Could you put the options below in layman’s terms for me please. All I am after when I retire is to get a decent pension with rises in line with inflation.
A lump sum would be handy but not a big deal. I am not sure how Pension Increase Exchange (PIE) works.
1. Standard scheme benefits 6.71 per cent LTA used £3,602 pa £0
2. Max tax-free lump sum 6.90 per cent LTA used £2,784 pa £18,561
3. Standard scheme benefits plus PIE 8.83 per cent LTA used £4,738 pa £0
4. Max tax-free lump sum plus PIE 8.37 per cent LTA used £3,375 pa £22,497
Option 4 looks good but there must be a pitfall as option 1 has no lump sum. Help!
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Pension question: Should you take a tax-free lump sum from your pension if you don’t need it?
Steve Webb replies: Now that you have reached pension age in your defined benefit pension scheme you have two key decisions to make.
The first decision is whether you want all of your pension as a regular income, or whether you would prefer a lump sum combined with a lower regular pension.
The second decision is whether you want to give up some of the inflation protection built into your pension scheme’s rules, in exchange for a higher starting pension.
Whilst there is no ‘right answer’ to these questions, I am happy to run through the main pros and cons of each option.
Looking at your first two options, you can either take an annual pension which starts at £3,602 or you can give up roughly a quarter of your pension (leaving you with £2,784 per year) in exchange for a tax-free lump sum of £18,561.
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One way of thinking about the generosity (or otherwise) of the lump sum offer is to compare the annual pension you are giving up (£818) with the size of the lump sum.
If we ignore the effects of inflation for now, the lump sum is worth just under 23 times the amount you are giving up each year if you go for this option.
In addition, the lump sum is tax free whereas your pension is taxable, so if you expect to be a taxpayer in retirement then the tax free lump sum looks relatively attractive.
Another attraction of the lump sum would be if you have a particular need for a capital sum now which could improve your finances in the long-term.
An obvious example would be if you have any high cost debts which could be cleared with a lump sum.
However, a lump sum is not for everyone. If you take a reduced pension now, you will have to get by on a lower income for the rest of your life.
If you have a long retirement you might end up getting less money over your whole retirement if you take a reduced pension now.
In addition, it looks to me as though your pension scheme has relatively generous protection against inflation, and you have mentioned that this is important to you.
By taking a reduced starting pension you will get a lower cash increase each year, and this will give you less protection against rising prices.
For anyone who expects to be on benefits in retirement, taking a lump sum needs to be done with care.
Some benefits (such as housing benefit or help with council tax) have strict rules on capital, and having a large lump sum sitting in a bank account could mean you are disqualified from benefit.
STEVE WEBB ANSWERS YOUR PENSION QUESTIONS
What is a Pension Increase Exchange, or PIE?
Turning now to options 3 and 4, you are being offered what is called a Pension Increase Exchange or PIE for short.
I have written about PIE before here, but the key point is that you are being given the option of taking a higher starting pension in exchange for giving up some of the inflation protection built into your scheme.
By law, defined benefit pension schemes have to offer a minimum level of inflation protection.
The exact rules are complex, but a key point is that your pension scheme rules may be offering something better than the legal minimum.
For example, the law requires any inflation increases to be linked to the Consumer Prices Index (CPI) whilst your scheme rules may link increases to the generally higher Retail Prices Index (RPI).
You are being offered a higher starting pension in return for giving up some or all of these advantages.
Turning to the specific figures, if you compare options 1 and 3 (both of which involve no lump sum), you can either have an annual pension of £3,602 which increases each year in line with the rules of your scheme, or a higher annual pension of £4,738 which will rise only in line with the legal minimum rules.
You have said that inflation protection is important to you, so that might be a reason for sticking with the lower starting pension but seeing it well protected against inflation.
On the other hand, if you are feeling the squeeze now you could go for a higher pension now, recognising it will rise more slowly in the future.
I am disappointed that the pension scheme seems not to have given you much explanation of your options.
With a PIE there should be some explanation of what inflation protection you are giving up and some indication of how long you would have to live to get more under one option than under the other.
If you have not received this information you should certainly contact your scheme and ask if they have any kind of helpline which can talk you through your options.
What is the lifetime allowance, or LTA?
Finally, for each option you have also been told how much of your Lifetime Allowance or LTA will be used up in each case.
The LTA is currently £1,073,100 and is the total value of lifetime pension rights you can build up whilst still enjoying the benefits of pension tax relief.
For defined benefit pensions, to work out how much of your LTA is being used up by taking this pension, your annual pension is multiplied by 20 (effectively assuming you will live for 20 years in retirement) and any lump sum is added.
For Option 1, your annual pension is £3,602, and multiplying this by twenty gives £72,040. Expressed as a percentage of the LTA, this is 6.71 per cent.
If you have large amounts of pension saving then you may need to keep track of how much of your LTA you have used up, but if you have modest savings then you can ignore this information.
