Posted: 29 September 2005
Issue: Vol 155, Issue 4027

I have been in practice for many years, and I have never met a client who has failed to take the maximum tax-free lump-sum commutation in connection with an occupational pension scheme. Financial advisers always seem to recommend this approach without offering any explanation. Are there any circumstances when a person should not take this course of action?
Query T16,687  — Shebeen.

Reply by New Road:

I am not authorised to give financial advice and so what follows is a personal view that cannot be relied upon and I accept no liability, etc.
The fact that many people take the lump sum will be because they have heard from the old proverb that a bird in the hand is worth two in the bush. In other words, taking a lump sum now is a certain amount. Taking a pension for the future is a gamble with inflation, length of time in retirement, future needs, annuity rates and many more.
In a final salary sacrifice scheme, the pension will be based on the salary at or near retirement, depending on the exact rules of the scheme. If that pension is sufficient to live on for the future after having taken the lump sum, the tax-free element can be invested or spent in accordance with the wishes of the individual. The same applies to the taking of a tax-free lump sum from a money purchase scheme. If the lump sum is taken, there will be less money to buy an annuity. Again, if the future payments from the annuity are likely to provide enough income, the lump sum can be invested or spent.
Where it is likely that the pension is not going to provide sufficient income for the future, it may be appropriate not to take the lump sum, increasing the future pension. Even this approach, however, is not clear-cut. It may be appropriate to take the lump sum and invest in some income-producing product such as an ordinary life annuity, or another investment vehicle.
After A day on 6 April 2006, however, the pension rules will change. It may be possible to enter into what is known as 'draw down' where the capital value of the pension is never used to buy an annuity, but is drawn on bit by bit. The level of lump sum that can be taken may be reduced to 25% of the fund whereas some pensions now allow a greater lump sum. We may see a change in the approach of financial advisers.
I have one final point. If the financial adviser will not offer any further explanation, I would be inclined to look elsewhere for someone who will back up the advice with explanations. - New Road.

Reply by Southern Man:

One might think that there is a straight choice in such cases when one has reached retirement, but perhaps the easiest example is to look at a money purchase scheme. Let us say that Bloggs is finally retiring and has a pension fund worth £100,000. This fund must — subject to the ability to take a commuted lump sum and ignoring the draw down facility that will come in next year — be used to purchase a pension.
Now, Bloggs may say that he has no actual need for a lump sum and he would prefer a higher pension. Logically, one might think that the answer is to therefore forego the lump sum. In fact, in many circumstances, I believe that he would still be better off by taking the lump sum. A financial adviser might suggest that he invest this elsewhere to produce a regular income to make up the pension shortfall or, of course, use it for other non-income producing purposes, but the lump sum option may often be better even if he wishes to take the income as an annuity.
The reason for this is that he can use the lump sum to purchase another annuity. However, unlike the pension annuity, this will be a purchased life annuity and the monthly payment that is received is treated partially as income and partly as a return of the original capital investment. Advisers whose clients have purchased life annuities will be familiar with the form PLA3 which is received from HMRC and which advises how much of the annuity is treated as income and how much is capital. The capital element is paid without the deduction of tax, which potentially boosts the net income receivable.
This is perhaps best illustrated by an example, with thanks to Hargreaves Lansdown (0117 980 9926 or www.hargreaveslansdown.co.uk) for providing the comparative figures. Advisers or clients should obtain specialist financial advice before embarking on such investments and this reply simply constitutes information, not advice. In this example, there would be commission payable of £500 to obtain the purchased life annuity.
Let us say that Bloggs is aged 65 (non-smoker) with a pension fund of £100,000 and wants the pension to be paid for his life only, not indexed or guaranteed. The annual pension that could be paid on £100,000 would be £7,091.
Alternatively, Bloggs takes 25% of his fund as a tax-free lump sum. The pension purchased with £75,000 on the same basis as above would be £5,318 p.a. The £25,000 tax-free lump sum is used to buy a purchased life annuity of £1,716 p.a. giving a total gross income of £7,034. This is less than the full pension annuity above, but £1,425 of the purchased life annuity represents the return of capital and is not subject to income tax. If we assume that Joe's personal allowances are set against his state pension and that he is not a higher-rate taxpayer, my calculations are that he will have a net income of £5,531 taking the full pension, but £5,805 taking the pension/purchased life annuity route — almost a 5% increase.
The same principle will apply to final salary schemes, but the pension element will depend upon final salary, length of service, etc. rather than the amount in the fund.
So the principle here seems to be: 'If you want the lump sum, take the lump sum. If you don't want the lump sum, take the lump sum'. - Southern Man.

 

Reply by Barnett Waddingham LLP

The main benefit of taking a retirement tax-free lump sum from an occupational pension scheme is that it provides 'exactly what it says on the tin' — a lump sum on retirement that is not subject to tax. This in itself is attractive for the majority of retirees who may wish to use the one-off cash payment to clear a mortgage or finance a round-the-world cruise.
But the lump sum payment is not necessarily the best option financially. Despite the tax-free nature of the lump sum, there are occasions when the net of tax pension income given up could appear more valuable to the member. Such assessments do have to make use of assumptions about the future, including future rates of income tax.
For example, a scheme may offer a tax-free lump sum commutation of, say, £9 for each £1 of pension given up. If the taxpayer lives for another 20 years, the value of that £1 of pension could easily be £20, before tax. After tax, the pension given up could be worth, say, £15.60 for a basic rate taxpayer and £12 for a higher rate tax payer.
However, the 'bird-in-the-hand' argument often wins — but this is for the member to decide rather than the financial adviser. There are occasionally other personal reasons why a lump sum would not be a preferred option, such as if the member were in bankruptcy. — Barnett Waddingham LLP.

 

 

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