Should I take my pension as a lump sum?

It’s one of the most important decisions you will have to make as you approach retirement. Peter Lawrence explains the pros and cons of taking your pension as a lump sum. 

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Most pensions will give you the option of a tax-free lump sum when you start to take some of your pension benefits.  So should you stick or twist?

There are pros and cons, of course, which will be different for each person.  And in a short article we can only really list the things to consider.  Let’s look at defined contribution (money purchase) and defined benefit (final salary) pensions separately.

Defined contribution

Most pension plans will offer you the standard 25 per cent tax-free lump sum when you take some pension benefits – anything different from that and you almost certainly need some help to avoid shooting yourself in the foot

“A typical commutation factor would be 15 – you give up £1,000 of annual pension income to get £15,000 of lump sum.  The lower the factor is, the worse the lump sum deal is”

Here are the pros…

•    You get a tax-free lump sum to spend – too good to resist?
•    You could invest it and you might get a higher income than by buying an annuity
•    You could invest it and withdraw lump sums when required – it’s good to have flexibility after all
•    You could invest it and buy a better rate of annuity later in life – perhaps when you are less healthy
•    It’s in your control

And the con…

•    You get less income from your pension

Defined benefit

Here the decision is rather different.  It largely comes down to how much pension you are giving up by taking a lump sum, and that’s down to the “commutation factor” which the pension scheme offers – that’s the level of tax-free lump sum which you get for every £1,000 of annual income foregone.  A typical commutation factor would be 15 – you give up £1,000 of annual pension income to get £15,000 of lump sum.  The lower the factor is, the worse the lump sum deal is.

So, here are some pros…

•    You get the tax-free lump sum to spend
•    You may (just) be able to get a better income by investing it or buying an ill health annuity later in life – it depends on the commutation factor, but it’s pretty unlikely
•    It’s in your control – and you may feel that may justify a lower income

And the con…

•     You get less income from your pension – in particular with a defined benefit pension you are likely to be losing out on inflation-linked increases in the income

There will always be non-financial considerations, too, like how badly you want that world cruise, or the new conservatory, but one way of looking at the financial aspects is to do a spreadsheet of the income which would be received year on year for each of the options.

Never forget that it’s an important decision which will affect your income for the rest of your life. So it could well be worthwhile contacting a financial adviser to help you decide.

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About the author

Peter Lawrence is a financial adviser for Prime Time Financial. Peter’s passion is to help people get the most out of life by making full use of what they have, and that certainly includes their finances.