Why lump sums don't add up for many with final salary pensions

Hundreds of thousands of retirees risk being short-changed if they take a cash lump sum from their final salary pensions.

In many cases, the calculations used to swap a lifetime pension for a lump sum today have failed to keep pace with financial markets. Savers may be getting less than half the ‘market value’ of the lifetime pension they give up.

Rules normally permit up to  25 per cent of the value of a pension to be taken as a lump sum on retirement, free from tax. Some longer-serving workers may have ‘preserved’ entitlements to higher lump sums.

Sitting pretty: Charles Ironside had to make decisions on eight pension schemes

Calculating a lump sum is relatively simple where savers have paid into a defined contribution pension. Each person has a pot of investments that is used to buy their pension and up to 25 per cent is simply hived off to provide tax-free cash.

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But in defined benefit pension schemes, often known as final salary – where the pension is linked to your salary and length of service – workers are frequently offered a trade-off at retirement. They can choose an annual pension for life, or a lump sum today and a smaller annual pension.

 

Each pension scheme sets out ‘cash commutation factors’ that determine the rate at which annual income is converted into a lump sum. And anyone retiring today needs to put these cash factors under the microscope to check whether taking a lump sum makes sense for them.

Bob Bullivant, who runs specialist retirement adviser Annuity Direct, says: ‘People will see a statement promising them a chunk of cash and say “wow”. It is easy to tick the box to say yes without stopping to ask yourself whether that figure is good, bad or indifferent.’

In particular, savers can drastically underestimate the value of having a guaranteed income for life that increases either fully or partially in line with inflation and provides for a partner after the retiree’s death.

Laith Khalaf, pension investment manager with broker Hargreaves Lansdown, says that at today’s annuity rates it costs a man aged 60 about £41.60 to buy £1 a year of index-linked income with a 50 per cent spouse’s pension – broadly equivalent to the benefits of a good final salary pension.

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By age 65, the cost of buying this income has fallen to £35 per £1. By contrast the trade-off from a final salary pension will typically be in the range of £14 to £18 of lump sum for every pound of pension income you sacrifice – at best half the annuity rate.

Some final salary schemes, especially those in the public sector, provide a separate ring-fenced lump sum as well as the original pension. Here commutation is not an issue.

While only a minority of private sector workers are now actively building up final salary pensions, there are millions who have existing entitlements.

Patrick Bloomfield, an actuary and partner at Hymans Robertson and who advises pension scheme trustees, says: ‘A regular pension income has become very valuable and the commutation terms aren’t really giving people good value for money.’

Charles Ironside had to decide whether to take tax-free cash when he retired last year. Job moves and company takeovers throughout his career as a manager in healthcare diagnostics had left Charles, 60, with five different final salary pensions and three money purchase schemes.

He turned to Annuity Direct for help. One of his pensions was with the NHS, which automatically gave the tax-free cash on top of his annual pension. But the other final salary schemes required a trade-off. On average he was offered £16.34 of lump sum for each £1 of starting pension sacrificed.

Charles, who lives with his wife, Frances, also 60, in Linlithgow, West Lothian, says: ‘I went through the equation four times and for each final salary scheme it was a no-brainer to take the pension rather than the cash.’

Instead, he opted to take tax-free lump sums from his money purchase pensions, including a top-up pension.

Bloomfield says many retirees underestimate their own lifespans. ‘A 65-year-old man retiring today has a reasonable chance of living to 90, while the odds of a similar lifespan for a 65-year-old woman are better than even,’ he says. The longer you live, the more valuable that annual pension.

But there can still be good reasons for taking a lump sum. Some savers have a need for cash at retirement, for example to repay a mortgage. And a tax-free lump sum is more valuable to someone who expects to pay 40 or 45 per cent income tax on their pension in retirement than to a basic-rate taxpayer.

Bullivant says retirees should be willing to be flexible: ‘You don’t have to take the maximum cash. You may opt to draw a smaller sum to meet needs today and then preserve the rest as pension to give a growing income in retirement.’

Five ways to enjoy a richer retirement

1) GIVE YOURSELF ENOUGH TIME: Do not leave it until the last minute to arrange pensions and annuities. It can take months to get detailed quotes and decide the best strategy. Charles Ironside, for example, started researching the market and getting valuations on his pensions in spring 2012, ahead of his 60th birthday last November. But his actual pension payment did not start until February this year.

2) THINK ABOUT YOUR HEALTH: Insurers now offer enhanced annuities that tailor the income to your life expectancy. These can produce an income that is up to 50 per cent higher for those with serious long-term conditions. Sometimes it may pay to switch out of a company pension to buy these enhanced rates.

3) CAN YOU USE ‘TOP-UP PENSIONS’ FOR YOUR LUMP SUM? If you have made additional voluntary contributions (AVCs) into a company pension, this money might be a better source for your tax-free cash. In many cases AVCs will sit alongside the pension in a separate pot.

With the help of Annuity Direct, Charles was able to negotiate with pension trustees and use the money in an AVC fund to provide the maximum tax-free cash from one of his pensions, leaving his guaranteed annual income intact.

4) THINK ABOUT YOUR SPOUSE OR PARTNER: Will another person depend on your pension after you die? If so you will need to look at what provision, if any, is built into workplace pensions and investigate the costs of buying an annuity that pays a partner’s pension after you are gone.

5) BUILD STATE PENSIONS INTO THE PLAN: You can get a forecast of how much your state pension will be by calling 0845 3000 168 or online at gov.uk. It may make sense, for example, to buy a level annuity (which pays the highest income at the start but does not rise over time) if you can draw on a decent state pension in a few years to boost your income again then.