Thursday, 9 April 2015

Defining the Benefit. When to take a Defined Benefit pension.

Timing risk and when to draw a Defined Contribution pension are well documented. I was fascinated to read RIT's recent post on this in which talks about SWR and links to a video which uses historical data to illustrate that when a pension "pot" is put into drawdown is a major factor in determining whether or not it will last and that no withdrawal rate (whether 4%, or even less) can be regarded as "absolutely" safe but must be assessed in the context of the "value" of the markets at the time the pension is taken.

I was fascinated, but in a detached kind of way, because this kind of deliberation about "when" has never been considered necessary for those of us lucky enough to have index-linked DB pensions. Received wisdom is simple - never take a DB pension before scheme payment age if at all possible, actuarial reduction is to be avoided at all costs. But I've been thinking about this recently and have come to the conclusion that deciding when to take a DB pension is not that simple after all. We may think that it is but that is only because, unlike with a DC pension, it is easy to count the cost of taking the pension early, when what we should actually be doing is making some effort to measure this cost against the benefit.

As an example my own figures come out like this: (I currently have £35,000 in my SIPP and was intending to boost this up to around £50,000, retire at 58 and defer my LGPS till 65).
  • Pension if I take it at 65 - £9,300. Tax free lump sum -  £13,000. (When taken this this would be partly subject to 20% tax as I have a small amount of rental income, plus state pension would become payable at 66).
  • Pension if I take it at 60 - £7020. Tax free lump sum - £11,500). (This would be taken tax free until 66 as I intend to pay myself just enough out of my SIPP to take me up to the PA).
As I would get the pension for 5 years longer if I take it at 60, I will start to go into a "loss" at age 75 when I will be £2,300 pa worse off. I would therefore be down by around £35,000 if I live to 90 and this loss would increase year on year. Sounds like a bad deal and I should not even be considering it as an option if I can avoid it?

But what this calculation doesn't take into account are the benefits attached to:
  • Not having to stretch our finances to allow me to retire at 58 (in other words, the pressure is off as I already have enough in my SIPP. In fact I shouldn't put any more in there as I am already at the limit of what I can use tax efficiently should I decide to access my LGPS at 60)
  • Being able to take advantage of a tax free lump sum of £8,500 from my SIPP at 58 which could be re-invested in my ISA, in whole or in part. The rest of my SIPP would adequately fund the two years before I taking my LGPS.
  • Being able to access my LGPS tax free lump sum and AVCs at 60 instead of 65 (when my husband would be 71 and we may not be able to put it to such good use). My TFLS/AVC fund currently stands at around £16,000 but could be bumped up to £25,000 by paying what I was going to put into my SIPP for the next two years into my AVC instead. (It is a perk of the LGPS pre-2014 that the whole of the AVC fund can be used to boost the tax free lump sum - subject to certain upper limits that don't apply to me).
  • A big part of my income between 60 and 65 would be index-linked and risk free (via the LGPS) rather than managed myself via my SIPP (and therefore subject to market risk or inflation risk if I move it down into cash).

All the above add up to a clear win, for me, to taking my pension early despite the 24% reduction. This win is personal and depends on my lifestyle and situation, what it actually costs in monetary terms is just one of the considerations. After thinking it all through I'm pretty sure which way to go and have revised my targets accordingly. In fact the only one that I haven't yet hit is the one that means I need to add another £1,000 pa to my LGPS pension and that is simple to satisfy  - I just need to keep working for another 2 years.  

On a more general note, if things stay as they are with DB pensions and public sector ones in particular - which is unlikely but does provide food for thought - then it seems probable that some sort of "retirement age" gap could grow up between those with DC pensions, who let the decision on when they want to retire drive their saving and investing plans because no-one can actually tell them in advance what will be the best time to go, and those on DB pensions who just "expect" to have to stay in work until they reach scheme retirement age (which is increasingly being brought in line with State Retirement Age). Of course, there is nothing to stop DB pensioners funding (slightly) early retirement but it does need the foresight to set up an additional personal pension, a fair excess of salary over needs and a willingness to confront the horned beast of actuarial reduction, and assess the benefits of taking a hit on total pension received, in the context of the whole retirement plan, rather than with "just don't do it" blinkers on.

Knowing the financial cost of something is an advantage, but it can be a brake in just the same way as not knowing can (and maybe even more so). When deciding when to take a pension we should all make sure we take due diligence with our cost/benefit analysis and never forget that the only thing we can really be sure of is the value of time.

22 comments:

  1. I am so bad with maths, I am not sure sometimes what the answer shoud be. Here, I think you laid things out quite clearly, and it is more 'valuable' to you to be on the option that actually gives you less money. But as you say, it is a matter of lifestyle. Maybe if you didn't have MrCerridwen you'd work longer?

    I'm not sure what kind of pension my Dad has, but it sounds a lot like yours. He got a massive tax-free lump sum when he retired and then quite a large pension, but he had originally planned to retire later, as he loved his job. Unfortunately, all the red-tape and middle management that was brought into the NHS by the Labour government made him more and more fed up. It was a bit sad to see this happen, but it then pushed him into the decision becoming a lifestyle issue for him to quite work at 65, instead of working until he didn't want to/couldn't anymore.

    My Dad couldn't afford to have a private pension, so tt's good that you have the option of retiring a bit early due to you having been wise about sorting a SIPP out.

    Cheers

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    1. Hi tv,

      The changes to pensions announced last year are largely what have made my early retirement possible because before then it wouldn't have been anywhere near as easy to get together a personal pension on top of my work one that could be used to cover the short period between leaving work and drawing my DB pension. Your Dad wouldn't have had the same kind of options so I do feel lucky from that point of view. I'm also pretty glad that a CoOp "advisor" almost 20 years ago suggested that I started paying £50 a month into a FSAVC which I did, but then promptly forgot about (although continued to pay). It has built up into a nice little fund now and makes up the biggest part of my SIPP.

      If I didn't have MrCerridwen I don't know if I would be planning to work longer. Yes, the fact that he is older than me and we want to be able to take long holidays etc together is a factor, as is the fact that his life expectancy isn't good. But another factor is the extreme dissatisfaction I have been feeling in my job over the last few years. The service I have spent a lot of my working life helping to build is being cut to the bone due to lack of funding and I despair over what is happening to public services in general. It's hard to see that first hand, every day.

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  2. Hi Cerridwen

    A great post about how the "conventional" wisdom drives decision making when we all have different drivers. In my view the thing that is never considered is that the value of money (over and above that needed to live basically), is linked to time. Is a sum of money when you are 80 years old and not able to do as much with it because of your age better than 75% of the same sum at 60 when most people are still fit and healthy and able to use the money to provide enjoyment.

    I have a final salary pension that will pay me around £7,000 per annum when I am 65 of around £5,000 when I am 60 and I really consider £5,000 from 60-65 to be worth far more than the extra £2,000 from 65-77.

    In fact I would actually prefer to transfer the value of this pension (transfer value around £127,000) to my SIPP and finish working now and have the freedom to travel, spend a whole Winter skiing, a whole summer in the South of France biking and walking. OK, I may have to live on less when I have used all the money (around 80), but there is no guarantee I will reach 80, and if I do I may not be able to ski, bike, walk in the mountains etc.

    I think the Financial Products and Advisers industry needs to review the belief of the value of a pension being the same regardless of your age, and consider that a final salary pension is not necessarily the holy grail. If a person can clearly demonstrate that they understand the risk, and that they cannot expect to be bailed out if their decisions go differently from how they expect, why shouldn't they be allowed to take more cash early?

    Best Wishes
    FIUK

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    1. I agree that time is one of the factors that determines value. It would be good to put time and money into a graph of some kind and be able to pinpoint the place where they cross - the "perfect" time to retire. But impossible of course (and thank goodness :-)) because the big unknown is where the timeline stops dead .

      I hope you get as much biking, skiing and walking as you can possibly handle before that happens - the best way to make sure of that is to start as soon as possible :-)

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  3. Hi Cerridwen

    You've brought up an interesting key point about retiring - what do we need/want to spend as the years pass and will there be enough money? Are there any 75 year olds out there blogging with advice to their 50-60 year old selves? (although 15 years ago, an annuity was the only way for most)
    We are both now 60, I've stopped work, and DH wants to stop next year.
    We are both very active and would like to travel about quite a bit (in a cheap way!).
    Some of the thinks we like are a bit pricy and require kit (diving, motorcycling)
    How long will our health and strength last for those sorts of activities? Should we spend our savings on them now? When will we find camping too uncomfortable?

    I see local 70, 80 year olds out and about during the day, we chat about everyday things, then the conversation gets around to their latest illness (though they appear very active!)...... but talking about finances is a no-no!

    What we have found, turning 60, is that you shed ideas that are not core (for us anything fashionable!) and get determined to do what has meaning for us alone.
    Doing things together is key for us (a few years ago my MIL found life without her husband almost impossible).
    But because financial security has importance for me, DH is worried that we will die without enjoying our savings.


    You've shown a good way to help make decisions about using/taking our pensions/savings to plan for the future. Thanks.

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    1. Hi Rowan Tree,

      Not long to go then before you will be able to plan your travels and adventures :-).

      I like the way you describe making a conscious effort to find out what has meaning for you. On the way to work I get off the bus a mile early and walk up into town, past the canal and through the park. Lately I have come to realise how much I enjoy this part of the day and have been wondering how I will replace the pleasure it gives me when I no longer have to come to work and the temptation will be to potter around with a cup of tea in bed and miss the best part of the morning. Making a conscious effort to identify key experiences that enrich our lives and make sure that we find time for them is very important, even in retirement when there is more of that time to go round.

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  4. Hi Cerridwen

    You've been pondering on this a while, thanks very much for putting your thoughts down in such a detailed post and well done on revising your targets - to me, it sounds like a great decision on your part.

    With 10 years minimum to go before I was struck with your dilemma, it's not been so urgent for me to think seriously about the consequences of taking my DB pension early.

    However, a big announcement today at work has brought things crashing down around me and I may need to rethink my whole plan for FI, not just whether to take my DB pension early or not!

    At the moment, there are a lot of unknowns so I'm not going to do anything different or change anything until I know more.

    Until then, I'll be carrying on as normal but I'll update on my blog when I know the facts.

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    1. Oh dear weenie, that sounds a bit scary. Hope everything turns out OK and please do keep us posted. :-)

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    2. Hi Cerridwen,
      I think I am in a very similar position and am considering a very similar strategy. Just one thing in relation to the maths, you say you will go into a 'loss' aged 75. I couldn't work out why at 75? Is it because this is when you SIPP fund top up will likely end?

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    3. "I couldn't work out why at 75?" Cos it's a mistake: she breaks even at 80.

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    4. Hi John and dearieme,

      My maths (for better or worse - and it seems to be the latter in this case) - went like this:

      Take my pension 5 years early at £7,000 - receive £35,000 for those 5 years
      Amount by which the pension is less than it would have been had I taken it at £65 - £2,300.
      Divide 35000 by 2300 = 15.21.
      Therefore after having received the lower pension for 15 years at (75) I would start to be losing money compared with if I had deferred and taken the pension at 65.

      But using dearieme's answer: - if I Take the pension at 60 then by 80 I will have had 20 x 7000 = £140000. If I had taken the pension at 65 I would have had 9300 x 15 = £139,500 so that is obviously correct answer. (Thanks dearieme :-))

      Something wrong with my logic there then but it's a little early on a Sunday for me to be able to work it out. Help please! :-) Is it that the 15 years should be added to 65 and not 60?

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    5. "Is it that the 15 years should be added to 65 and not 60?" Yup.

      I think your conclusion is right, by the way: taking a DB pension early might suit a few people's situation well. I'd check on the effect on the widow's pension too, though.

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    6. Many thanks dearieme.

      I will check out the survivor's pension as you suggest. Although I think my husband would be OK even with a very cut down offering should I go before him which is statistically unlikely in his case more than most. Thanks for the heads up though (and for sorting out my faulty calculation :-))

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    7. You are most welcome, deah lady.

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  5. That was me trying to speak in the tones of Sir Humphrey, by the way.

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  6. Hi Cerridwen,

    You've highlighted very well that thinking about these things in a purely logical financial way isn't the only way, and certainly not always the best way.

    "Pension if I take it at 65 - £9,300. Tax free lump sum - £13,000. (When taken this this would be partly subject to 20% tax as I have a small amount of rental income, plus state pension would become payable at 66).

    Pension if I take it at 60 - £7020. Tax free lump sum - £11,500). (This would be taken tax free until 66 as I intend to pay myself just enough out of my SIPP to take me up to the PA)"

    5 years of time being your own for £2,280 pa and £1,500 reduction in the tax free slice...I don't know exactly where everything sits, but that seems to be the question here. Like you say, time will plow on regardless and your own free time is hard to value (especially in monetary terms).

    If you really needed that extra money it wouldn't take much work to get it, perhaps not true financial independence, but you could pick and choose what you wanted to do each year :)

    Has the decision been made final?

    Mr Z

    (Thanks for being so open with the numbers btw :) )

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    1. Hi Mr Z,
      I'm pretty sure this last round of calculations has made the decision to take the pension early, and reduced, final. This doesn't make any difference to when I stop work, just to how the money is distributed over time. I have enough in my ISA to more than cover any shortfall and the difference in absolute income will only come home to roost after I'm 80. I think it's the right thing to do. I have cancelled my contribution to my SIPP and started putting more into my AVC instead so this is a firm commitment to the plan.(Don't hold me to it though :-))

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  7. Accrington Mike15 April 2015 at 11:33

    Thank you Cerridwen for this post. Your insight has allowed me to rethink my personal situation and bring forward my retirement by 18 months.

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    1. Hi Mike,
      Thanks for commenting - I'm really pleased to hear that reading my thoughts on this helped you to firm up your own plan. Good luck with it all :-)

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  8. Hi Cerridwen

    Great and thought provoking read, thanks.

    It might be interesting to check the actuarial reduction rate used by your scheme. In my case I have a small deferred DB pension, and the actuarial reduction is 0.25% per month (3% p.a.). On average, the total return from a tracker fund might be about 6%, so on the face of it and for my own pension's rules it is worth taking the pension early and reinvesting (ISA and/or SIPP), even if you carry on working in some form. Some would say this strategy is still risky as 6% is not guaranteed whereas the DB scheme payments are, but I think that would be depend on your own risk profile.
    Cheers,
    Ric

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    1. Hi Ric,

      Many thanks for your kind comment. :-)

      The actuarial reduction on my scheme is around 5% pa so it is pretty steep but I think it's worth taking the hit and having the guaranteed income and tax free lump sum 5 years early. As you say this is all a matter of personal situation and choice though.

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