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Make hay while the sun shines

In my last few articles I have discussed a number of key issues which should be of prime importance to clients and, therefore, also to their financial advisers in various aspects of pension planning.

My last article evaluated a topic which, on the face of it, should be a basic and core aspect of almost every financial adviser’s know- ledge and understanding – the importance to clients of taking the maximum allowable tax-free cash from all money-purchase pension plans and many or most final-salary schemes.

I will not repeat the comparative numbers I presented in that article but will content myself by introducing a development on this theme by simply reminding readers that even if clients with vesting pensions do not want or need to take the maximum allowable amount of tax- free cash, they should nonetheless do so and reinvest that lump sum in a more tax-efficient method of providing lifetime income – a purchased life annuity rather than an annuity bought directly by the pension scheme fund.

I have so far only noted the importance of taking tax-free cash from a money-purchase scheme and have only briefly mentioned that this issue has a very significant importance for retiring members of final-salary pensions due, not least, to the wide variation in commutation factors used by different defined-benefit schemes.

To illustrate the principles involved, I will use a few examples of the impact of different commutation factors on a client’s promised benefits. Suppose, as in Table 1, that a scheme uses a commutation factor of 6:1 on John’s retirement from the scheme.

Now, if John were to discount the possibility of a transfer, his choice of benefits from the scheme would be an annual pension of 20,000 or a reduced pension of 16,250 and a tax-free lump sum of 22,500. Considering the PLA option for reinvesting this lump sum, if he neither wants nor needs such a “windfall”, even the tax advantages of this type of annuity over a pension annuity would not compensate for a loss of income of almost 4,000 to buy a lump sum of 22,500. This lump sum would buy – albeit tax-efficiently – a gross annuity (50 per cent spouse’s benefit with 3 per cent escalation, to provide a like-for-like comparison) of only 900 a year.

Unless John really needed or desperately wanted the lump sum, perhaps to pay off pressing debts or because his state of health indicates he may have a very restricted life expectancy, he would be well advised to take all his benefits in the form of annual income.

If he were to consider transferring his benefits to a personal pension, you can see from Table 1 that although his annual pension, taking no lump sum, would be expected to be very similar to that promised by his scheme, the significantly enhanced amount of tax-free lump sum with only a slightly smaller residual pension would start to look very attractive, especially bearing in mind the tax-effectiveness of the PLA option if he did not need or want the lump sum and chose to reinvest it, as we would probably advise in these circumstances.

A standard transfer analysis system (with a notable exception of O&M’s software) typically would only compare scheme-promised pension with the amount of pension which could be bought from the transfer value, totally ignoring both the very low commutation factor used by the scheme (relatively very little cash for the amount of pension forgone) and the tax advantages of the enhanced tax-free cash entitlement after transferring. Bearing in mind these various aspects of John’s options, a transfer might start to look a feasible, if not preferable, alternative to benefits from the scheme.

Now, here comes the main message within this article. How would John’s options differ if his scheme were to use a cash commutation factor of either 9:1, 12:1 or 15:1 instead of the 6:1 factor used in my first example? Table 2 shows a comparison.

Ignoring for the moment the possible attractions of a transfer of pension benefits to a personal pension, you should be able to note clearly that the higher the commutation factor, the lower the reduction in pension to buy the same amount of tax-free cash. Within the scheme, assuming that the option to pay 25 per cent of the equivalent fund has not been adopted, you should confirm yours and the client’s understanding that the commutation factor used by the scheme neither increases nor decreases the available amount of tax-free cash. For any given level of tax-free cash, it affects the amount of residual pension.

As regards the possible advantages of a transfer, it should now be obvious that although a basic transfer analysis – comparing all pension within the scheme to all pension from a transfer – would not give any obvious empirical reason to recommend a transfer, the enhanced tax-free cash entitlement (and attaching tax merits of a PLA alternative over a pension annuity) could come with an attractively competitive residual pension. This potential benefit of transferring reduces, though, the higher the commutation factor used by the scheme, as the comparison in Table 2 shows.

In closing, please note that although I have used a slightly contrived example of a scheme member at the exact tine of his proposed pension vesting, all the principles I have illustrated also apply – but with variations I will highlight and discuss in my next article – to final-salary pension scheme members some years away from their stated normal retirement age.

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