Welcome to our weekly column where readers can submit questions regarding retirement and pension savings, which will be addressed by our expert, Tom Selby. Tom is the director of public policy at the investment platform AJ Bell and possesses extensive knowledge about pensions. If you have a question for him, feel free to reach out via email at [email protected].
Question: I am 66 years old, recently retired, and have just begun receiving my full state pension. In addition, I have a modest defined benefit pension from my previous employment. Considering this pension is not a large sum, I want to ensure that I am making the most appropriate decision. Should I opt for a larger tax-free lump sum with a smaller annual pension, or should I choose a smaller lump sum with a larger annual pension? The minimum lump sum available to me is £7,528, accompanied by an annual pension of £5,191. Conversely, the maximum lump sum I can take is £24,937, which corresponds to an annual pension of £3,740. There is a sliding scale available between these figures. I have no mortgage or debt, and I am looking to my pension to cover my monthly expenses, which are expected to be around £1,100, with the potential for an occasional holiday.
Answer: Congratulations on reaching this exciting phase of your life! Defined benefit (DB) pensions hold significant value, and it’s commendable that you are thoughtfully considering how to draw income from it.
Understanding Defined Benefit Pensions
For those who may not be familiar, DB pensions offer a guaranteed, inflation-protected income for life starting from your “normal pension age,” which generally aligns with the UK state pension age. The income you receive is contingent upon factors such as your salary (either final or career average), the duration of your service in the scheme, and your “accrual rate.” For instance, if you participated in a career average DB scheme for 20 years with an accrual rate of 1/60ths and an average salary of £30,000, you would be entitled to 20/60ths (equivalent to one-third) of your salary, translating to an inflation-protected annual income of £10,000 for life from your normal pension age.
As you highlighted in your query, members of DB schemes can typically access a portion of their pension as a tax-free lump sum. Unlike defined contribution (DC) pensions—where individuals accumulate their own retirement pot and can withdraw up to 25% tax-free from age 55—DB pensions operate differently since there isn’t an individual pot of money. Instead, schemes typically allow you to withdraw a certain fraction of your promised income as a tax-free lump sum, with the corresponding reduction in the income you will receive in retirement determined by a “commutation factor.” For example, if the commutation factor is set at 12:1 (as in your situation), this indicates that for every £12 of tax-free cash you receive, your promised annual income would decrease by £1. Notably, the maximum tax-free cash you can take over your lifetime is capped at £268,275.
Considerations for Taking Your Tax-Free Lump Sum
While understanding the mechanics is essential, the pivotal question regarding the amount of tax-free lump sum you should take ultimately hinges on your personal preferences and circumstances. If you seek specific guidance on the best course of action, it is advisable to consult with a regulated financial adviser.
It’s important to recognize that by opting for more than the minimum tax-free lump sum, you would be relinquishing a guaranteed, inflation-protected income for life. Therefore, it’s crucial to have a clear plan for how you intend to utilize any extra tax-free cash you choose to withdraw. Common uses for pension tax-free cash include settling debts, paying off a mortgage, or establishing a financial cushion for emergencies. You may also consider using it for other purposes, such as enjoying a holiday or purchasing a new vehicle. If you do not have a pressing need for the cash, you might determine that maintaining a higher guaranteed income for life is the wiser choice.
Your health could also play a role in your decision-making process; the longer you live, the more income you would benefit from your DB pension. Before finalizing any decisions, ensure that your income will sufficiently cover your retirement expenses. Additionally, some individuals may wish to consider the implications of passing on financial support to loved ones. Typically, DB pensions offer a guaranteed income to a spouse or civil partner, often amounting to 50% of the income you have been promised. Consequently, if you reduce your income by taking a higher tax-free lump sum, the income your spouse could receive after your passing would also decrease.
