I recently advised a client, Sally, on whether or not to take her public sector final salary pension early at age 55 instead of her normal retirement age of 60. Sally, who is single, has recently retired early at age 55. Her job was very stressful. She has no intention of ever working again. She is sick and tired of the rat race. Does this sound familiar?
Like most people I have ever advised, she is unsure whether or not to start taking her pension early because there is a penalty for taking pension benefits from a final salary pension scheme before normal retirement age. It is known as an actuarially reduced pension. In her case, the penalty for taking her pension 5 years early is a reduction of 22%. So, in other words, she will receive a pension of 78% of what she would have received had she waited until age 60 to start receiving it.
It could have been a lot worse. Many private sector final salary pension schemes impose a penalty of 6% a year for early retirement. This means that the penalty could be as high as 30% for withdrawing benefits 5 years early or even 60% for taking it 10 years early!
Quite naturally she thought she would be worse off taking her pension early. She has enough savings to see her through until age 60 without touching her pension but only just. It will be a bit tight. She owns her own house outright with no mortgage. She has no children. She does, however, have some dearly loved nephews and nieces.
I advised her that an actuarially reduced pension isn’t in fact a penalty. It is calculated actuarially (mathematically) to pay broadly the same level of pension benefits over the rest of your life as you would have received had you taken your full pension at your normal retirement age. The crucial factor here is the fact that you will receive the pension for longer albeit at a lower rate. So, it is calculated to be cost-neutral.
I advised Sally that the only way to work out whether or not she should consider taking her pension early was by doing the calculations using our Money Forecast cash flow planning software. We assume life expectancy of 100 for cash flow forecasting but we do always ask clients how long they expect to live. Sally’s answer was 85.
We used two “what if” scenarios.
- Retirement at normal scheme retirement age of 60.
- Early retirement at age 55 with an actuarially reduced pension.
The results were interesting. Under both scenarios, we assumed that Sally received the same overall level of cash flow, or income, up until age 100. What was astonishing was the amount by which her overall wealth was increased by taking her pension early at a reduced level of 78%. The increases in her net worth (wealth) are summarised below;
Age 55 £132,000
Age 60 £205,000
Age 85 £324,000
Age 100 £657,000
Even I was surprised at the amount by which Sally’s wealth was forecast to rise by taking her public sector final salary pension early at a reduced rate because it is counter intuitive. However, the numbers do not lie. In fact, if anything, her forecast increase in net worth is likely to be an underestimate because the assumptions we used for investment returns, inflation and interest rates were all conservative.
Of course, this is just one example. As such it should not be relied on because every case is different as everyone’s individual circumstances are different. In other words, each case should be judged on its merits. Nonetheless, it does go to show how important cash flow planning is. Without understanding the numbers it is impossible to make the right decision.
There are a number of factors to consider which I have summarised below. One of the most important ones is what happens to your deferred final salary pension if you die before taking it? If you are single or divorced with no spouse or partner and no dependent children, usually your pension dies with you. Let that fact sink in for a minute. Your entire pension dies with you. Is that what you want?
Factors to consider in assessing whether or not you should take a reduced early retirement final salary pension.
- A realistic forecast of your life expectancy.
- Your level of savings and investments and any other sources of income.
- Your life goals.
- Your family e.g. are you married or single, do you have children, have you married more than once, are you divorced?
- Do you want to take your benefits early so that you can enjoy them while you are still young enough to do so?
- Your tax position.
- Whether you wish to continue working or not.
- What happens to your preserved (deferred) pension on your death?
So, if you are considering taking a reduced early retirement final salary pension do take advice from a financial planner first, preferably an Independent Financial Adviser who is a qualified Chartered or Certified Financial Planner. In other words, a specialist.* You know it makes sense.
*The contents of this blog are for information purposes only and do not constitute individual advice. The blog is based on my own opinion. You should always seek professional advice from a specialist. All information is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future.