Key Post Retiring - should I take a higher lump sum in exchange for a lower pension?

Billydog

Registered User
Messages
18
My defined benefit pension is to commence in May next. I have been offered either a annual pension of €65k or a reduced annual pension €53k and a tax free lump sum of €148k.

So for each €12 of tax free lump sum I take I will lose €1 of annual ongoing pension.

It looks like I should take the full lump sum because

1) Its cash in hand.
2) With some income from other part time work I will be paying tax at the marginal rate for the foreseeable future.

i am open to contradiction on the above points.

My main query is in relation to the commutation rate offered by my ex employer. This is 12.1. Is this normal or below average. i.e. are they trying to screw me? It seems less than generous when compared to interest/annuity rates.

Do any members have knowledge of commutation rates being offered by other large employers in the state?

Thanks for your help.

Billydog
 

Brendan Burgess

Founder
Messages
47,206
This is a very difficult question to answer. Here are some initial comments.

If you invested €148k today, where would you get a return of €12k per annum or 8%?
OK, after tax, it will be reduced to 4%. Still a very good return.

Of course, that is not comparable to a normal return, as you don't get the money back when you die.

What is your state of health? If you had a shortened life expectancy, then it would argue for taking the cash. If you expect to live until 150, the return is pretty good.

What would you do with the €148k? If you have a mortgage which is costing you 4% interest, then paying it off would be a better return.

Do you have a spouse who gets a dependent pension on your death. This would argue for the higher annuity.

How well is the scheme funded? Pensioners get first priority in the event of a wind up, but this could, and should, change. So if the fund has a big deficit, maybe you should take the cash now.

I don't know how the commutation rate compares. Who sets it?

Does the fund pay the pension itself or does it buy an annuity on your behalf? If so, can you shop around?

Brendan
 

Billydog

Registered User
Messages
18
Thanks for advice. I am fortunate in not having any debt. I hope to live for awhile yet I will be 60 in May.!! Yes my wife would get a widows pension from the scheme at 50% of my entitlement. The scheme is a UK bank one and I suppose as secure as any other but does have a shortfall which I am advised is being addressed.

Taking a lay mans approach - If I take the cash the annual reduction in my income will be €12k. After tax at my marginal rate say I lose €6,600 pa so against the lumpsum of €148k I will have to live for over 22 years to lose out. Would also have the benefit of the cash with investment return etc.

The scheme funds itself. The commutation is set by the trustees of the scheme - I presume after actuarial advice.

I think I am attracted to taking the lumps for reasons outlined above but am wondering if it is worth challenging the commutation ratio. So curious if you or other members have any comparisons.

Again thanks for you help.

Billydog
 

Bronte

Registered User
Messages
14,162
The difference is 12K a year. You are 60. Life expectancy is what, 80? Can you live very comfortably on 53K annually. Do you need 65K. Good that your wife can get 50%. That is either 26K or 32K. Can she live on 26K?

The older you get the less you need as you're not going to galavanting at 75, just saying. So being a young 60 is the time to take a lump sum and have some fun. That trip around the world, the new car that will do you 10 years, the new kitchen etc. Based on the maxim that you never know what is around the corner and we only live once I would take the lump sum.

And I've never believed anything was secure. (Waterford Wedgewood employees, and the ones in Cork (?), Equitable Life, Enron etc)

Of course you should question the computation ratio so that you get the max.

Another thing to be clear about, what will pay for ill health in retirement. Continue your company insurance if it's good would be the ideal.
 

Gerard123

Registered User
Messages
294
Interesting scenario. Lots of ways to look at this and things to consider, many set out above.

I looked at it this way. Say that you can live on 53K per year and that you can save above that, i.e. save the 148k lump sum or save the 12k (net 5,400 per your numbers, ie 12k less 6,600).

How long would it take saving the 5,400 per year to save 148k? Need to obviously factor in annual interest, return? What should this be. I assumed 2% net in my first calculation. I also assume that you both continue to live.

By my calculation you would need to live to 98 at which time the money saved by saving the 5,400 each year at 2% interest would be the same as the amount if you saved 148,000 on day one also at a 2% return. (pretty much 148,000 divided by 5,400 = 27.4 years, with increase due to interest on larger cash lump sum up front)

Very simplistic, but sometimes simplicity helps to focus the mind.

Also if you were to pass away before 98 then your wife gets 2,700 per year (??) so she would need to live most likely way beyond 100 for the sums to add up.

(At an annual return of 1%, the two amounts would correspond at your age of 91. 3% annual return net, age 114!!).

All other things being equal I would think the cash makes more sense.

However, health care, nursing homes, etc. Risk that any cash lump sums will be factored into the cost of nursing homes so can't discount those. I can't get away from the security of knowing that there is a significant cash lump sum available and under your direct control, should something happen.

Forget to say, obviously seek a better computation ratio.
 

Billydog

Registered User
Messages
18
Thanks very much for the views. I will challenge the commutation rate but feel it is just part of the scheme and applied to all. I would have more ammo if I heard that other schemes were being more generous. Or would feel better if I heard this was pretty standard in other defined benefit pensions so I am getting the norm.

Regards

Billydog
 

Conan

Registered User
Messages
1,437
In comparing the two options you need to remember that the lump sum will be paid to you tax free, whereas any income will be taxable. So whilst the gross pension might be €12,000 lower if you take the lump sum, the net pension might be only €7,000 lower since your pension will be subject to marginal rate tax. However the lump sum is tax free.
In general the advice is always to take the tax free lump sum. Looking at the numbers above it would take 21 years of a net €7,000 to give you €148,000. And that ignores any interest you might earn on the €148,000 over the 21 years and the flexibility of having cash as opposed to an annual income (which would in any event cease on death).
I think it is a simple decision, take the cash ( a bird in the hand etc).
 

Steven Barrett

Registered User
Messages
4,503
How old are you? And how old is your wife? I can then work out the net present value of €12,000 gross per year and compare it to the income a net present value of €148,000 net will provide.

Steven
www.bluewaterfp.ie
 

JoeRoberts

Registered User
Messages
511
Regarding decision to commute or not, if you have a spouses pension option of say 50% then after commutation it is normally still 50% of the original pension, not the reduced pension. This should also be considered in favour.
The rate of 12:1 while a long way from current interest rates, is still better than many schemes on 9:1. Decision on the rate will depend on the Trust deed but normally it is the Trustees with the agreement of the employer. Funnily enough, many employers shudder at the thought of giving a better commutation rate but it can work in their favour as they can use it in reducing the liability assumption for accounting.
So you could ask the Trustees to review it but it would take some time.

Like the others, I can see no reason not to commute your full entitlement. Especially since you would fall into the category of pensioner in payment that can now be cut in a restructure under the new legislation. So get the bird in the hand and reduce risk of a cut.
 

oysterman

Registered User
Messages
580
Pension is from a UK employer. That exposes the OP to exchange rate risk throughout retirement period. Taking more of the benefit upfront (in the lump sum option) hedges some of that risk.
 

Billydog

Registered User
Messages
18
Thanks to you all for great advice.

A point of clarification. The pension is payable in Euro.

In relation to the commutation rate of 12:1 your members may find the following quote from an article in the Actuary Magazine (trade journal for actuaries) of interest:

"Defined benefit pension schemes typically use a factor of 12 to determine the reduction in pension of those who take tax-free cash at retirement. This is a lot less than the projected cost of the pension given up; the reduction in the cost of benefits improves the scheme’s funding position and/or reduces the employer’s costs.

This practice is wrong. Trust law requires trustees to be even-handed between members, the fund, and the employer. Members taking cash should not be penalised. Even ignoring trust law, the practice is clearly inequitable and contrary to members’ reasonable expectations. Commutation factors should reflect the cost to the scheme of providing the pension given up, allowing for any uncertainties arising from the level of the funding of the scheme, and the covenant of the employer.

Actuaries advising trustees on the factor to use and our profession will both be in the firing line when consumer representatives understand what is going on. We must change the way in which we advise trustees. Urgent action is essential – for example in the form of guidance to members. The brief reference in the September issue of The Actuary was a start, but didn’t go nearly far enough."

It seems that schemes are not treating those seeking to take a lump sum on an equitable basis. Those with defined benefit pensions should be aware of this.

The commutation rate at these sort of level do make contributing to AVCs more attractive as these can be used to pay a portion, or all, of the tax free lump sum.
 

Steven Barrett

Registered User
Messages
4,503
Trust law requires trustees to be even-handed between members, the fund, and the employer.

In imposing the rules of the scheme. If the scheme rules say the commutation rate is 12:1, they have to ensure it is across the board.

Actuarial funding and real funding is very different. For example, if you transfer your benefits to a DC arrangement, the actuaries assume an annual growth rate of 7% in the DC arrangement. This is simply not realistic, so the member always gets less from transferring out. They also use an annuity rate of 4.5%, which again is unrealistic.

DB pensions come down to how much the employer is willing to put into the fund on the employees behalf. If they reduce the commutation ratio, they will take it away somewhere else, probably by offering a lower pension rate. They won't pay for a Rolls Royce pension for everyone, it will send them to the wall.

...I have never met a client who didn't take the tax-free lump sum.


Steven
www.bluewaterfp.ie
 

Homer

Registered User
Messages
432
A number of points here.

  1. As pointed out by JoeRoberts, spouse's pensions are based on a member's pre-commutation pension, so taking the lump sum will not affect the amount of pension your wife will receive if you pre-decease her.
  2. The basis on which commutation factors are calculated is specified in the rules of each scheme. Typically, there are three possible approaches
    1. The commutation factors are specified in the rules (and may well be as low as 9 to 1 at age 65)
    2. The commutation factors are decided by the trustees in consultation with the scheme actuary, but nothing is specified regarding whether these factors should represent reasonable value for money.
    3. The commutation factors are decided by the trustees in consultation with the actuaries, and there is wording included to the effect that these factors should take account of market conditions, life expectancy, etc.
  3. Under both 2 and 3 above, the factors should be reviewed on a regular basis (typically as part of each formal triennial valuation), but this doesn't always happen.
  4. Trustees in the schemes that are supposed to take account of market conditions are potentially exposed and subject to challenge if they fail to adjust commutation factors. The position in relation to schemes under category 2 is less clearcut, as it could be argued that commutation is an option than a member can choose not to exercise and that members can fund their lump sums by paying AVCs.
  5. Where a scheme is using commutation factors based on current market conditions, these are still likely to be a lot lower than open market annuity rates as they will reflect the cost to the scheme of paying the pension from the fund rather than the cost of buying these pensions outright and paying costs that include a life office's margins for prudence, overheads and contribution to profits.
  6. A factor of just over 12 to 1 at age 60 is probably not significantly out of line with what other schemes are doing and better than many, assuming there are no pension increases. However, if the scheme provides pension increases (particularly if these are guaranteed rather than discretionary), then the gap between the lump sum and the value of the benefits being commuted is somewhat greater.
  7. In addition to considering future life expectancy, the rate of tax that would have been payable on the commuted part of the pension and the net return that could be obtained by investing the lump sum also need to be factored into the comparison.
  8. Another key issue is the additional flexibility that is afforded by having a lump sum and the uses to which it might be put by the OP.
  9. As others have mentioned, a lot of pension schemes are in financial difficulty and the possibility of the pension being reduced if the scheme is wound up (or, at the very least, future pension increases being curtailed) also needs to be taken into account.
  10. One final point. The lump sum option does not apply on an 'all or nothing' basis. The OP could choose to take a lump sum of less than the maximum amount permitted and the reduction in pension would be adjusted accordingly.
 

Billydog

Registered User
Messages
18
Again, thanks for all the really useful advice. Pretty clear that I will be taking the lump sum. While not totally happy I do feel more comfortable with the commutation rate at 12:1. However I do intend to tackle them on the rate but highly unlikely I can get an improvement as it seems to be written into the scheme and not individual to me.
 

SuperDuper

Registered User
Messages
3
Hi Everyone,

I'm tagging on here as it's in the area that I am looking for some input on. I have a defined benefit scheme coming to maturity, I also have an occupational scheme in place. Based on the Tax Free lump Sum on offer in the DB scheme the DB fund total value is about 600K my other pension pot is valued at about 150k - ideally I would like to combine the 2 pots and use my occupational scheme to take my TFLS but because they are different employers this cannot be done (I am told). Is there a way around this - if I moved my funds from the Occupational Scheme to a buy out bond could I then calculate my TFLS using a combined value and use the buy out bond to fund my TFLS entitlements hence leaving the max in my defined benefit scheme or do I have to 25% of each fund up to my max entitlements.
Hope that makes sense - basically I am trying to take max annuity from DB scheme and use my other pension pot to fund my TFLS.
Any input greatly appreciated.
 

Steven Barrett

Registered User
Messages
4,503
You won't have 25% tax free at all. You are in a defined benefit scheme, your lump sum is calculated based on years service.

Administrators find it very messy to take a lump sum from one scheme and annuity from the other, so most just don't allow it.

Remember, that unless you are in the public service, DB schemes are no longer as secure in retirement. Pensioners in receipt of DB benefits are having 10% taken off their pensions, so maybe it's not a bad idea to take the lump sum, they can't come after that in the future.

Steven
www.bluewaterfp.ie
 

Tintagel

Registered User
Messages
495
I see that a person can take a lump sum of up to €200k tax free from their pension. Is this correct?

I am being offered a small lump sum pension of circa €50k plus a reduced pension. I am being asked by my pension provider if I have taken a redundancy package, which I have. Does a redundancy package impact on a pension lump sum?

My redundancy package was taken back in the year 2000. Does this date matter because there are references to the date December 2005 in correspondence, suggesting to me that only redundancy amounts after this date are taken in to consideration?.
 
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