Is Civil Service Inverse Commutation a Good Deal?

Steve489

I'm in the Civil Service Classic Scheme and I'm about to claim my pension at age 60. I can give up some or all of the lump sum for a higher annual pension. The conversion rate at age 60 is £5.06 gross per annum additional pension for every £100 lump sum given up. I have no immediate need for the lump sum.

The resulting pension is uprated annually by the CPI unless the politicians change the rules again.

I expect to be a higher rate taxpayer for most of my retirement. In this situation and assuming reasonable rates for CPI (2.5%) and investment return (4%), the break even age is my early 90s.

I'm inclined to give up only about 1/3 of the lump sum in case I live to a ripe old age.

Have others faced with a similar decision chosen to to take up the inverse commutation option and do you think it is a good deal?

kidmugsy

Steve489 wrote: »

I'm in the Civil Service Classic Scheme and I'm about to claim my pension at age 60.

So your old age will be funded in pretty much its entirety by HMG. In your shoes I'd be tempted to diversify by taking the lump sum and investing in foreign equities, gold bullion, TIPS, and other stuff that doesn't depend on HMG to hold its value.

jamesd

Ignoring tax the 5.06% inflation-linked annuity equivalent is quite a good deal vs purchasing an annuity. But the tax can't be ignored and reduces the value by 40%.

The most obvious alternative is to take the lump sum and invest it via a stocks and shares ISA then use it to generate a tax free income that way. Long term returns for the UK stock market are about 5.1% plus inflation less perhaps 0.5% costs so you on average should expect to be able to beat the increased pension value after tax.

The forward commutation rate is probably too dire to consider increasing the lump sum beyond the base level, unless your health is less good than average or you have a desire to increase the provision for others after your eventual death.

Because of the tax effect and not particularly challenging to beat investment target my inclination would be to take the normal lump sum and go the ISA route, perhaps with some limited use of VCT investing.

Depending on your other objectives possibly some additional commutation, perhaps to take your pension income down to the basic rate level but no lower.

Steve489

The rate for trading annual pension into a higher lump sum is 12:1 i.e. £12 lump sum for every £1 pension given up. Many forum posts consider this to be a poor deal.

jamesd

It is a poor deal as commutation rates go. One of the lowest around. Standard advice is don't do any commuting at that rate and that is almost always correct within the basic rate tax band.

However, some of your income is taxed at higher rate and you might have other objectives that make it a better choice for you to accept that commutation rate. Maybe to get tax free income now that is inheritable on your death or a desire to have the capital available for use while you're alive.

Say you were to commute £5,000 at 12:1, that would get you a lump sum of £60,000. After higher rate tax the £5,000 income drops to £3,000 net and that is the target you have to at least match in an ISA to break even on current income terms. £3,000 / £60,000 * 100 = 5% and that's just 0.1% below the long term average investment return of the UK stock market, after deducting inflation. So not a bad deal in your specific higher rate tax range if having the money either available for potential use or inheritable matters to you.

What that means is that for the higher rate portion of your income the tax rate makes it not as bad a deal as it usually is to do normal commutation. And of course this helps to explain why reverse commutation is not a good idea - you can probably do better after tax and keep the flexibility of having the money.

You can also consider whether you can simply defer some income or get a tax break along the way to the ISA for a lump sum by using investments inside a Venture Capital Trust. Those get you 30% tax relief up front that has to be repaid if you sell within five years. Tax relief is capped at the amount of income tax actually paid each year. Dividend income is tax free and levels of around 5-6% are readily available, translating to more like 8-9% after allowing for the effect of the initial tax relief on the capital amount invested.

VCTs are quite high risk as investments go because they invest in smaller companies, so you wouldn't want a huge part of your investments in them but they are a useful tool for those with appropriate circumstances to use to save tax and use them as part of their investment mixture. I don't know enough about your risk tolerance and other assets to know whether they might be suitable for you.

I don't know just how far into higher rate your income will be but the difference between higher rate and basic rate or nil rate is significant and it's worth looking to see whether it's sensible to arrange to cut your taxable pension income level down to basic rate only. The tax difference provides the payback that can make it worthwhile.

Steve489

Thanks for your advice.

According to the Civil Service Pensions Calculator, I could give up a maximum of just over £5000 pension to generate an additional c.£60000 lump sum. However, that would not not reduce my overall income below the higher tax threshold especially when the state pension and a significant expected inheritance are considered.

My risk attitude is cautious - I have c. 60% of my assets invested in cash (fixed term bonds, cash ISAs & RPI linked NS&I bonds). The remainder is invested in a variety of income unit trusts, European & international growth unit trusts, corporate bond unit trusts and a small share portfolio.

On balance, I'm tempted to claim the pension as quoted i.e. pension plus lump sum equal to 3x pension, with no inverse commutation.

jamesd

Your balanced approach seems reasonable. It's nice and safe with the government behind the pension income portion that you take.

For the base lump sum you seem to have sufficient capital and income to consider a somewhat higher risk level for at least some of the new money.

kidmugsy

Steve489 wrote: »

According to the Civil Service Pensions Calculator, I could give up a maximum of just over £5000 pension to generate an additional c.£60000 lump sum.

That's such lousy value I'd just take the pension. If you like, consider income tax avoidance using VCTs and EISs. It's also permitted to give to charities.