Pros and cons of taking a tax-free lump sum from your pension
Pension investors have historically considered their tax-free pension lump sum - formally known as the pension commencement lump sum or PCLS - as an excuse for a big treat or a one-off financial outlay such as clearing their mortgage. But can investors still afford to do this in times of straitened pension provision?
Q: How does this lump sum deal work?
A: The PCLS is cash you can withdraw from your pension fund any time from age 55. Provided you have not exceeded the pension lifetime allowance (currently £1.5 million, falling to £1.25 million for the 2014/15 tax year) you can take up to 25% of the value of your fund tax-free, whether you have invested in a defined contribution or a defined benefit (final salary or career average) scheme.
Q: Sounds great - why on earth would I want to pass it up?
A: A combination of increased longevity, inadequate savings, low annuity rates, and now the threat the government may drop the triple-lock guarantee (that state pensions will increase each year by the lowest of inflation, earnings or 2.5%) after the next election, is forcing investors to reassess how they use their tax-free cash.
"Fewer people will be able to take their cash and spend it: they won't be able to afford losing the income it could have generated," says Chris Noon, partner at pension consultant Hymans Robertson.
Q: What's likely to influence my choice?
A: The benefit of taking or leaving the cash varies considerably, depending on what type of scheme you are invested in; but other factors such as the size of your fund and your state of health will also influence your final decision. For example, says Mitch Hopkinson, managing partner of adviser Chase deVere: "If you think you won't live long into retirement, say beyond your mid-seventies, you might want to take the tax-free cash now. If you're fit and your family has a history of longevity, the decision is harder."
Q: Does it make a difference whether I'm in a money purchase or final salary scheme?
A: Yes. Taking your tax-free cash from a money purchase pension scheme is a fairly straightforward decision, even if you want to maximise income. "Provided you use tax-efficient wrappers like ISAs, it can continue growing and generating an income tax-free. If you used this money to buy an annuity instead, the resulting income would be assessable for tax," says Noon.
Q: So what about final salary schemes?
A: Deciding whether to take tax-free cash from a defined benefit pension is harder, as the impact on retirement income is potentially much greater.
Different pension schemes use different "commutation factors" - the figures used to work out how much pension income you have to give up for a certain amount of tax-free cash.
Laith Khalaf, pensions analyst at Hargreaves Lansdown, estimates that for a defined benefit scheme where the saver expects a £10,000 annual income (before taking tax-free cash), the amount they could withdraw as cash would typically be £46,000, leaving them with a residual income of £6,900 a year. "But the income from the final salary scheme increases in line with inflation each year," he says.
Q: And if I went into income drawdown?
A: Many modern defined contribution schemes allow you to take your pension in stages through income drawdown, leaving the money invested and withdrawing an income rather than buying an annuity.
This means you can "crystallise" or convert as much tax-free cash and income drawdown as suits you at the time. Robert Graves, head of pension technical services at Rowanmoor Group, points out that if you are earning a salary and don't need to draw an income straightaway, you can still take tax-free cash by crystallising part of your fund without drawing an income.
This gradual conversion also helps investors to reduce potential death duties on their pension funds. Your estate could face a 55% tax bill on the remains of any crystallised pension pot when you die. However, says Hopkinson: "If you crystallise and take tax-free cash from a portion at a time, then if you die the 55% tax bill will only apply to that portion. The remainder can be passed on to any beneficiary free of tax."
Money purchase pension
A pension plan where the level of benefit paid out in retirement is solely dependent on the accumulated value of the contributions. It’s another term for a defined contribution pension.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Defined benefit pension
Often referred to as a “final salary” pension, benefits paid in retirement are known in advance and are “defined” when the employee joins the scheme. Benefits are based on the employee’s salary history and length of service rather than on investment returns. The risk is with the employer because, as long as the employee contributes a fixed percentage of salary every month, all costs of meeting the defined benefits are the responsibility of the employer. (See also Final Salary).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).