Should I take my pension as a lump sum to pay off my mortgage?

16 September 2014


I have been advised to retire on ill health grounds from the NHS and plan to take full commutation and use the lump sum towards paying off my mortgage of around £120,000. I am 51 and my husband works full-time but his job isn't secure. Is this a good idea?
PP/County Durham


Your query raises two questions for me. Is full commutation of the pension a good idea and is paying off the mortgage with this lump sum the right thing to do?

When you take benefits from any pension scheme you are usually entitled to take up to 25% of the scheme's value as a tax-free lump sum.

With a defined benefit pension scheme such as a final salary scheme, you are often presented with a number of options at retirement and this will generally take the form of a higher annual pension with a lower lump sum or a maximum lump sum with a lower income, or something in between.

Under the NHS scheme, the pension is converted to a lump sum at the rate of £12 additional lump sum for every £1 of pension given up.

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Bad value

While it can be tempting to take a lump sum from a pension, it can often represent bad value for money. With a 12 to 1 commutation factor, what is more valuable – a £12,000 lump sum or a £1,000 per year index-linked income?

It depends on what you would do with the lump sum, what tax rate you would pay on the income, how long you live for and what level of index linking you get in the future – the higher the inflation rate, the more valuable the income is.

For you, part of this decision will depend on the nature of your ill health and whether that has an impact on your life expectancy but I would advise you and anyone else reading this to think long and hard before taking the full lump sum from a defined benefit pension as £1,000 per year would be much more valuable than £12,000 as a lump sum for many people.

Whether to pay down your mortgage with a lump sum depends largely on your mortgage interest rate.

There are quite a few people with tracker mortgages who are paying less than 1% a year in interest on their mortgage. Those people could get a better net rate of return by leaving the money in a good savings account rather than paying off the mortgage. Others will be paying much more in mortgage interest than they would get in the bank so paying off the mortgage looks more attractive.

However, remember that paying a large part of a mortgage reduces your monthly outgoings but leaves you short of accessible money so can cause cashflow problems.

You raise the point about your husband's job security – if money in the bank would earn you, say, 1.5% and a mortgage was costing 2.5% you might feel comfortable accepting the higher mortgage cost for the cashflow flexibility it gives you. Ultimately, it comes down to the mortgage interest rate.

Jason Witcombe is an independent financial adviser at Evolve Financial Planning