Should I opt for a £64,000 lump sum or a higher monthly local government pension? STEVE WEBB replies

I am 60 and have a defined benefit local authority pension.

My lump sum (if I retire soon) would be approximately £15,000 with a £1,144 per month pension, or the lump sum would rise to £64,000 with a £800 per month pension (and of course anything in between).

I cannot decide what to do. Could £64,000 earn me £344 a month if I took the lower pension? What type of investment would give me a monthly income? I am flummoxed.

Steve Webb replies: One of the attractions of saving in a pension is that you can usually take part in the form of a tax-free lump sum.

There is a lifetime limit on such tax-free sums of £268,275, but assuming that this is your only or main pension then you don’t need to worry about that.

As well as offering a standard lump sum figure alongside a standard regular pension, some defined benefit schemes such as yours give you some options.

In particular, if you are willing to give up some of your regular pension you can have a higher tax-free lump sum.

The decision as to where you may wish to strike the balance between tax-free cash and regular pension depends on a number of factors which I will run through here.

As ever, however, I don’t know your individual circumstances so I can only give you guidance as to some of the issues to consider and not personal financial advice.

As you appreciate, when you take a higher lump sum you are giving up regular pension.

But the amount of regular pension you have to give up per pound of extra lump sum varies considerably from scheme to scheme.

The Local Government Pension Scheme, in common with many other public service schemes, makes a relatively large cut in your pension for each pound of extra lump sum.

To be more precise, you have told me that you can get an extra £49,000 in lump sum if you are willing to go without £344 per month or just over £4,100 per year.

This means that for every extra £12 in lump sum you are giving up £1 per year in pension.

This ratio of 12:1 (known as a ‘commutation factor’) is amongst the worst to be found in the DB pensions system, with most private sector schemes applying a much smaller reduction in pension.

One reason why a ratio of 12: 1 is so unfavourable is that you are – on average - likely to live a lot longer than 12 years.

A woman of your age in average health can be expected to live around 27 years according to the Office for National Statistics.

So, if the price for an extra £12 in lump sum was to give up £1 each year for 27 years, you would be down £27 over your retirement if we ignore the tax difference and would only have gained £12.

Even if we take account of income tax, you gain £12 of lump sum after tax, and you sacrifice 80p per year (assuming you are a basic rate taxpayer) after tax.

If you live the average of 27 years you are still down by more than £21 in pension compared with the gain of £12 in lump sum.

In addition, your pension is not actually a flat figure but will rise in line with inflation every year.

The actual loss to you will therefore end up even bigger than the £21 figure quoted above.

You asked about using the lump sum to try to generate an income to offset the pension you have given up.

I have looked at the rates currently available for a person aged sixty who uses £64,000 to buy an income for life – an annuity – and one which will rise roughly in line with inflation (which is what the pension you have given up would have done).

I have also assumed that you want a pension for a surviving spouse or partner, as this is what your local government pension would have given you.

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At current rates, you could expect to get a taxable income of around £3,000 per year, or £250 per month, rising at 3 per cent per year.

This is obviously a lot lower than the £344 per month that you gave up to secure the extra lump sum.

Of course, the best balance for you between lump sum and pension doesn’t just depend on the arithmetic.

If you have an urgent need of capital now, perhaps to clear debts on which you are paying a high rate of interest, then the balance might shift.

You also need to think what pattern of spending you will want or need through retirement.

If you are living in rented accommodation and expect to have to pay a rent – perhaps rising with inflation – for the rest of your life, then a good level of regular pension will help provide you with the security that you need.

Conversely, if you are a homeowner and can cover your regular needs in retirement through your state pension, (lower) council pension and other income, then a higher lump sum might look more attractive.

This could be particularly true if, for example, you wanted to enjoy the early part of your retirement through taking the holiday of a lifetime or through a home improvement.

Recent retirees also often use some of their lump sum to help other family members such as with a wedding, help in buying a house or a car or with the costs of education.

All of this can be more difficult if most of your pension is in the form of a regular income which is spread evenly over the next 25-30 years.

I don’t normally conclude a column with the words ‘it depends’! But the right mix of lump sum and pension really is a personal decision.

As I’ve explained, in this scheme you are giving up a lot of pension to boost your lump sum, but in some situations that might still be a relatively attractive option.