Gareth Shaw: Will you like it if you lump it?

The pension commencement lump sum could help you fund the retirement of your dreams, but taking up this option does have implications for your future finances. Picture: Getty
The pension commencement lump sum could help you fund the retirement of your dreams, but taking up this option does have implications for your future finances. Picture: Getty
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It’s always been seen as a retirement bonus – a pot of gold at the end of a four-decade career. The opportunity to have tens of thousands of pounds in your pocket on the day you kick off your work shoes. And the best thing about it? You don’t have to pay a single penny of tax.

I’m talking, of course, about the “pension commencement lump sum” to use the technical jargon, more commonly known as the 25 per cent tax-free lump sum.

Every retiree has the chance to withdraw a quarter of their pension, without any bites taken out of it by the taxman; and it remains enormously popular.

Insurance giant Royal London recently found that 75 per cent of its customers took their tax-free lump sum before going on to take more income from their pension.

In the past, the tax-free lump sum used to be the only way you could get your hands on a decent wad of cash at retirement.

Prior to 2015, you were either forced to buy an annuity, or needed to have a significant amount of guaranteed income from other sources in order to enjoy the flexibility of an income drawdown plan.

But, the pension freedoms introduced two years ago threw that out the window. Now, you can take your whole pot out in cash in one go, if you like (subject to tax). Or, you can take little chunks of money as you see fit, with 25 per cent tax-free and the remaining 75 per cent subject to income tax.

Which begs the question – is it a good idea to be lured toward that gleaming pot of tax-free gold and take a lump sum?

First, it’s helpful to understand what you’re actually going to get. With a defined contribution pension – the ones that invest your contributions along with your employer’s resulting in a big pot from which you generate an income – the sums are pretty easy. Take your pension pot, divide it by four and, hey presto, that’s your tax-free lump sum.

If you have a defined benefit, or final salary, pension, the calculation is much less clear cut. You don’t have a pension pot, per say, but a promise of a defined income for the rest of your life, which will often increase every year by inflation. Plus, there’s a crucial figure that determines your lump sum, called the “commutation factor”. This is the rate at which you give up the annual pension you will have in retirement, in exchange for getting some cash upfront. The higher the commutation factor, the better the deal generally is for you.

Public sector schemes, such as those operated by the NHS, the civil service and education, tend to have a commutation factor of 12. Private sector schemes are more likely to have a higher, more generous, commutation factor of 14 or 15. You can find out what your commutation factor is from your pension scheme.

So, what does this actually mean? Well, if you were set to receive £20,000 a year from a final salary pension, and your pension scheme had a commutation factor of 12, you’d end up with a tax-free lump sum of around £85,000. Not bad, eh?

But by taking a lump sum, your annual income will fall by around £7,000, leaving you with just £13,000 a year to live off in retirement. That’s 35 per cent less income initially for a 25 per cent lump sum.

If you’ve got a defined contribution pension, you perhaps should be looking at whether or not you should take the lump sum upfront, or withdraw your money gradually in smaller chunks.

Imagine you had a £100,000 pension. Taking £25,000 tax-free and withdrawing £5,000 with the rest invested, growing at five per cent a year, would see you emptying your pot entirely after 25 years.

Foregoing the lump sum and withdrawing £5,000 a year, with £1,250 tax free and the remainder taxed, would see you end up with around £80,000 left in your pension after a quarter of a century, after five per cent annual growth.

So am I suggesting that taking a lump sum is a bad deal? No. People’s retirement income mix is not as black and white as either final salary or defined contribution. They have a mix built up over a number of jobs, some of which they’d be happy to cash in, others which they know will form a good foundation of income in retirement.

People decide to access their pension at different ages for different reasons, and often plan their finances and retirement dates with their partner. Taking 25 per cent tax-free before you retire doesn’t stop you from continuing to build up your savings, and could have a huge benefit in paying down debt or financing a big purchase. A decent chunk of tax-free money could help people reach their dreams quicker.

But with the pace of change in the pensions world, it might be worth challenging the perceived wisdom of a tax-free lump sum as a no-brainer and spending a bit of time doing the sums before you act. You could find that pot of gold is a bit heavier and more valuable if you do.

Gareth Shaw is head of Which? Money Online