A different 'taking a lump sum from a DB pension' question

Stay_Or_Go

Hello all, there have been many posts on the topic of DB pensions and whether it was worthwhile considering taking a lump sum and then a reduced pension, but mine is slightly different as I wondered what the thoughts were when the missing pension would not have received any inflationary increases due to the pension being from the early 1990's when guaranteed inflationary proofing could be extremely limited.

I'm lucky in that as a male I am able to take this pension at age 60 without actuarial reductions and I've been offered a lump sum which is just over 12 times the amount I'd lose annually from the reduced pension.

I've run the sums and the reduced pension (whilst I'm still around) would not impact us in any significant way - I've been early retired for the last 4 years and we're in as good a financial state as when we started. I have a good sum in cash and equities and those alone would get us to state pension age even if there was a significant drop in the markets now and little recovery from then on.

The main reason for taking the lump sum would be to leave as much as possible to my OH should I not be around during the early part of our retirement. We are both approx the same age and are in good health but I realise that on my death she will receive the same widows pension regardless of whether I take a lump sum or not, so in that case she would also have the income coming from the lump sum which would have been invested into ISA funds (something like VWRL) and would hopefully hold its own against inflation over the medium to long term at least.

I'd be doing this on the basis of my understanding that only pension in excess of GMP can be commuted, so my OH (and myself if I'm still around) will get the same amount of GMP increases regardless of my taking a lump sum or not. There really is zero chance of any discretionary company increases - if anything I can see the scheme falling into the PPF at some time in the future, so I'm thinking a commutation rate of 12 times is actually quite good for a pension with such lowly inflationary proofing.

[Edited to put in new lines that seem to have been lost.]

Shedman

I am also mulling over whether to take a tax free lump sum from my DB pension for similar reasons to your line of reasoning. Like you one of the factors to be taken into my considerations is that about 1/3 of my pension has no indexation.  I also like the idea of being able to leave a an additional sum for my wife on top of the widows pension if I pop my clogs early (as she only has a modest pension in her own right).  In my case the lump sum would be at a commutation rate of around 17-18 (so more generous than yours) and there would be no reduction in the widows pension.  

I've got about 9 months before I need to make the decision so I'm putting together some models to help me decide.. It'll be interesting to see what thoughts others provide.

Black_Cat2

Hi both, I've been trying to understand about DB pensions for some time and I see you both mention 'commutation' which I don't quite understand.  The statement I have says: "Death in deferment pension - Spouse's pension of 50% of revalued pension.  Death after retirement pension - 50% of member's pre-commutation pension at DOD" .   What does this mean? 

Dazed_and_C0nfused

I think it means the spouse gets what the pension would have been if you hadn't chosen to take a bigger lump sum.

So say standard pension is £10,000 but you give up (commute) £2,000 in return for a one off tax free lump sum of £30,000 and actually receive a pension of £8,000.

When you die your spouse gets a 50% pension but it is 50% of £10,000 not 50% of £8,000.

Black_Cat2

Ty for your answer dazed, much appreciated and I completely understand it now 👍

jamesd

It's also worth comparing to taking a CETV, transferring out and then using a combination of state pension deferral and possible annuity buying to get any guaranteed income you need. With private sector multiples often 35 or higher there's a lot of scope to become better off.

Say you and a spouse would each get £9,000 state pension. The increase from deferring for five years would be £2,610 each, £5,220 combined. In effect this provides a 50% spousal pension. It can also be more tax efficient because the spouse might have unused personal allowance. You'd substitute drawing £18,000 a year from the transfer capital while deferring.

The increase from deferring gets uncapped inflation increases using CPI. Private sector DB typically (mode) have a 5% cap and some with less r none.

Using this sort of approach people with DB income up to around £10k may be able to both match effectively guaranteed income and have around 45% of the lump sum left over. How much depends on the specifics.

For simplicity I've assumed everything is in today's money, meaning inflation is matched by interest or investment growth.

Stay_Or_Go

Shedman said:

I am also mulling over whether to take a tax free lump sum from my DB pension for similar reasons to your line of reasoning. Like you one of the factors to be taken into my considerations is that about 1/3 of my pension has no indexation.  I also like the idea of being able to leave a an additional sum for my wife on top of the widows pension if I pop my clogs early (as she only has a modest pension in her own right).  In my case the lump sum would be at a commutation rate of around 17-18 (so more generous than yours) and there would be no reduction in the widows pension.  

If your scheme has a similar derisory history of discretionary rates as mine then I'd definitely be very tempted to take a lump sum with a commutation rate of 17-18 times (provided of course the reduced pension was suitable for your needs). My wife does have a small DB of her own (which luckily is from the council so has much better inflation protection) and we are making voluntary NI contributions to get her state pension to the max, but there's definitely not enough between just those two to provide for her needs and so as with you I'm looking to see what the possibilities are.

I go between hot and cold on the 12 times that mine offers, and in my case there is also the fact that the DB pension guarantees that 5 years of DB pension will be paid out, which does to some degree mitigate the problem I'm trying to solve (i.e. my early demise). Taking a lump sum would reduce the value of that guarantee (as it would only guarantee to pay out 5 x the reduced pension) and so needs to be considered.

jamesd said:

It's also worth comparing to taking a CETV, transferring out and then using a combination of state pension deferral and possible annuity buying to get any guaranteed income you need. With private sector multiples often 35 or higher there's a lot of scope to become better off.

Unfortunately my CETV multiple is only 24 so I'm 90% decided that I should keep my sole DB pension as I doubt that I could use the CETV to get safely to a guaranteed income (with some inflationary proofing) near to the DB income (though I will be double checking), whereas the DB pension can help as a diversifier from my DC pension/other investments (which are approx 3 times the amount of the CETV), especially as a means to derisk to some degree the early and possibly middle parts of retirement depending on inflation. However as the lump sum would come from the non-GMP part of the DB pension I did wonder whether that part of it would be worth taking as it would have no impact on the widows pension.

This would all be easier if I knew what the inflationary outlook over the next decade was and whether I was going to pop my clogs early!

Stay_Or_Go

Shedman said:

I've got about 9 months before I need to make the decision so I'm putting together some models to help me decide.. It'll be interesting to see what thoughts others provide.

Hi @Shedman if you don't mind me asking I wondered what your current thoughts on this were.

At present I'm 70% sure that I will take the lump sum as I plan to invest it into our S&S ISAs and use the tax-free returns to subsidise what I'll lose out on by sacrificing some taxed pension income. Initially I'll be a bit down by doing it this way, but the returns from the invested lump sum will hopefully rise by inflation over the longer term whilst the sacrificed pension component will always have remained at their original value (because they rely on discretionary increases which have not been applied since sometime close to the millenium). Then on my demise my OH will get the same spousal pension as she would have received if I'd taken the full pension + whatever the lump sum is then providing.

I'm 25% thinking of simply taking the full pension (despite 50% of it having zero inflationary proofing) as the DB does make a good diversifier from the big chunk of DC pension + S&S ISAs we currently have. My main reasoning is that having the full DB pension (even with zero inflationary increases in the first 5 years and then little afterwards) may come in useful with avoiding issues with a poor sequence of returns should there be a prolonged market downturn in the early part of my retirement.

Then finally I'm 5% thinking of looking into taking the CETV (which is 25 times the gross pension at 60). My main  reason for this is that I would not be surprised should the pension scheme enter into the Pension Protection Fund at some point in time - in which case the pension would receive no further inflationary increases at all because the pension is built entirely from pre-97 pension contributions.

TVAS

STAY where you are the CETV of a factor of 25 times the gross pension at 60 represents poor value.

If you are saying the commutation factor is 12:1 i.e.£12 cash for every £1 pension given up it is poor value to commute to cash. A good commutation factor is 20:1 and over. 

You have not said how long you have to 60 nor have you said if the company are making additional contributions to address the scheme deficit. The performance of the company is key as they are the sponsoring employer of the pension scheme. So if they are doing badly then the scheme may go to PPF. If the company are doing well and they have profits they can pay an additional contribution over a certain period or transfer their liability to an insurance company or other provider by sending them a big phat cheque. This is cold a Bulk Buy out.

At 60 the provider would pay your benefits as per the scheme rules and your entitlement. This is a competitive market and sometimes the new provider can offer you enhanced benefits, such as escalation on the whole pension in payment or an additional pension if the money they receive from the scheme trustees enables them to provide such enhanced benefits.

jamesd

For spousal protection, why not take the higher pension and use that to fund life assurance?

For low CETVs with no flexibility or health needs, comparing how much state pension deferral could be paid for is worth doing. You can decide the spousal split by having one person defer more than the other. State pension deferral for the first year costs about the same as 17.2 CETV multiple and gradually gets less good over time, but no spousal benefit. Uncapped inflation increases using CPI.

Marcon

TVAS said:

You have not said how long you have to 60 nor have you said if the company are making additional contributions to address the scheme deficit. The performance of the company is key as they are the sponsoring employer of the pension scheme. So if they are doing badly then the scheme may go to PPF. If the company are doing well and they have profits they can pay an additional contribution over a certain period or transfer their liability to an insurance company or other provider by sending them a big phat cheque. This is cold a Bulk Buy out.

If the scheme is in deficit, then a deficit recovery plan is a legal requirement, not some sort of option. The company doesn't just have to be 'doing badly' - it has to go bust before the PPF becomes a possibility. 

TVAS said:

If the company are doing well and they have profits they can pay an additional contribution over a certain period or transfer their liability to an insurance company or other provider by sending them a big phat cheque. This is cold a Bulk Buy out.

At 60 the provider would pay your benefits as per the scheme rules and your entitlement. This is a competitive market and sometimes the new provider can offer you enhanced benefits, such as escalation on the whole pension in payment or an additional pension if the money they receive from the scheme trustees enables them to provide such enhanced benefits.

No chance at all - the market isn't so competitive that the benefits would be bought out in line with the scheme rules and then the provider would kindly add in a bit more for people when they retire.

The 'competitive' bit would be the cost of buying out in the first place.The massive cost of buying out benefits makes it unlikely in the extreme that the trustees would be handing over any more cash than would be strictly necessary - it is likely that the employer would already have had to fork out a hefty top up just to get to buy out level (with the resultant dent to the employer's financial statements).