I had a very interesting conversation yesterday afternoon about commuting pension income for tax-free cash.
The lady in question had received a letter from a former employer (she worked for this employer many, many years ago and only for a very short period of time) advising her that she was now entitled to a pension from her membership of their scheme.
The letter, as many like this do, explained that she could receive a pension each year or alternatively a smaller pension in addition to a tax free cash lump sum.
The question she posed to me was “which should she choose?”
The answer of course depends upon her individual needs and wants and her personal circumstances but we had an interesting conversation around the decision making process.
Just prior to taking her call I had read the Financial Conduct Authority Occasional Paper No 1 on the subject of “Applying behavioural economics” which explained how many people make errors when choosing and using financial products and could see exactly what the authors of that paper meant.
‘Gut feel’ (horrible expression but we all I think know what it means) told her that she should take the reduced pension income in exchange for the tax free cash, but she asked, was that the right thing to do?
The best answer really is, it depends.
It depends upon her need or otherwise for capital and what she might do with it.
I helped her with a calculation showing the ‘yield’ she would need to receive on her cash if she invested it to replace the pension income that she would give up to get the cash.
We spoke about the fact that she would probably have to pay income tax on the yield from her investment (she would of course also have to pay income tax as well on the pension income if she took that instead of the tax free cash).
We did a quick calculation about the number of years she would have to live if she were to forgo the tax free cash and take the higher pension income in predict to be no worse off.
At 66 years old there was the chance that she might seriously underestimate her life expectancy.
The answer to the earlier question how long would she have to live to get the same value was just over 20 years.
She also told me that both her mother and auntie had lived into their mid-90s.
But she also told me that she and her husband has an outstanding mortgage and that it would make them both feel really good if they could reduce this outstanding debt.
On balance she felt taking the tax free cash and paying off part of her mortgage made sense. I have to say I agreed with her.
It is not always the right thing to do to take tax free cash from a pension fund but sometimes it is the right thing to do. In this case I believe it was.
Sometimes it makes sense to but financial advice in order to validate your decision and note it does not have to end up with buying a financial product!
Photo credit: Flickr/yum9me
