Pension - lump sum commutation?

monty_pylon

Hi
I'm thinking of early retirement, taking my PCSPS Classic pension at 59 in 3 years time, when it would be worth c14000, less 5% early deduction, while the lump sum of 3x pension is cut by 3%. As we have quite a large savings pot (mainly ISAs) I am looking at reverse commuting the lump sum into pension - I understand this would be at the rate of £4.61 per £100 of lump sum, based on my age and taking the widow's option. I'm not sure if the starting lump sum amount would be reduced by 3 or 5% though.
Also while a return of 4.6% looks good value (index linked as well), adding say £1835 to my pension, as pension that would be taxed while the lump sum is tax free. Any thoughts on whether it would be better value to take the lump sum and invest?

jamesd

The index linked 4.6% is good compared to an annuity. The FTSE All Share Index has averaged 5.2% plus inflation for the last hundred plus years so it is possible to beat it, but at the cost of taking investment risk. One significant benefit to investing is that the lump sum would be inheritable and that will matter to some people.

A lower risk way is to take the higher income and then invest perhaps half of the extra income to accumulate a lump sum. The safety of the guaranteed income plus the lump sum accumulation, but at a lower level that won't ever actually catch up.

Taking it early is likely to be a bad idea. You can almost certainly borrow money to live on more cheaply than the loss from taking it early. And since you have a large savings pot no borrowing might be needed. An offset mortgage or equity release mortgage where you can draw on it as needed is another good way to handle this for those without ample savings. Take the money from the mortgage for income, then repay with some of the increased income from taking the pension at the normal date instead of early.

Taking the widow's option might be a bad idea. Depends in part on how much it costs. You could instead not take that option and invest say 75% of the extra payment to provide a lump sum that the widow can use for extra income, but which alternatively is inheritable if not all used, or if the putative widow dies first.

Between the work pension and the state pensions you will have more than £20,000 of guaranteed income. This means that you will qualify for Flexible Income Drawdown. That lets you take out 100% of a personal pension pot at any time. The usual 25% tax free lump sum, the rest is added to your taxable income for the years in which you take it. This can make personal pension contributions a wonderful deal because you get the tax relief but not the pension restrictions. Given apparently ample savings you might seriously consider maximising your personal pension contributions until you retire, so you can maximally exploit this.

Note that the income has to be actually in payment to meet the flexible drawdown test, so you wouldn't be over it until state pension age. Until they you could use capped income drawdown instead. That lets you take out around 5-6% of the capital value a year, increasing as you get older to perhaps 20%+ at 85 and above.

kidmugsy

Will your wife be retiring at much the same time? Will her pension be big enough to make her an income tax payer?

monty_pylon

kidmugsy wrote: »

Will your wife be retiring at much the same time? Will her pension be big enough to make her an income tax payer?

Kid, my wife is 55 & can't pick up her teacher's occupational pension (£4-5k) until 65, state pension at 66. So she will be borderline taxpayer. At the moment that's one of the main weaknesses of our retirement planning if I pop my clogs early. Hence thinking about the commuted lump sum with widow's protection. For the non-widow's option I would get £4.79 per £100 of lump sum (£1911
instead of 1835). Are there advantages to her being a non-taxpayer, we were thinking more of boosting her retirement income but so far that's been more ISA than pension based.

kidmugsy

monty_pylon wrote: »

Kid, my wife is 55 & can't pick up her teacher's occupational pension (£4-5k) until 65, state pension at 66. So she will be borderline taxpayer. ... Are there advantages to her being a non-taxpayer, we were thinking more of boosting her retirement income but so far that's been more ISA than pension based.

It's tempting to use your wife's unused personal allowance by taking a pension income (e.g. by "income withdrawal" aka "income drawdown"). The point is that you get a 25% boost on the money you contribute, but pay tax (while a non-taxpayer) at 0%. If your wife will be a non-taxpayer until she's 66, you then have to work out how much to contribute for her. Is she earning at the moment?

monty_pylon

jamesd wrote: »

Taking it early is likely to be a bad idea. You can almost certainly borrow money to live on more cheaply than the loss from taking it early. And since you have a large savings pot no borrowing might be needed. An offset mortgage or equity release mortgage where you can draw on it as needed is another good way to handle this for those without ample savings.
Between the work pension and the state pensions you will have more than £20,000 of guaranteed income. This means that you will qualify for Flexible Income Drawdown.

James, thanks for your detailed reply, lots to think about there - I thought it was a simple case of lump sum vs pension! Looks like a trip to an IFA is needed.
Re savings, I should probably have said the pot is adequate, 260k which would certainly yield enough to top up our total pensions at 66, to a target figure of c30k. Might not be enough to cover several years of little or no earnings though, although I plan to run my own business instead, but on a part-time basis to bring in say £5k pa.
Re Mortgage, it seems counter-intuitive having paid off our endowment mortgage a few years ago (kept the policy, worth c£15k in 2016) to then enter into another mortgage at 56? What sort of mortgage would be appropriate, what sum should we borrow, and for how long? The house is probably worth £280k.
Finally Re pension, I have a tiny FSAVC although I suspect this was mis-sold as I'm sure it would have been better value (15 years ago) to top up my Classic Pension. In any event you seem to suggest additional pension could be advantageous, possibly more so for my wife who has lower provision?
Thanks again for your help,

monty_pylon

kidmugsy wrote: »

It's tempting to use your wife's unused personal allowance by taking a pension income (e.g. by "income withdrawal" aka "income drawdown"). The point is that you get a 25% boost on the money you contribute, but pay tax (while a non-taxpayer) at 0%. If your wife will be a non-taxpayer until she's 66, you then have to work out how much to contribute for her. Is she earning at the moment?

Thanks - she works regular part-time hours, net c£1300 pm and would probably need to continue working both for income and pension building, until I collect my pension. If I take my 14k pension at 60, we could earn 10k between us, add add 6k from savings to achieve our target income. At that point she would be 58 and earning say £5k.

kidmugsy

monty_pylon wrote: »

If I take my 14k pension at 60, we could earn 10k between us, add add 6k from savings to achieve our target income. At that point she would be 58 and earning say £5k.

In four years time she'll be 58 and earning £5k. So there will be unused personal allowance of probably £5k or more. So there would be a real advantage in her building up a SIPP so that she could start to take drawdown income at 58. She should consider contributing up to the maximum, even if that would mean your putting capital into it from (especially) your un-ISAd savings. She's allowed to make a maximum annual contribution gross of a sum equal to her earnings (that's pay, not interest received) minus her contribution to other pension schemes. She multiplies that gross amount by 0.8 to find the net amount to contribute. The pension company claims the tax rebate from HMRC. So, for every £ she's contributed there is £1.25 in the fund after that tax rebate is received. Now the beauty is that when she "crystallises" the pension, she gets a lump sum of 25% tax-free, plus the amount of pension income that she elects to withdraw each year. That pension income will be set against her otherwise unused personal allowance so she gets that income tax-free too. It's only when her main pensions kick in at 65 and 66 that she'll have to start paying income tax.

The main disadvantage is that it's hard to tell exactly how much income she'll be able to draw each year. Firstly you don't know how much her pension pot will grow (or shrink) and secondly you don't know what the government's GAD limit will be. Still you might consider it an attractive use of your unISAd savings.

jamesd

monty_pylon wrote: »

I should probably have said the pot is adequate, 260k which would certainly yield enough to top up our total pensions at 66, to a target figure of c30k. ... Re Mortgage, it seems counter-intuitive having paid off our endowment mortgage a few years ago (kept the policy, worth c£15k in 2016) to then enter into another mortgage at 56? What sort of mortgage would be appropriate, what sum should we borrow, and for how long? The house is probably worth £280k.

How much of the savings is outside ISAs or other tax wrappers?

I'm not sure that any mortgage use is needed in your case. Partly that'll depend on where the money is. Partly it'll depend on the required after tax income level and how much of that is coming from inside tax wrappers and how much outside.

An offset interest only mortgage is ideal for this, with one option being repayment from the work pension lump sums at normal retirement age. Next best would probably be interest only equity release, the type that allows variable drawing as needed, and repaying as appropriate. Then perhaps a long term repayment mortgage as next option, with a term ending at 85, the longest currently available. But you might have trouble getting the non-equity release types.

I'm a bit puzzled about needing a top off to circa £30k because even early yours work pension would be about £14,000 plus about £7,000 state pensions for you and her, taking your potential combined taxable income to £28,000 even without her own work pension.

monty_pylon wrote: »

Finally Re pension, I have a tiny FSAVC although I suspect this was mis-sold as I'm sure it would have been better value (15 years ago) to top up my Classic Pension. In any event you seem to suggest additional pension could be advantageous, possibly more so for my wife who has lower provision?

What is her anticipated income? In general I'm thinking of the flexible drawdown case, so she'd need £20,000 before I would think it makes most sense for it to be contributions for her rather than for you. If she will also be over £20,000 then whichever of you has the lowest income would be the best choice, or if it's similar, both of you. This is to maximise the amount of basic rate income available when taking capital out of flexible drawdown after the tax free 25%).

monty_pylon

jamesd wrote: »

How much of the savings is outside ISAs or other tax wrappers?


I'm a bit puzzled about needing a top off to circa £30k because even early yours work pension would be about £14,000 plus about £7,000 state pensions for you and her, taking your potential combined taxable income to £28,000 even without her own work pension.

What is her anticipated income? .

Thanks for the additional info. The savings breakdown is 48% cash ISA, 19% S&S ISA, 6% S&S, 26% cash. Of the S&S ISAs though, I have 43k, while OH only has 5.5k. The non-ISA S&S are jointly held. We recognise the large cash holding, this includes several fixed interest acc due to pay in 2016 at 3.5-5%, plus NS and 20k in Santander.
Re pensions, my pension is currently worth 13.5k, if I stay to 60 it would be 15.5; I have pitched it inbetween based on when I hope to leave. All these figures are before tax and without commuting the lump sum. My figure was £14k minus 5% early reduction less tax, = £12640.
Obviously I need to do some homework on the state pension as I had it in my mind as £5700, if its £7k each that will certainly help. Presumably the difference is the second state pension element.

My wife is unlikely to earn over 20k as she approaches retirement

jamesd

If the non-ISA money is sufficient then using that is sensible. Not impossible to justify taking money or income out of ISAs but that's probably worse than taking income from a pension pot.

I assume your pension commutation rate is poor, perhaps 12:1 or 16:1, when actuarially neutral is more like 28:1. So it usually does make sense not to take the lump sum from final salary pensions.

The basic state pension is more like £5700 but there is also the potential additional state pension and the proposed flat rate pension to consider. A state pension statement for each of you might at least tell you the current additional state pension entitlement.

Given the increase in pension from not taking it early I'm inclined to go with savings and borrowing and normal retirement date, then repaying using perhaps half of the higher income. That way you get half of that as more income and then ongoing higher income once any borrowing is paid off. I'd probably prefer borrowing to taking money out of the ISAs because of the loss of tax relief. But it seems that you're unlikely to use the full ISA allowance each year after retiring, so this matters less in your case, I think. Which might favour taking money out of the ISAs instead of borrowing.

But even so, I might prefer some borrowing so that the ISA lump sum remains available to cover the unexpected.