan, however, the repayments continue until you die.

(At least, that's my rationale! Is it too simplistic?)

jamesd

It's not too simplistic. It's part of why I compared it to a mortgage, which at least does have an end date and is a cheaper way to get the lump sum in most cases.

ed123_2

Thanks for the replies, all good information. I've just thought of another factor-tax. The £1200 would attract a 20% rate bringing the difference down to £960.Although with a net rate of 3.62% on a five year savings account giving £638 this leaves a shortfall of £322pa. Another factor is my health is not to good and my parents passed away aged 66 and 67. (although the later may have no bearing on my lifespan). Thanks ed