A defined benefit pension is the gold standard of pensions, the scheme promises you a guaranteed income at your agreed retirement age for the rest of your life, the amount of income you receive will rise in line with inflation and the amount you receive is based on the number of years you were a member of the scheme and your pensionable salary.
These schemes offer benefits, which for the majority of cases mean that they are best left alone until your scheme retirement date, however, if you wanted to retire early, should you take benefits early?
This is the situation I found myself in this week with a client, they needed access to capital and an income, about 12 months earlier than expected and their scheme retirement date, which is when they had planned to retire. Due to health reasons, they have both decided to retire now, the main pension was a defined benefits pension due to become payable in 12 months’ time, however they needed capital and income now.
We reviewed all their options, which included early access to their defined benefits pension, however this early access involved suffering a 5% reduction/penalty on the pension income for the privilege of taking benefits now, rather than in 12 months, was it worth it?
Our first thoughts were that it would be silly to pay a penalty of 5% on a c.£30,000 pension just to access it early, because this would reduce the pension not only in year one, but in every single year in payment, the client was 64, so for an estimated 36 years, that’s a lot of 5%’s!
In financial planning it’s important not to prejudge a decision and an open mind has options, so we ran some numbers. We assumed an indexation rate for the pension in payment and forecast this to age 100, next we reduced the initial pension by the 5% penalty and ran the numbers again, with the same indexation, on the reduced pension.
The calculation showed that the pension taken early would never catch up with the normal retirement age pension, so it seemed silly to access it early. However, what I also showed the client was the cumulative value of the pension received over the years. Taking the defined benefits pension 12 months early, gave a full year payment head-start and the cumulative figures showed that it would take about 20 years to receive more pension income cumulatively taking the pension early, than at normal retirement date. In other words, for the first 20 years you would have received more money, each year, by taking the pension early.
The client is age 64 so from 64 to 84 she would have received more income. I often speak to my clients about chapters in their life, your retirement years I find has three distinct chapters; the first where you’re newly retired, active and hopefully healthy enjoying the fruits of your available time traveling, family and activities. The second chapter tends to include less long-haul flights, more European travel and time at home, the third chapter is the least expensive (care fees excluded), and little flying is involved. Therefore, a front end loaded retirement income, taking more money in the first two decades, rather than later, is a lifestyle financial planning decision which would work for them, also if their health does deteriorate, they have 12 months more memories to value.
It’s important you calculate the numbers, reflect on any decision before it’s made and discuss the decision with everyone effected, but doing what everyone else does, may not be the right thing for you. Because of the complexities surrounding this, I recommend you seek independent financial planning advice before making a decision, even if you can crunch numbers, having a professional review your calculations and acting as a sounding board is invaluable, you won’t get a second chance at this decision.
The case is similar when considering the deferment of the state pension, every year you defer, you effectively give up as you are unable to get that year back and this has been the case for retirees since April 2016, yes I appreciate you receive a higher indexed pension amount, but the 5.8% increase takes about 15 years to make up the missed year. Make sure you run the numbers first, maybe I’ll cover state pension deferral in a future article.
If you know you had a defined benefits pension, but have lost the details, you can use the government’s Pension Tracing Service by clicking the link below, please don’t use any service, there are companies charging for this free service provided by your tax paying £’s!