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Retirement

Annuities and Cash Pensions

Recently we posted our first pension calculator, ‘Annuity vs. Cash Pension’, which warrants an article explaining what it does, and how it works.

Published October 2020

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Pension Valuation

Recently we posted our first pension calculator, ‘Annuity vs. Cash Pension’, which warrants an article explaining what it does, and how it works.

Careful management of your pension is a critical part of looking after your future. One of the key decisions, particularly as you approach retirement, is whether to convert a cash pension (for example, in a Defined Contribution pension) into an Annuity (a guaranteed income, like a salary, which often goes up with inflation) or, whether to convert a Defined Benefit Annuity Pension into a cash sum (called CETV - Cash Equivalent Transfer Value).

Our calculator compares an Annuity with a cash equivalent. You can talk with your pension provider about your options, including requesting a cash sum (CETV) and the alternative Annuity offer, to then compare the two with our calculator and see which is more beneficial based on life expectancies.

There are two main variables a pension provider is concerned with when pricing an Annuity, one is life expectancy (which you set in our calculator, giving you an advantage over the providers as you know your family history), and the other is the return earned on money set aside today to fund any future Annuity payments.

The UK government borrows money by issuing government-bonds (‘Gilts’). These bonds range in maturity and trade regularly, so at any point we can see what the rate of return would be for investing in gilts with a specific term (e.g. 1 year, 5 years etc.). This rate is useful for pension analysis as it approximates the ‘risk-free rate’ i.e. the rate you would earn investing in something with zero risk of capital losses (as the government can always print-money to repay investors) between now and maturity. We use a risk-free return used to discount future payments in an Annuity as they carry no risk of reduction - the payments are guaranteed until end of life.

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If we approximate an Annuity so it pays each year (in practise they pay out monthly) we can use the 1-year, 2-year, 3-year gilt yields to calculate how much money we need to set aside to meet future payments. If the 1 year gilt yield is 1%, and an Annuity pays £1,000 in one year’s time, we only need to set aside £990 (£1,000 / (100% + 1%)) today, invested in gilts with a 1-year maturity, to fund that future payment – this is why the cash sum offered is often lower than the sum total of expected Annuity payments.

Gilt yields change in line with expectations of interest rates – so it is worth trying our calculator again when there are movements in the factors that affect rates (e.g. when base rate rises or falls, or when the UK economic outlook changes) as the value of the cash equivalent or Annuity on offer is likely to have changed. It may also be worth getting a refreshed CETV from your pension provider if you are thinking about converting a defined benefit scheme.

It is worth noting that cash (e.g. Defined Contribution) pensions can be transferred to any dependants free of inheritance tax, whereas in most cases Annuities or Defined Benefit pensions are closed once the Pension Holder and any beneficiary (normally spouse) have died. Cash or Defined Contribution Pensions also have the added benefit of allowing you to draw down varying amounts over time, for example taking more funds from the pension during the early years and then reducing the drawdowns over time.