I'm retiring with a small pension - should I avoid taking too much as a lump sum?

In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].

Question: I am 66, retired and just started taking my full state pension. I also have a small defined benefit pension from my former employment. As it’s not a huge amount of money I want to be sure I am doing the right thing. Do I take a larger tax-free lump sum and a smaller annual pension or a smaller lump sum and a larger annual pension? The minimum lump sum I can take is £7,528 with an annual pension of £5,191. The maximum lump sum is £24,937 with an annual pension of £3,740. There is a sliding scale between these figures. I have no mortgage or debt so am looking at my pension to fund my monthly outgoings which will be about £1,100 a month with hopefully the occasional holiday.

Answer: Congratulations on your retirement! Defined benefit (DB) pensions are incredibly valuable, so it’s good that you’re thinking carefully about how you take an income from it.

For readers who aren’t familiar, DB pensions pay an inflation protected, guaranteed income for life from your “normal pension age” (which is often aligned with the UK state pension age).

The income you receive will depend on your salary (either final or career average), the number of years you were in the scheme and your “accrual rate”.

For example, if you were a member of a career average DB scheme for 20 years with a 1/60ths accrual rate and your average salary was £30,000, you would be entitled to 20/60ths (i.e. 1/3rd) of your salary, or £10,000, as an inflation-protected annual income for life from your normal pension age.

As you note in your question, members of DB schemes are usually entitled to some of their pension as a tax-free lump sum. While defined contribution (DC) pensions – where the saver builds up their own pot of money and accesses it as they wish from age 55 – allow you to access up to 25 per cent of that pot tax-free, in DB there is no individual pot of money, meaning the calculation is done differently.

Instead, schemes often allow you to take a certain portion of your promised income as a tax-free lump sum, with the amount of income you receive in retirement reduced by a “commutation factor”.

This is just the ratio of income you give up in return for taking your tax-free lump sum. For example, if the commutation factor was 12:1 (as in your case), this would mean for every £12 of tax-free cash you took, your promised annual income would drop by £1. For most people in either DB or DC schemes, the maximum tax-free cash they can take over their lifetime is capped at £268,275.

Those are the mechanics, but your central question of how much tax-free lump sum you take will depend on your preferences and personal circumstances.

If you want someone to tell you the best course of action, you’ll need to speak to a regulated financial adviser.

Given you will be giving up a guaranteed, inflation-protected income for life if you take more than the minimum lump sum, you should make sure you have a plan for any extra tax-free cash you choose to take.

A common use of pensions tax-free cash is to pay off debts, a mortgage or establish a rainy-day fund in case of financial emergency. You may also want to free up some cash for other things, like going on holiday or buying a new car. If you have no particular need for the cash, you may decide it’s better to keep a higher guaranteed income for life.

Your health might also factor into your decision as the longer you live, the more income you will receive from your DB pensions.

Before making any decision, you should make sure you will have sufficient income to fund your retirement spending. Another consideration for some people will be passing money onto loved ones.

DB pensions usually offer to pay a guaranteed income to a spouse or civil partner worth, for example, 50 per cent of the income you have been promised. If you reduce that income by taking a higher tax-free lump sum, the income your spouse could be entitled to when you die will also drop.