Pros and Cons of taking a Lump Sum

poseidon1

Phossy said:

If you are in a final salary scheme (DB) and take the lump sum, then it may keep you in a lower tax bracket (especially when you also get the state pension). It is also money in your hand right now rather than eeeked out over 20 years (if you are lucky).  Down to the individual whether this suits you or not (pay of your debts, blow-out holiday, new car etc)..

I would chip in here that always taking the maximum tax free lump sum from a DB scheme without properly  exploring alternative outcomes in exchange for sacrificing some tax free cash can be counter productive.

Case in point would be a relative taking early retirement, I advised a number of years back  hell bent on taking his maximum  cash ( £220k) for a reduced £32k annual index linked pension. I told him to ascertain how much extra pension he would receive by forgoing £100k tax free cash, this turned out to be an extra £17k per year ie an initial 17% lifetime income return for the £100k forgone.

To drive the point home, interest rates on bank deposits were around 1% at the time so exchanging £100k of cash which would earn just 1% compared to  £17,000 guaranteed index linked (albeit ) taxable  life time income plus a reduced widows pension thereon if wife survived him seemed to me a no brainer . He agreed, as a result his total  £49,000 starting pension, is now just shy of £67k after prior years inflation increases, and scheduled to hit in excess of £72k in April.

Of course he does pay 40% tax  on his excess income over £52k, which will be aggravated when his state pension comes on stream next year. However, he accepts that notwithstanding all this the income security he has achieved by  'sacrificing 'some of his tax free cash was one of the best financial decisions he has ever made. Also pointed that his pensions alone , would  in due course put him amongst the top 5% of UK income 'earners' - a sobering thought.

Please note his DB scheme was an extremely generous legacy private sector scheme, long since closed to new members, so his outcome will not be mirrored by lesser schemes. Nonetheless the  point is not to automatically seek to take maximum tax free cash ( which does seem to be the default position of many contributors on the pension forum) without exploring and analysing all options.

Finally, this obsession with keeping one's pension income well within the 20% band, does seem to me a little irrational, after all even if ( say ) an extra £10k of income nets down to £6k after 40% tax, one  still has that extra to spend ( or save). In these highly inflationary times, a high growing income stream ( even after 40% tax), must be worth striving for?

Pat38493

Albermarle said:

MetaPhysical said:

It's normally better off *not* to take the TFS from a DC pot IMO.  But it all depends on your circumstances.  If you need the money to pay off mortgage or for some other pressing purpose then that would be a good use of the TFS.

If you do NOT have a pressing need for the money, consider this.  Let's say you have £100k in your pot.  If you take the TFS you will then get £25k tax free.  Nice and a bird in the hand and all that.......  However, say you don't take the TFS and, instead, you take a 25% tax free from each withdrawal (i.e. UFPLS).  Over several years you can potentially get a *lot* more than £25k because as the pot grows and you keep getting 25% tax free on each withdrawal it can soon make up and overtake the £25k had you took the TFS.

Only if you spend the tax free cash, or keep it in your current account. If you invested it in a similar way to the pension, it would grow the same as if you left it in the pension.

However overall I  agree that it is better left in the pension if you have no real need for it. The mistake that many make is to withdraw it all 'because it is there' and do nothing with it. 

There can also be rare cases where it makes sense to do this for future tax management - e.g. if you have a very large planned capital expenditure a few years in the future and you need to avoid paying a huge 40 or 45% tax bill in that year - you can try to smooth the tax bill over several years (you can also do that with UFPLS of course but this will depend on amounts and scenarios).

RogerPensionGuy

poseidon1 said:

Phossy said:

If you are in a final salary scheme (DB) and take the lump sum, then it may keep you in a lower tax bracket (especially when you also get the state pension). It is also money in your hand right now rather than eeeked out over 20 years (if you are lucky).  Down to the individual whether this suits you or not (pay of your debts, blow-out holiday, new car etc)..

I would chip in here that always taking the maximum tax free lump sum from a DB scheme without properly  exploring alternative outcomes in exchange for sacrificing some tax free cash can be counter productive.

Case in point would be a relative taking early retirement, I advised a number of years back  hell bent on taking his maximum  cash ( £220k) for a reduced £32k annual index linked pension. I told him to ascertain how much extra pension he would receive by forgoing £100k tax free cash, this turned out to be an extra £17k per year ie an initial 17% lifetime income return for the £100k forgone.

To drive the point home, interest rates on bank deposits were around 1% at the time so exchanging £100k of cash which would earn just 1% compared to  £17,000 guaranteed index linked (albeit ) taxable  life time income plus a reduced widows pension thereon if wife survived him seemed to me a no brainer . He agreed, as a result his total  £49,000 starting pension, is now just shy of £67k after prior years inflation increases, and scheduled to hit in excess of £72k in April.

Of course he does pay 40% tax  on his excess income over £52k, which will be aggravated when his state pension comes on stream next year. However, he accepts that notwithstanding all this the income security he has achieved by  'sacrificing 'some of his tax free cash was one of the best financial decisions he has ever made. Also pointed that his pensions alone , would  in due course put him amongst the top 5% of UK income 'earners' - a sobering thought.

Please note his DB scheme was an extremely generous legacy private sector scheme, long since closed to new members, so his outcome will not be mirrored by lesser schemes. Nonetheless the  point is not to automatically seek to take maximum tax free cash ( which does seem to be the default position of many contributors on the pension forum) without exploring and analysing all options.

Finally, this obsession with keeping one's pension income well within the 20% band, does seem to me a little irrational, after all even if ( say ) an extra £10k of income nets down to £6k after 40% tax, one  still has that extra to spend ( or save). In these highly inflationary times, a high growing income stream ( even after 40% tax), must be worth striving for?

17K PA and 17% sounds like mixed up nbrs.

DBdoobydoo

Moonwolf said:

For DB , to use the NHS scheme as an example

(Ignore the old (1995) scheme includes a 3x pension lump sum which doesn't involve losing any pension.  You get it anyway.)

For the 2015 scheme you lose £1 of pension for each £12 of lump sum you take.  This is the "commutation" rate (you commute pension to lump sum).  In simple terms, that means if you live 12 years after retirement you would have been better off keeping the pension.  Of course your pension will have grown by inflation over those 12 years, so perhaps the lump sum is only the best option if you live less than 10 years; but what would you do with your lump sum, if you managed to invest it and get a good % over inflation or if you paid off expensive debts then you might to be better off taking a lump sum if you live less than 15-20 years.

For reference, if you retire at 67, currently you will expect to live on average another 18 years.  Unless you know something very specific, I would never bet on dying earlier, too many people say "I'm taking the lump sum as I might die tomorrow anyway."

One last point.  If you have a £20k DB scheme and £10k state pension and £30k is your budget then do you want to give up pension for a lump sum and not be able to meet your budget later; or do you think your basic budget is smaller and having cash savings for more expensive holidays in the early years is better.

So is a lump sum the best option?

For a DB scheme you need to know
 - What the commutation rate is? How long will you have to live before you would be better off keeping the pension? 
 - What will you do with the lump sum.  Good might be paying off expensive debt, holiday/new car fund or money for the kids.  Bad could be, "I might die tomorrow", while true is probably less likely than living 15-20 years.
 - Including state pension, what will I have left to live on after taking the lump sum, is it enough?

For DC it is similar but the calculations are more complex and depend if you are drawing down, taking an annuity or a bit of both.

Even if you lose £1 of pension for each £12 of lump sum you take it can still be worthwhile if you need the lump sum & have no other source of a large cash sum especially with a small pension that is not a major part of your pension portfolio. Traditionally retirees buy a caravan or motorhome with a tax free lump sum or you might want to pay off the mortgage.

If you had an NHS pension of £10,000 with no TFLS you could opt for a maximum TFLS of £43,000 with a reduced pension £6,400. That would buy a nice motorhome to use for the rest of your life. Paying off the mortgage so you have no debt would also be reassuring. If you can manage without the index linked £3,600 per year then why not?

hugheskevi

Moonwolf said:

So is a lump sum the best option?

For a DB scheme you need to know
 - What the commutation rate is? How long will you have to live before you would be better off keeping the pension? 
 - What will you do with the lump sum.  Good might be paying off expensive debt, holiday/new car fund or money for the kids.  Bad could be, "I might die tomorrow", while true is probably less likely than living 15-20 years.
 - Including state pension, what will I have left to live on after taking the lump sum, is it enough?

For DC it is similar but the calculations are more complex and depend if you are drawing down, taking an annuity or a bit of both.

A person's future tax rate is also an important consideration - with a 12:1 commutation rate, a non-taxpayer takes 12 years to receive as much through pension as they would have received from lump sum (ignoring inflation increases on pension and explicit/implicit returns on lump sum), a basic rate taxpayer takes 16 years, and a higher rate taxpayer takes 20 years.

For public service pension schemes age is very important too, as the commutation rate is the same for someone taking their pension at age 55 as it is for someone taking their pension age 67.

The 12:1 rate is so poor that even for a higher rate tax-payer taking their pension age age 67 the tax-free lump sum is only around about the same expected value as the taxed pension (noting that DB members have higher than population average life expectancy).

The insurance aspect of the pension also has a value - even if the expected value of lump sum is the same as taxed pension, as the pension continues for life this may well be preferable to protect against longevity risk, although that has to be balanced against a lump sum possibly being of greater use earlier in retirement.

DBdoobydoo said:

Even if you lose £1 of pension for each £12 of lump sum you take it can still be worthwhile if you need the lump sum & have no other source of a large cash sum especially with a small pension that is not a major part of your pension portfolio. Traditionally retirees buy a caravan or motorhome with a tax free lump sum or you might want to pay off the mortgage.

If you had an NHS pension of £10,000 with no TFLS you could opt for a maximum TFLS of £43,000 with a reduced pension £6,400. That would buy a nice motorhome to use for the rest of your life. Paying off the mortgage so you have no debt would also be reassuring. If you can manage without the index linked £3,600 per year then why not?

Other than in niche cases such as reduced life expectancy, I think scenarios such as this are usually a case of failing to plan properly, eg using DC to build up the desired lump sum alongside the DB pension.

Even in this case, the hypothetical person would probably earn something like £30,000 per year. So just by working one more year, they would have £30,000 of earnings plus £10,000 of pension plus around another £3,000 of DC pension (assuming an employer DC pension with combined employer/employee contribution rate of 10%). Some of that will be lost to income tax, NI and pension contributions, but it will still come reasonably close to £43,000 and in return for just one year of work their pension which they accrued over a lifetime of working would be over 50% higher than it would be compared to retiring one year earlier and taking maximum lump sum. That is a pretty compelling argument for one more year, rather than ravaging their pension. 

Pat38493

hugheskevi said:

Moonwolf said:

So is a lump sum the best option?

For a DB scheme you need to know
 - What the commutation rate is? How long will you have to live before you would be better off keeping the pension? 
 - What will you do with the lump sum.  Good might be paying off expensive debt, holiday/new car fund or money for the kids.  Bad could be, "I might die tomorrow", while true is probably less likely than living 15-20 years.
 - Including state pension, what will I have left to live on after taking the lump sum, is it enough?

For DC it is similar but the calculations are more complex and depend if you are drawing down, taking an annuity or a bit of both.

A person's future tax rate is also an important consideration - with a 12:1 commutation rate, a non-taxpayer takes 12 years to receive as much through pension as they would have received from lump sum (ignoring inflation increases on pension and explicit/implicit returns on lump sum), a basic rate taxpayer takes 16 years, and a higher rate taxpayer takes 20 years.

Yes - but the it's quite complicated to calculate - this is where cash flow modelling tools can be useful as a more realistic situation is that by taking the lump sum, that's how you avoided paying 40% tax or 20% tax or suchlike.

With a 12:1 ratio you are right this is pretty bad, but what I have found with various modelling tools that I tried, is that with ratios of between 18 and 23 depending on age, which seems more common among private sector DB schemes, it usually worked out better off to take the lump sum according to the modelling software - I suspect htis is precisely because it avoided paying 40% tax in some of the earlier years in my particular scenario.

happymum37

Reading with interest as my CARE scheme pension has a commutation of 12:1 and all my colleagues still take the maximum lump sum incase they die 

Phossy

I have a DB pension and I will be taking the full Lump sum when I finally commit. I have done many calculations and I know that it will take 23 years (based on todays money) for me to 'break even'. However, I really don't care about the break even point. I did focus on this when I first started thinking about the pension, but as I built more and more detailed spending projections, I came to realise that our spending would be so much more significant in the first 10 years and that I'd rather maximise the money available to us. I may even take a variable pension option to effectively take more money out in the years up to SPA. If we get to enjoy more years then as long as we have enough income, then that is all that is important - I don't feel the need to maximise what is taken from the pension by beating the break even numbers by denying ourselves a nice lump sum. We have worked hard for a long time and I really hope we get to have a few years of really treating ourselves.

RogerPensionGuy

Think I can show a good example of when taking a chunk of TFLS out of a DC pot looks sensible in my opinion. 

Person is 66 now, DC pension of 50K PA and State Pension of 11K.

Person is offered a commutation rate of say 26 approx. 

Person does full 25% TFLS availability of 268K Tax free Cash and puts it to good use whatever, maybe investing it.

So Person has 268K cooking and freely available to liquid cash if they like, that's a nice buffer.

Pension state is 40K DC & 11K State Pension is 51K PA and just knocking on 40% income tax.

Or Person could of been getter an extra 10K PA in year one obviously going up  but use just year one, that's 40% tax off, so just 6K net PA in year one or a 268K tax-free cash bucket.

As long as that 268K isn't lost on a day at races, the above example looks like a fair way to go in my opinion.

DBdoobydoo

hugheskevi said:

Moonwolf said:

So is a lump sum the best option?

For a DB scheme you need to know
 - What the commutation rate is? How long will you have to live before you would be better off keeping the pension? 
 - What will you do with the lump sum.  Good might be paying off expensive debt, holiday/new car fund or money for the kids.  Bad could be, "I might die tomorrow", while true is probably less likely than living 15-20 years.
 - Including state pension, what will I have left to live on after taking the lump sum, is it enough?

For DC it is similar but the calculations are more complex and depend if you are drawing down, taking an annuity or a bit of both.

A person's future tax rate is also an important consideration - with a 12:1 commutation rate, a non-taxpayer takes 12 years to receive as much through pension as they would have received from lump sum (ignoring inflation increases on pension and explicit/implicit returns on lump sum), a basic rate taxpayer takes 16 years, and a higher rate taxpayer takes 20 years.

For public service pension schemes age is very important too, as the commutation rate is the same for someone taking their pension at age 55 as it is for someone taking their pension age 67.

The 12:1 rate is so poor that even for a higher rate tax-payer taking their pension age age 67 the tax-free lump sum is only around about the same expected value as the taxed pension (noting that DB members have higher than population average life expectancy).

The insurance aspect of the pension also has a value - even if the expected value of lump sum is the same as taxed pension, as the pension continues for life this may well be preferable to protect against longevity risk, although that has to be balanced against a lump sum possibly being of greater use earlier in retirement.

DBdoobydoo said:

Even if you lose £1 of pension for each £12 of lump sum you take it can still be worthwhile if you need the lump sum & have no other source of a large cash sum especially with a small pension that is not a major part of your pension portfolio. Traditionally retirees buy a caravan or motorhome with a tax free lump sum or you might want to pay off the mortgage.

If you had an NHS pension of £10,000 with no TFLS you could opt for a maximum TFLS of £43,000 with a reduced pension £6,400. That would buy a nice motorhome to use for the rest of your life. Paying off the mortgage so you have no debt would also be reassuring. If you can manage without the index linked £3,600 per year then why not?

Other than in niche cases such as reduced life expectancy, I think scenarios such as this are usually a case of failing to plan properly, eg using DC to build up the desired lump sum alongside the DB pension.

Even in this case, the hypothetical person would probably earn something like £30,000 per year. So just by working one more year, they would have £30,000 of earnings plus £10,000 of pension plus around another £3,000 of DC pension (assuming an employer DC pension with combined employer/employee contribution rate of 10%). Some of that will be lost to income tax, NI and pension contributions, but it will still come reasonably close to £43,000 and in return for just one year of work their pension which they accrued over a lifetime of working would be over 50% higher than it would be compared to retiring one year earlier and taking maximum lump sum. That is a pretty compelling argument for one more year, rather than ravaging their pension. 

Sorry but I'm not seeing this apply to the scenario that I quoted (which is based on my personal circumstances). I have several DB pensions. I have no DC pension as I never needed one as I have sufficient DB pensions & in any case never worked for an employer who would have contributed to one.
I will be a higher rate tax payer in retirement. Why shouldn't I commute part of a small DB pension for maximum lump sum to enable me to do home insulation & install solar panels or pay off the mortgage or buy a motorhome? Your suggestion that I work another year is laughable. I'm seventy. Why should I work longer than I want when I don't need to? Why this obsession with how much pension I will be receiving when I'm 80 or 90? It's today when I'm able to enjoy a motorhome not 10-20 years time.