Let’s talk about pensions, baby: ‘lump sum’ vs. ‘annuity’

 

Now that my foray into the property selling/nationality mess up domain is over, I opened my work e-mail for the first time in about a week. And there it was – a reminder that I should be preparing my retirement (not even an early one, guys) and thinking about the various options opened to me.

There was an e-mail from the HR department of my employer telling me that the rule for auto enrolment in employers’ pension schemes in the UK is in ‘full swing’ (right, they didn’t say this; they used a much less casual word – we are talking HR after all) but because I am already in the scheme I don’t have to do anything.

However, the elephant was already out in the open and the problem was on the table (or screen).

This – and our programme to build sufficient wealth over the next five years so that I don’t have to be employed if I don’t want to – made me think about the different options when it comes to drawing ones pension. And it seems to me that the basic choice is between taking out a lump sum or annuity (and, of course, different combinations between these are also a possibility).

We already had to deal with this choice three years ago when we looked into a private pension fund John had been building up with the intention to take a lump sum out (we were trying to pay off the debt back than so all pots of money were looked at very carefully). We found the following:

a)      the pension fund hadn’t be doing anything and the money in it was about the same amount John put in;

b)     being over 55 John could take 25% of it out but being under 65 (and not having another pension of £20,000 per annum) he could not take it all; and

c)      he could, however, take an annuity.

At the time, we decided against annuity since it was so small that it wouldn’t have made a difference to our lives and finances. We are waiting for the time to take it all out (whichever of the two conditions mentioned above comes first).

My case is somewhat different and a bit less straight forward. According to the rules of the scheme my pension will come in two parts – a lump sum and a regular, monthly pension income. These are discretionary – in other words I’ll have to decide what proportion to take out as lump sum, if any. Which made me think about the pros and cons of each, as well as about the questions I’ll need to consider to make an informed decisions (to be able to run the numbers when the time comes).

• It seems to me that the main pros of taking out a lump sum are related to control and choice. In other words, one can choose to spend it on something large and/or expensive – like the back-end of the mortgage, for instance; or even a Jaguar or a facelift if one is having a mid-life crisis. Similarly, one can choose to invest the money.
• There are serious cons about taking out a lump sum in that some of it may be taxed (although not all pension schemes tax it); if one makes a bad investment or lives far too long one may run out of money; and, of course, taking a large lump sum reduces one’s regular, monthly pension income.
• The pros of taking an annuity are that this will increase one’s regular, monthly pension income and also security in that this will pay out for the duration of one’s life. Since there is no certainty in life, this is a positive only if one live for a long time in retirement; otherwise it can be a bad decision.
• Some of the cons of annuities are that these may be small; generally they cannot be inherited (although here rules can vary and usually at least part can be left to your partner); inflation can be a problem though one can get inflation adjusted annuity (but the costs are substantial); and of course, one doesn’t know how long they will live.

These pros and cons, I find, may be useful for getting a general idea but fall short where deciding in specific cases is concerned. I for one couldn’t decide what to do! So, for myself, I came up with a number of questions the answer to which will help me make up my mind whether and how much lump sum to take out of my pension. These are:

1)      Do I have substantial liabilities (any outstanding mortgage, debt, necessary purchases etc.)?

2)      Were I to use the lump sum to buy annuity is this going to be more that the predicted inflation over the next 20 years?

3)      Are there any investment options that will generate more regular income that the annuity?

4)      By how much will the annuity increase my monthly income?

Of course, a lot will also depend on where we are in our wealth building when the time comes for me to retire.

What would you choose – lump sum or annuity? And how would you decide?

photo credit: scottwills via photopin cc