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Should DB scheme members be taking the tax-free cash option?

Tax free cash is one of the big attractions of savings in a pension but Axa’s Andy Zanelli says it is not always the best option.

Andy Zanelli Axa 2012

The right to take a portion of your pension as tax-free cash is still one of the main reasons given when asking what the biggest attraction of this type of saving is.

I suppose we should give it the right name: pension commencement lump sum, as this A-Day change has always signalled to me that there is a future intention by HM Treasury around tax. This bastion of pension savings had led to a perceived wisdom that you are always better off taking the PCLS.

Even if the ultimate need was to produce income, the way forward was to take the cash and buy a purchased life annuity. As with all aspects of financial planning these days, it is never that simple so some careful thought, hopefully mixed with some quality advice, should be the way forward.

Many clients will have gone through some sort of financial planning, life coaching, goal-setting type exercise either driven personally or with an adviser. For many of these people there will be some very specific aspirations that will be satisfied by the PCLS from their pension savings: paying off the mortgage; a new car; the holiday of a lifetime and so on. These goals will have been clearly set and planned for so the decision has already been made.

But for many who are approaching retirement the question of whether to take the PCLS has become a much more difficult decision recently due to factors like the growth in defined contribution provision over defined benefit, the flexibility in the age at which you can retire from your scheme, the decline in annuity rates, the volatile economic environment and increasing longevity. All of these factors can affect this one-way choice.

One of the biggest groups of people affected by this choice are those with benefits in a DB scheme; current active members are a dwindling group, but there are millions of clients with deferred pensions available to them in the future.

For these clients some careful consideration of what they are giving up is needed. I find it ironic that the FSA and others are taking a very keen interest in the whole area of transfers from a DB scheme, concerned about the very valuable potential benefits that may be lost, but have no interest in looking at the commutation factor used if the client has the option to give up some of their income for cash.

This is not the case for all DB schemes as some offer cash plus a pension, however, some of these schemes are moving over to an income with the option of commutation.

The latest Occupational Pension Schemes survey, published last October by the Office for National Statistics, puts the average commutation rate offered as 12:1.

So as an example that is £5,000 of income transformed into a cash sum of £60,000. There is an obvious attraction to a lump sum that (currently) has no tax liability and this aspect steals the attention for many.

However, people should consider the fact that this income would be paid for life. Invariably it will rise in line with a measure designed to give some protection from inflation and may well have valuable dependent’s benefits.

Taking a quick look at some best buy annuity rate tables demonstrates that £60,000 for a joint life, (where the surviving spouse/civil partner benefit would be 50 per cent), a 3 per cent escalation annuity would give less than half the income being given up from the DB scheme through commutation.

Logic would suggest that a commutation rate of closer to 25:1 would be more representative if the object of the exercise was to try and replace income given up.

This contradicts the perceived wisdom of ‘always take the cash’ but there are some who stand to gain from this: the sponsoring employer who has to fund the liabilities of the scheme.

Having members take their full entitlement to PCLS at a commutation factor of around 12:1 reduces the future liabilities associated with an index-linked pension in return for a one-off hit to the scheme on very favourable rates.

Taken at face value this is a stark headline but at this point the concept of value for money comes into play both from the context of the client’s position and the value added by quality financial advice.

As with any client situation, the wider perspective is needed and one of the main factors is life expectancy. Even if the income need is predominant there are alternatives like enhanced annuity rates for the cash or investing the capital, taking the natural yield of the investment and supporting the required income level with a targeted capital erosion strategy.

A dependent’s pension from the pension scheme will usually drop to around 50 per cent but the invested capital strategy could sustain the initial income levels for survivor.

If the client wants the potential to leave a lump sum to someone, then they have this option if cash is taken; they may be single and have no need for a dependent’s pension.

These and many other factors will determine the best way forward for the individual.

The one thing they should do is ignore any headlines that may look at only one aspect and carefully consider all of the circumstances in the currently complex planning environment – preferably in conjunction with a suitably qualified adviser.

Andy Zanelli is head of retirement planning at Axa Wealth

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Comments

There are 3 comments at the moment, we would love to hear your opinion too.

  1. The important thing to remember is no one size fits all.
    For some taking the cash is the correct option for others it isn’t.

  2. If I get to retirement with a £400k fund of which £300k is from DB and £100k is totally separate DC, then can I take all my 25% PCLS from the DC pot, effectively emptying it, and leave all the DB pot to provide income?

    If not, why not? Is it pension rules or provider rules that are stopping me?

  3. All depends on the client circumstances – personal, health and life expectancy etc.

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