Lump sum versus pension

scottiescott

I can never get my head around how to work out commutation.
Here's my figures. I can currently get:


Full Pension 19 363
or
Lump Sum 100 357
and
Reduced pension 15 053


What would my pension be if I only took £60K lump sum?
What is the formula so I can play about with numbers?


Many thanks in advance.

ajbell

Should be £16784

jamesd

£19363 - £15053 = £4310 cost to get £100357 lump sum. Commutation rate: 100357 / 4310 = 23.28 which is the lump sum per Pound of income given up.

£60,000 lump sum cost in income is £60,000 / 23.28 = £2,577.32. So pension income would be reduced to £19,363 - £2,577.32 = £16,785.68. Rounding errors would account for the difference between the number given by ajbell and that.

You appear to be getting one of the best commutation rates seen these days, close to twice that of the major government pensions.

To match the income given up by investing you'd need to make 4.3% plus inflation. That's doable today via things like P2P and even the UK stock market has historically averaged a little over 5% plus inflation.

There's even a VCT, the Albion VCT, that is expected to pay out 10% tax free for almost 100% secured lending, with 30% of the purchase price returned by HMRC, capped at the income tax actually paid in the tax year of purchase. Has to be held for five years or the 30% has to be returned. Anticipated to be available for investing again in November.

Due to the excellent commutation rate and because the lump sum is tax free I'm inclined to suggest that you take the largest lump sum permitted by the scheme and invest it in a S&S ISA or P2P ISA from April, taking taxable income from it in the meantime. One advantage of this is that it will eventually provide fully tax free income while the money left in the pension provides taxable income. The lump sum is also fully inheritable as part of your estate while the money left in the pension either isn't or is used to provide a spousal pension that also eventually vanishes leaving no inheritance.

You might also consider the VCT use to get the money into a tax wrapper faster and generate the handy tax free ongoing income at a rate well above most mortgage interest rates.

As usual for lump sums it is unlikely to pay to take the lump sum and use it to pay off a mortgage because the equivalent rate is 4.3% plus inflation and few people have mortgages that are so costly. Likely to be better to invest the money and use the interest to pay the mortgage instead.

PensionTech

Personal question, scottiescott: how old are you?

scottiescott

Numbers based on next birthday (56).

jamesd

Is 56 the normal retirement age for this scheme or are you taking it early? The reason this matters is that there is usually a large reduction for taking the pension before the normal retirement age and it usually makes sense to use savings or borrowing instead of taking the pension before NRA. Then repay from the higher pension value after that.

Since you're 55 or older you also have the option of using savings or lump sum money to pay into a personal pension, capped at your earned income or £3600 gross each tax year. You can then take out 25% of the personal pension value tax free and the rest tax free, though taking any of the rest will reduce your money purchase annual allowance from £40k to £10k, something that doesn't happen if you take just the 25%.

scottiescott

Would be taken a 20% hit at 5% per year for taking pension 4 years earlier than my maximum years that I may contribute, i.e. 40.

xylophone

Would be taken a 20% hit at 5% per year for taking pension 4 years earlier than my maximum years that I may contribute, i.e. 40.

Are you desperate to retire at 56 and have no means of funding yourself unless you draw the DB pension with actuarial reduction?

jamesd

scottiescott wrote: »

Would be taken a 20% hit at 5% per year for taking pension 4 years earlier than my maximum years that I may contribute, i.e. 40.

There are two possible hits:

1. fewer years paying in so the 40/80, 40/60 or whatever becomes 36/80 or whatever. This tends to be a fair deal and worth doing since you get to stop work as well.

2. taking before NRA potentially losing an additional 5% a year or whatever the scheme says. This tends to be a poor deal because you can borrow money far cheaper than say a 20% cut to your income for life. Credit cards and such are cheaper, so are mortgages including equity release.

Is the 20% both of these things or just the second or just the first? How old is the normal retirement age for this scheme?

scottiescott

Yes, I would be taking pension at 36 years service on a 60ths scheme and therefore a 20% reduction.
NRA is 65 but would have maximum years contributions (40) at age 60. Went into the scheme at 20.
I am really keen to go at 56.
I know I would need £10k-£12k pa to live on but havn't done the sums regarding deferring pension and living off savings.

robin61

It's a difficult decision Scottie.

Nobody likes getting an actuarial reduction but on the other hand you get 4 years extra pension. The money you spend on living whilst deferring could be invested and gaining interest if you don't want to spend it.

But maybe you'd like more money to spend on enjoying yourself when you are in your 50's and 60's knowing you've got extra income coming with the State pension later?

Really it's all a gamble on how long you will live but taking the pension early might mot be a bad decision if the reduced pension is still enough to get by on comfortably. How much money do you really need when you are fast approaching 80 ?

I am wrestling with a very similar issue myself and all things considered I worked out that it could take the best part of 20 years for me to start making a profit on deferring. Calculating the break even point is not an exact science though - there are some variables such as inflation, return on investment etc.