Bridge the gap using DC scheme or actuarial reduction?

OldSmithy

Long post - sorry!

I realise this is a very first world problem/plan I’m trying to resolve but as part of my pensions planning I think I’ve assumed something which I may wish to completely reconsider and would welcome any views.

To start with, figures I use are at today’s rates so please ignore inflation and also exclude tax which I’m happy with for the purposes of illustration and to just test my theory.

I have been in the very fortunate position of having relatively long service in a DB pension scheme (now deferred and I pay into a works DC scheme) and although my other half is part-time she continues to accrue benefits in a DB scheme and has a personal SIPP. We have been trying to maximise our annual DC/SIPP contributions whilst still living a reasonable life in the hope that we can have the option, even if we decide not to, to take retirement at age 55.  Again, please ignore changes to future increases in pension age as we will just have to deal with these as they come along.  We have two children who may have some call on funds if they decide to go to university but equally we know that post retirement we will downsize at some point and have funds from this available, at present I’ve ignored both of these events.  House has £20k left on mortgage and no other debts so expect to have this cleared well before 55 (both late 40s at present) but we are only just building up savings too.

So, my plan, if we retire early at say 55 or thereabouts was to use funds from our current DC/SIPP to see us through as long as possible towards drawing our DB and state pensions.  Hence, used purely for bridging the gap.  However, I am beginning to think this makes for an imperfect balance between availability of retirement funds at an age when I would value them most and vice-versa. 

In the above scenario we were thinking that (ignoring tax and inflation remember) that a pension of £35k per annum would be very comfortable to live off for us and do the things we wish to.  My estimate is that the DC schemes will be worth about £300k when we turn 55.  We would look to run these down over the 10(ish) year period and use any other savings to try to obtain the £35k per annum.  This seems and feels possible at a bit of a push.  I then thought that we might equally want one or two nicer holidays in those earlier years so how could I leverage funds earlier in life.

Hence, I’m now thinking that it may be better to take our DB benefits early and keep the DC schemes as our top up when required and also to have a balance on these later life to pass on anything remaining to our children.  My estimated value of annual DB pensions for us both (assuming all deferred at 55) is £41k.  For illustration purposes, if these were reduced by 46% for early payment at 55 that would mean we would receive £22k per annum leaving the balance to be topped up by the DC scheme in the earlier years, and to support any bonus holidays.  A significant proportion of this could be from the tax free 25% or just from drawdown.  At state pension age, we would receive state pension of an additional £18k in today’s money thus taking us back above the £35k (£22k plus £18k) in the years when we are likely to want to spend less.

Given that our parents at 80 aren’t really in great health I just can’t see us needing sums of £59k per year (£41DB plus £18k state) in our later lives if we go with my original plan and access the DB schemes at normal retirement age. 

Other than the risk associated with the value of the DC schemes fluctuating in those early years of retirement, have I missed a fundamental point?  It strikes me we could have much more flexibility to enjoy retirement this way than guaranteeing an overly comfortable position when we don’t need it whilst having less available through the earlier years when we value it most?  All views welcome and as I say I do appreciate that this feels like a reasonable position to be in compared to some but equally we have saved very hard for this and perhaps forgone certain things we may otherwise have chosen to do which is why we want the option to catch up later!

Albermarle

It seems not an unreasonable plan and of course there is a possible half way house of taking the DB pensions early but not necessarily ten years early. 
Depending on the balance of DB and DC pensions between you , then you may have to watch out for Lifetime Allowance Tax ( which is looked at an individual level ) and taking DB pensions early helps to avoid this .
As you mention DC pots that are left on death could be passed on to your heirs . An extra advantage here is that they are not taken into account for inheritance tax calculations , so they can be a very good way of passing on assets to children/family etc

 Given that our parents at 80 aren’t really in great health I just can’t see us needing sums of £59k per year (£41DB plus £18k state) in our later lives if we go with my original plan and access the DB schemes at normal retirement age. 
Although you might not be spending as much on nice things in your eighties you may want to spend to make life more comfortable and of course you may need care at some point . Also do not underestimate you possible longevity . Statistics show something like there is a 25% chance one of you will live to 95. 

In the above scenario we were thinking that (ignoring tax and inflation remember) that a pension of £35k per annum would be very comfortable to live off for us and do the things we wish to
Most surveys show that an after tax income of around £45K for a couple is needed to live a very comfortable lifestyle, but everybody is different and clearly many manage on a lot less.

zagfles

46% is a massive hit on the DB pensions, also generally the inflation protection on pensions in payment is worse than pensions in deferment (eg lower cap, no averaging of the cap), so you'd need to look at this.

On the other hand, have you examined the position re the LTA? It depends how the pensions are split between you. Taking a DB pension early can be a way to avoid exceeding the LTA.

OldSmithy

Good points so thank you for taking time to reply. 

Looking at my deferred DB figure and multiplying by 20 plus the DC pot I think I’ll have I believe I’ll be under the LTA at todays rates. Of course if that comes down further or doesn’t increase in line with pensions increases I may need to rethink as the majority is in my name. We are trying to target increasing my wife’s pensions too however. 

Albermarle

OldSmithy said:

Good points so thank you for taking time to reply. 

Looking at my deferred DB figure and multiplying by 20 plus the DC pot I think I’ll have I believe I’ll be under the LTA at todays rates. Of course if that comes down further or doesn’t increase in line with pensions increases I may need to rethink as the majority is in my name. We are trying to target increasing my wife’s pensions too however. 

The expectation is that the LTA limit will not be reduced but the current freeze may last longer than the current 4 years , so inflation will effectively reduce it.
On reflection , I agree with Zagfles that a 46% hit to a guaranteed pension income is too much , so maybe as already suggested taking the DB pensions early , but only by two or three years could be an option.

jamesd

You suffer a large actuarial reduction. How does that compare to the cost of a mortgage used to fund the reduced payment level until you can take it without reduction? Then you can use much of the higher payment to repay the mortgage if you like. You might say take a mortgage until age 85 or perhaps one of the relatively newly introduced retirement interest only mortgages to keep the monthly cost down during the delay.

Add term life insurance to repay the mortgage if you were to die young.

The pension will increase with at least some level of inflation so it'll gradually be able to repay more of the mortgage while still leaving yo better off, say by keeping a quarter or half of the increase. Even better when your state pensions start, which might be the best time to do any repaying you want to do.

This sort of approach can leave you with more DB certainty and more money when younger, just via handy time-shifting of when you have money.

With downsizing already in your plans that can also be used to clear the mortgage if you like.

AlphaKappa

You will need to run the numbers to see the implication of taking your DB 1,2,3..and up to X yrs early. In your computation, you can assume to live up to say 88, and see how much payout you get over your lifetime. In your case its 22kx33yrs vs 41kx21?yrs if taken at 55. This difference is now what you need to optimize against how many additional years you wish to stay in work. (The real delta is actually less as the potential growth of the monies withdrawn early is not factored in).
In anycase, you certainly don't want to have loads of money at 70yrs+ coupled with less spending needs.
I will look at the problem the other way round:
-What are my spending needs each year from 55
-How much DC would I like to have (as reserve/buffer/inheritance) by the time I start drawing my secure income (DB+SP) as you may not be willing to fully spend your DC prior to accessing secure money.
-How early would I need to cash in my DB to meet the above requirements
- Am I happy to forgo some cash (which could be in the region of 100k) to retire earlier
(You did not say when you DB becomes payable. SPA?. Also, check your scheme as the AR may not be linear, so for example, you may only lose 10% at 60).

itsmeagain

I don't know the best answer of whether to take the DB and topping it up with DC/SIPP, OR taking your DC/SIPP to defer your DB, however - that's a huge reduction. Are you sure it's correct? You need to do an xls to compare your options.

I was in a similar position and took my DB at 55 (circa 28k PA) but that had only a 30% reduction. I also considered that If I take my DB, I'd have more chance of PPF without the 10% reduction if the company goes bust. Also, as you mention, you can handover your DC when you die.

You talk about paying off your mortgage, but that's saving circa 1.5% interest with money you have already been taxed on! Surely it's better to get 8% on a pre tax DC/SIPP and pay of the mortgage later?

With your wives DB, do they run an AVC or DC for new employees that uses salary sacrifice? If so, she wont get a company contribution but she should pay into that instead of external SIPP's that will not get the NI benefit.

OldSmithy

Company DC is not salary sacrifice. I completely get the mortgage side of things but I think the comfort of knowing it’s out of the way is very important to us equally. 

The reduction is worst case and in reality is unlikely to be quite that high, my pension is with the LGPS and a large proportion of service has a retirement date of 65 I believe. In addition I’m not sure we will stop working completely at 55 but maybe reduce to part time. I think it’s just about getting us to the point of having the option. 

The points raised are really helpful and I can now factor all of this into my thinking. I’m no expert but trying my best to understand all options to maximise the opportunities. 

Thanks once again. 

Albermarle

 to defer your DB, however - that's a huge reduction. Are you sure it's correct? 

I do not know for sure , but although  4.6% per year actuarial reduction is on the higher side, I do not think it is that unusual ?

itsmeagain

Albermarle said:

 to defer your DB, however - that's a huge reduction. Are you sure it's correct? 

I do not know for sure , but although  4.6% per year actuarial reduction is on the higher side, I do not think it is that unusual ?

Well... I just googled JLR, gov, nhs, teachers etc 'DB early retirement factor'. It comes up with many DB schemes factor tables. Admittedly I haven't looked at every scheme, but none of the first 5 tables I looked at had factors as harsh as 46% reduction for claiming 10 years early. Even the pension protection fund is better.

I do know that I got lucky with the timing of mine. Every 3 years, the scheme review things to ensure it's fair/completive etc. 6 years ago, my scheme had a 40% reduction for going 10 years early, so I was also putting in an additional 30k PA to build a bridging DC fund. Three years later it improved to 35% reduction, then another 3 years later to only 30% reduction by the time I reached 55. I no longer believed that the reduction factor was unfair. This changed my mind and I took the DB instead of deferring, leaving my DC & VR money as a rainy day fund.

At least if you build up the DC/SIPP funds, you have the flexibility when the time comes if the factors change. Although I no longer need my AVC/DC, i'm still pleased that I have saved the NI & tax.