Pensions: better to take a lump sum or leave it?

The importance of pensions

Interest rates are extremely and historically low. As a result, there has been a lot of recent news about annuity rates for pensions being incredibly low. Given that this is the case, I want to discuss whether it might be better or not to take your 25% tax free lump sum from your pension pot.

Pension explanations

At this point, some of you may be wondering what an earth I'm on about. As this may be the case, let's take some time to set out some key definitions:

Pension - nowadays this tends to mean a pot of savings from which a person will live off once they have retired. In its most basic form a person can either live off the savings or exchange the savings pot for an annuity (see below) to pay an income for life. 

Tax free lump sum - most pensions allow you to take up to a 25% lump sum from your pension pot upon retirement. The remainder in the pension pot is used to buy the annuity (below).

Annuity - the pension pot is transferred to an insurance company who in exchange pay you an annual salary for the rest of your life. There are several types of annuities to be purchased but for simplicity we will consider a few. One pays you a set amount (e.g. £20,000) every year for the rest of your life. Another may be linked to inflation such that it would pay you a lower amount in the first year (e.g. £10,000) but that the payment would increase by a rate of inflation each year. There are also variants of the inflation linked annuity at different inflation or percentage rate annual increases. 
The size of the annuity is determined by several variables:
1. The size of the pension pot - obviously the higher this is, the higher the annuity
2. The timing of the purchase of the pension - the later you buy one, the higher it'll be worth
3. Your medical history (yes that's right!) - the more likely you are to die young the bigger it'll be
4. Lump sum that you take out - the more you leave in your pension pot the bigger the annuity you can buy I.e. the more you'll be paid annually
5. Linking to inflation - if you link your annuity to inflation figures then you can expect to receive less in the first few years than had you not linked it to inflation. This is because the amount that you are paid per annum wi increase each year with inflation.
6. Interest rates - the higher interest rates are, the higher the annuity payments per year. Without going into too much detail this is partly because to pay you your annual amount the annuity provider invests some of your money in investments linked to interest rates. Thus, the higher the interest rates, the more money the annuity providers make from your pension pot, and the more they can pay out to you per annum.

The case for taking your full lump sum

The argument goes as follows:
Annuity rates are so low at the moment that you will probably end up with an annual income from your annuity much lower than originally expected when you first started saving for your pension. As such you may be able to supplement this smaller income by reinvesting the lump sum. For example you could earn rental income by purchasing an investment property. Or you could earn additional income from dividends by investing your lump sum into Shares.

The case against taking a lump sum

Some may argue that to take any lump sum with such low annuity rates is madness. Your pension income is already lower than expected so why would you choose to reduce it further by taking a lump sum pension?

Pension lump sum - Balancing the argument

I suppose your decision really depends on your circumstances. For example, let us say that you already had plenty of other investments providing multiple streams of income. As such you may believe that you can comfortably take the risk to invest the lump sum elsewhere. This may be the case as you can afford to cope with the worst case scenario of a poor return on your alternative investments for a few years.

Taking the lump sum is definitely the more risky strategy in the short term but could definitely work out in the long run as you eventually make a return on your investment (assuming you live that long!).

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