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Q&A: Slicing up retirement income
Reader's query
I've decided to retire from full-time work next August and claim my state pension, plus my occupational pension. My state pension is around £80 a week - I don't have the full rate of National Insurance contributions. My occupational pension will be a £13,000 lump sum plus £80 a week. I can commute this lump sum to either a smaller amount and more weekly pension or a larger lump sum and less weekly pension. What do I need to consider when making my decision?
DS/Kent
Expert's advice
Michelle Cracknell
IFA for Origen, providers of the Moneywise Financial Advice Service
I assume your occupational pension arises from a defined benefit scheme, also known as a final salary scheme. If so, under the scheme's rules, you will have an entitlement to benefits based on your pensionable earnings and your period of pensionable service.
Under current legislation, the trustees of the scheme can permit you to take a maximum tax-free lump sum equating to 25% of your pension fund.
To get the higher lump sum you must exchange (commute) a part of your pension, and the value of your fund will be calculated using a formula based on the commutation factor for your particular scheme.
The commutation factor determines how much cash you get in exchange for each £1 of pension that you give up. Let's assume that you can increase your tax-free cash to, say, £22,000, an increase of £9,000. In that case, your weekly pension might fall to £65. So the cost of commuting the pension in that situation is a reduction in gross income of approximately £15 a week. The pension you receive in retirement is taxed as if it was earnings, but you might find that you can generate a more tax-efficient income from your additional £9,000 cash sum by investing it outside of the pension fund. As a basic rate taxpayer, £15 reduces to around £12 after tax, so what you need to achieve to match the pension that you would have had if you had taken no additional cash would be around 7% a year after tax.
However, if you did not take the additional £9,000 lump sum, you would have to live for around 15 years after retirement to secure the equivalent amount from your pension income. But the older we are when we retire, the less likely we are to recover any tax-free cash entitlement that we forego at retirement.
If you do opt for the tax-free cash sum then you need to seek advice as to the best place to invest to replace the income that you have given up, depending on your objectives, risk strategy and investment timescale.
One option might be to consider buying an annuity, which would provide a guaranteed income throughout your lifetime, part of which is tax-free. Another might be to use the cash to reduce any debts that you may have to carry into retirement with you. Reducing debts means that you have fewer outgoings and, hopefully, more disposable income.
These two options involve parting with the capital, meaning you cannot have access to it again as a lump sum in the future. Depending on your circumstances, you may consider using other forms of investment, such as stocks and shares ISAs, which can provide a tax-efficient income and some potential for capital security and/or longer-term capital growth. These investments involve a greater degree of risk because the capital value and the income that arises from them can go down as well as up, so you should seek professional advice in selecting which funds to invest in.
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