Congratulations! You have won the competition and the first prize is an inflation-linked income of £10,000 every year for the rest of your life. However, if you prefer, you can also elect to receive a one-off lump sum instead.
Just for a minute, put yourself in the position of the lucky winner and imaging the process that you would use to make your decision – would you opt for an income or a lump sum?
The mathematically-minded amongst you may wish to attempt a calculation based on the investment returns needed on the lump sum to replicate the income: for example 4% per annum on a £250,000 lump sum would replace the income of £10,000. However, this scenario ignores the fact that you would still have your original capital of £250,000 when the income eventually ceases and it also does not account for inflation.
An alternative would be to build a model based on an expected lifespan - I call this the “last cheque bounces principle”. This approach would yield a lower lump sum but the danger is that, if investment returns are less than expected, the fund will expire before you do and you would have been better off with the guaranteed income for life.
The other problem with a linear mathematical model is it does not account for the time-value of money so, if there is an immediate need for a lump sum, the long-term income stream has a significantly lower value.
Also, what if the income stream is superfluous to requirements today? In this instance a lump sum has a greater value as the returns could be rolled up to produce a larger income at a later date or the lump sum could eventually be passed down to needier future generations.
But what about the probability that the income provider could go bust – in this instance you would definitely wish you had taken a lump sum, whatever the amount.
How confident are you now that you would make the right decision unaided?
The purpose of my musings is that, according to the Purple Book 2014 (published by the Pensions Regulator), there are 11.1m people who could potentially face the above calculation - this being the number of participants in UK Final Salary pensions. And the advent of Pension Freedom has meant that, rather than just accepting the pension offered by the scheme trustees, retirees and pre-retirees can elect to transfer out and manage the funds themselves.
The option has become even more attractive in the last year as transfer values from these types of scheme have been generally on the increase and it is not uncommon to see amounts of 25-35x the immediate pension being offered to scheme members – this equates to an investment return of 3-4% pa over inflation so the above example can be a real part of the decision-making process for many immediate retirees.
And when it comes to pensions, it should not surprise you that the process is not nearly as simple as I have painted above – the myriad of technicalities embedded into most final salary schemes would test the technical abilities of many a mathematician: protected benefits, widows’ and dependents’ pensions, commutation for tax-free lump sums and early retirement factors to name but a few.
What it does mean is that, if you are one of the 11.1m people with such a scheme, you may want to embark upon an actuarial degree before you decide to retire. Alternatively you should seek out the services of a specialist retirement financial planner.