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.

The income you generate by investing your tax-free lump sum may not be as high as that produced by an annuity, however. Nonetheless, there are advantages: you can access the money easily, and there is potential for the investment, and the income it generates, to grow. Against this, funds can fall as well as rise in value, while an annuity provides an income for life.

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."

More about