Pension lump sum commutation factors

alanfp

I would value a little advice if possible …

My wife is retiring soon and has the option of foregoing some of her annual pension for a tax-free lump sum. We all like a bit of tax-free anything, but I’m not convinced about the commutation factor being good value.

The factor being offered is about 20. So basically, she can have her index-linked pension reduced by £2500 p.a. (or £2000 after tax) in order to take a lump sum of £50000. Looking at the annuity rates on the interweb for a 55 yr old female, a £50k lump sum should yield about £1200 for an index-linked annuity. So I think the lump sum looks very bad value – at market rates, it should be closer to £100k (or the reduction for the lump sum on offer should only be £1200 p.a.).

Am I missing something here, or is it an obvious choice to go for the full pension rather than the lump sum? (assuming she has an ‘average’ life expectancy). We have no immediate need for a lump sum - in fact I think she'd only try to spend it all at Primarche.

Secondly, would I be wasting my time discussing this matter with an IFA? They are supposed to be independent (the clue’s in the name) but I get the impression that generally, they are only interested in advising you to buy one of their products.

kidmugsy

Here's a way to look at it. Suppose she takes the bigger pension. How large a loan could that £2000 p.a. (net) service ? Suppose it's a cheap loan e.g. a mortgage secured on your house to age 75. If it could service a loan that's big enough to buy anything you might suddenly take the urge to buy, then you've not lost much by giving up the lump sum and taking the pension instead.

You can assume that it's a variable rate or tracker mortgage to compensate (more or less) for the pension being index-linked.

Or look at the current Index-Linked Savings Certificates on offer when rolling over an old issue. They yield just 0.25% above inflation. So on £50k you could look at that as £125 p.a. index-linked. OK they preserve your capital rather than your surrendering it, but still!

One last thing: consider your wife's life expectancy. Good health, good health record, long-lived family? Take the pension: she's only 55 after all. If you end up with surplus income you can always give it away free of inheritance tax!

kidmugsy

kidmugsy wrote: »

Or look at the current Index-Linked Savings Certificates on offer when rolling over an old issue. They yield just 0.25% above inflation. So on £50k you could look at that as £125 p.a. index-linked.

How badly I phrased that! I should have said that it's £125 p.a. index-linked plus the index-linking that preserves the value of your capital. But the intended point stands: it seems pretty small beer compared to a £2000 p.a. net index-linked income.

Zelazny

20:1 isn't a bad commutation rate. A lot of the government schemes offer 12:1, which is poor.

Annuity rates aren't a great guide as they're so low at present. Better to consider the returns on investment. Invest £50k and you should be able to get 4-5% returns over inflation with fairly low risk, meaning that you could get an income of £2k-£2.5k from the money (the key point being that there is still some risk, whereas the pension would be relatively risk free).

As such, I'd say it depends on two things - are there any big ticket items you'd like to buy right now or debts you can pay off (that attract more than 5% interest)? If so, I'd be inclined to take the lump sum. If not, then it's really somewhat academic - you should be about as well off either way.

bilbo51

Zelazny wrote: »

Invest £50k and you should be able to get 4-5% returns over inflation with fairly low risk...

7.6%? Where?

alanfp

Zelazny wrote: »

20:1 isn't a bad commutation rate. A lot of the government schemes offer 12:1, which is poor.

I know that her factors are better than a lot of schemes. If it was 12:1 I wouldn't even have to ask the question - we'd take the pension.

If she took the lump sum, we'd probably end up putting it in a deposit account and draw it down a few grand a year (but we'd have to keep moving it every 18 mths to get the best rates :mad:)

kph100

No expert but,

taking the £50k would give 20 years of £2500 pa.

Less than 20 years if 2500 ps increased by inflation.

So you have to way up the benefits of cash lump sum now to maybe not getting full benefits if life ended earlier, and availibity of cash for dependants ?