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17 / 08 / 23

Maximise Pension or Tax Free Sum?

Is it a good idea to maximise how much you take or to leave as much for the annuity? If you were to take the 25%, what should you do with it? Are there investments you could put some into to get a better return than the annuity? Is that worth a try? Or is better to keep cash savings?

When taking retirement benefits the question rises about whether a tax-free lump should be taken.  The answer depends very much on personal circumstances but when evaluating the financial implications I believe the starting point is to consider what type of scheme you are dealing with, a Final Salary scheme or a Money Purchase arrangement.

With a Final Salary Scheme there is often the ability to commute pension for a tax-free lump sum. However, in my experience, the commutation rates can be out of date. It is not untypical to find a commutation rate of 9:1. This means that for every £1 of pension you give up you will receive £9 of cash. However, you could find that if you were to purchase £1 of a typical final salary pension, including a spouse’s benefit on death and increases to payments linked with inflation, it could cost you £35 on the open market.  This demonstrates what good value a scheme pension can be and how such poor commutation rates benefit the scheme.

In contrast, I would tend to suggest that the default choice for a money purchase scheme would be that the 25% tax-free lump sum is withdrawn. This is because it is a tax efficient method of withdrawing a pension benefit and it puts the capital directly under your control. Also, any annuity income purchased would be subject to tax as ‘earned income’.

Secondly, if an annuity were purchased, you are locked into the death benefits selected at the outset and the prevailing annuity rate (often considered poor at the moment) provides no further flexibility. However, the annuity would provide a guaranteed and secure income with no further need for consideration.

Upon taking the tax-free lump sum there are a number of choices about how to use this. The basic areas that I would be encouraging clients to consider are:

  • If they have sufficient emergency funds [3 months worth of expenditure]
  • If they have sufficient protection in place to provide income in retirement in the event of their death or their spouse, and,
  • If they have expensive borrowing that could be repaid.

Consumers tend to focus on how they can use the capital to provide income. Holding more money than necessary in a cash account would currently only serve to erode the ‘real’ value of the capital as inflation outpaces interest rates. This is where the cost of goods and services is increasing each year and what you buy with £10,000 now could cost £10,250 at the end of the year. We are aware of current interest rates and if we apply basic rate tax to the interest payment, that’s a fifth of that return lost to HMRC.

Increasingly I find I am discussing a client’s attitude to risk with available capital and more often I find that I am now questioning if they can afford to be so ‘cautious’ with their investments (such as cash) when they are losing money. Can they afford not to take more risk in search of a greater return?

It would make sense to use your ISA allowance, either the Cash ISA or the Stocks and Shares ISA because again this is tax efficient.

In the past, National Savings would have been a consideration for secure, tax-free investments but the government has withdrawn both the Index Linked and Fixed Interest Savings Certificates.

Any other capital investment should be under the guidance of an adviser because of the issue of risk and the complexity of tax wrappers. However, with the introduction of RDR (retail distribution review) I would generalise that many consumers who require advice do not have sufficient capital to make it cost effective to employ an adviser (£50,000 for investment needed), with the typical pension fund for annuity purchase under £30,000.

Things to compare:

Building Society Interest – 2% gross, access to capital, Interest Taxable.

Pension Annuity – 5.21% gross for a 65 year old for their life only not increasing in payment with loss of access to capital.

Purchase Life Annuity – I couldn’t currently find a provider but these typically used to be lower than a pension annuity because much of the annual payment would be treated as a return of capital and a very small part of the payment could be taxed as an interest payment. In addition, surely you would only seek to buy a voluntary annuity with your capital if you thought that you would live long enough to benefit from it. Thus reducing general rates. Typically Standard Life or Partnership (for enhanced annuities) has existed in this market.

(Annuity rates from Avelo. 28/01/2013. Annuitant age 65. Wife 3 years younger where widows quoted. )