When you decide the time is right to begin claiming your defined benefit pension you will usually be presented with at least two choices, take the maximum income available or a lump sum option and lower income.  

This is not a decision that should be taken lightly as once made it will be irreversible and you will be stuck with that choice for the rest of your life.  

So which option is best? Well, it will depend on your circumstances so let’s explore further.

What does the lump sum option mean

A defined benefit pension, also normally referred to as a final salary pension is set up to pay you a secure income for the rest of your life from a set retirement age. 

The level of income you build up will be based on your salary with the sponsoring employer, how long you worked and was part of the pension scheme and a formula set by the scheme.  

As you approach the scheme’s normal retirement age the pension administrators will write to you and present your options for claiming your pension.  

The first option will usually confirm the annual pension income that is due from the normal retirement age. The income figures quoted will be gross and will be subject to Income Tax at a rate depending on what other income you have. 

The second option will quote you a lower gross annual income figure (still subject to Income Tax), but this time will offer a one-off tax-free lump sum. You basically get the chance to give up some of your annual income for the advance of a larger one-off amount now. Remember that if you do take the lump sum option the income stays reduced for the rest of your life.  

Here is a genuine example we have seen recently for one of our clients.  

Option 1) Full pension from age 55 = £3,654 per year. 

Option 2) Reduced pension from age 55 = £2,837 per year plus a one-off tax-free lump sum of £18,534. 

You may find your pension scheme allows you to take a reduced lump sum and therefore a slightly lower reduction on the income.  

There may be further options added for things like a Pension Increase Exchange (PIE) or higher income at the start and then lower income once your State Pension is available.  

At this point it’s a good idea to really sit down and think about your retirement plan, what you want your retirement to look like and what it’s going to cost. Don’t base your decisions on the money alone. Money is a tool to help you live the life you want.  


When it’s best to take the lump sum option  

When considering your retirement, you need to think about the following:  

  • Are you going to be spending more in the early years of retirement rather than later?  
  • Are you concerned about the long term rise in prices? Would you prefer the security of a higher income later in life?

  • Do you need a lump sum? Do you have debts to pay off? A new car to buy? 

  • What would happen to your spouse or civil partner if you died first and the defined benefit pension income was cut in half?

  • What other pensions do you have and what lump sums will they offer?

  • What is your health situation? Do you have a reduced life expectancy? 

Taking the lump sum option will make sense if there is a genuine need for a one-off payment and you can cope with the reduced income.  

If you don’t have a real need for a lump sum, it can still make sense to take this option providing you do something with it.  

Looking at the numbers, it can often take a number of years before the higher income/no lump sum option recoups the lump sum you give up.  

Going back to the example above, the difference between the two income options is £817 per year (£3,654 – £2,837) before factoring in future pension increases or tax rates.  

It would take 22 years to recoup the lump sum you give up if you went for the higher income option (£18,534 / £817).  

However, as your pension income is likely to have some form of inflation linked increases over time, if you just let your tax-free lump sum sit in a cash account then the lump sum will lose purchasing power over time and actually be worth less.  

Instead, you could invest the pension lump sum and over time, in the right investment strategy, could see growth above that of inflation meaning you could generate another source of income from this lump sum amount. To match the £817 extra income, you would only need to earn a return of 4.4% a year on the £18,534 lump sum before factoring in any increases or tax. If you were able to get the lump sum in an ISA, then any returns would be tax free. 

There is another potential option to explore if you have a private sector defined benefit pension. You could look at transferring your defined benefit pension to a personal pension. This would mean giving up the secure income in exchange for a cash equivalent transfer value so it’s not going to be right for some people. However, if you are keen on maximising your tax-free lump sum then you tend to get a higher lump sum from a personal pension as you can take 25% of the total pot. If you did go down this road, then professional advice is essential and actually mandated if your benefits are worth more than £30,000. 

If you would like to get your retirement organised, then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.  

Risk warning:

Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.