I’m a Millionaire (but don’t look it) part 2

Following on from part 1, no how with an old final-salary pension I’m now a millionaire but don’t live the millionaire lifestyle.

Over the years at the old company, I built the final salary pension.  It is (or was) a good pension and because it was so good, it gave me good reason to put up with shit jobs, shit bosses and shit work.  But it also gave me the confidence to leave when I did.  Knowing that I’d have a secure(ish) old-age was a real comfort to me.

No matter how messed up my investments get – no matter how bad things are – I’d always have the pension. It maybe led me down the path of riskier investments and some of those paid off and some didn’t.

The pension itself is worth just over £10k a year paid from 60, increases with RPI and if I die, the Lady will get two thirds.  I value it at just over £200,000 or 20 times the annual value now. This is the same valuation that the HMRC use when calculating final salary pension values.  Given my current life expectancy is 86, that means 26 years of pension or you could value it at about 26 times today’s value.  But the discounted cost now to the pension fund means they value it at much higher than 20.

The HMRC value these final salaries a bit differently, they say that the value is 20x the annual payment.  Get £20,000 a year then it’s worth £400,000.  This is used when calculating your lifetime allowance.  As rules of thumb go, 20 isn’t too bad.  It’s conservative, a nice round number and seems about right doesn’t it, that’s like 5% annuity?

Well, the truth is that 20x has major flaws.  It’s well known that to buy an annuity with the same protections of (my) final salary pension (rising with inflation, transferable upon death to spouse) it will cost you a lot more than 20x.  The best buy that I found has £100,000 paying only £2,428 a year for a 60 year old male, single, guaranteed for 5 years and rising with RPI.  At that price my pension is worth over £400,000.

It’s no surprise that annuity rates are low and with pension freedoms, annuities have fallen out of favour.  Up until the GFC you could expect maybe 6-7%, but with falling gilt yields that’s now much lower.

This shouldn’t come as a surprise. Pension funds are restricted in what they can invest in and what risks to take so they are very much exposed to government bonds. The graph below from thisismoney shows how annuity rates float above long dated UK government bond (gilt) prices.

Image result for annuity rates and gilt yields

The 15 year gilt yield now sits around 1.5% which is (as far as I can tell) below the expected inflation for the next 15 years. This is the price the government has to pay to borrow money from the markets for the next 15 years – pretty cheap eh?

It is this steady drop in gilt yields (and if you hold them, booming prices!) that is making the cost of servicing the final salary pensions very difficult. In the past many companies offered them – but that’s largely over now. Even my old company has closed its final salary pension for new joiners and it might even close it for current employees too I’m told. The cost of a guaranteed income for life (from age 60) is very high – especially in the face of a perfect storm of rising longevity and falling gilt yield.

Annuity Rates Chart

I am not alone

My final salary pension is relatively modest. I never earned mega bucks at the old company and I’m sure that there are many people who will retire at age 60 with maybe £100,000 per year – I once tried to see what the average pension fund was in the company but it was hard to access the figures. But it’s safe to say that if you were lucky and had a final salary pension and finished working with a high salary you could easily hit your lifetime allowance on your pension.

The lifetime allowance is a funny limitation on pension funds. I won’t get into it – but if you have the privilege of holding more than a million pounds in your pension funds then you might end up on the wrong end of punitive tax charges. £1m is equivalent to £50,000 a year from your pension provider but if you choose to transfer out a £25,000 pension and get a 40x CETV rate then you will easily hit that £1m. Throw in any SIPP, AVCs, other pensions add on a couple of years of compounded growth and you could easily be above the lifetime allowance.

What to do ?

Choices, choices, choices. I once thought that my pension was a set and forget account. I don’t have to watch it, manage it, measure it, track it or worry about it. I’d get it when I turn 60 and it’s part of my FIRE plan for then. Having it means that I don’t have to worry so much about my 60s – my focus right now is on how to survive the next 20 or so years to 60.

I’m not sure if I’ll cash out the old pension and go balls deep into equities. I’d appreciate any thoughts on the matter from other people. I’ll write more about how to blend a final salary pension into our pension planning in Part 3.

Thanks, GFF

5 comments

  1. I am delighted that we have Defined Benefit pensions. We don’t need to solve the testing question of how to live off Defined Contribution pension pots.

    On the other hand, if our principal DB pensions ended up in the hands of the Pension Protection Fund we’d be in the soup. I’d lose virtually all my protection from inflation; my widow would lose that too. But even worse, her widow’s pension would be cut from being 90% of mine to 50%. Calamity!

    DB and DC pensions carry different risks; diversifying by having both might be a good idea. In your shoes I’d incline to make my default option that I’d retain my DB pension unless I was made an offer so absurdly large that it would be rude to turn it down.

    What is large depends on your circumstances. For instance if you contracted a life-threatening illness would that make the value of a tax-free DC pension pot for your widow compelling?

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  2. Following on from my previous comment on your part 1 post, I stated that I wasn’t intending to cash my DB pension in. The reason is because of the low annuity rates you’ve mentioned – there’s no way I would get any sort of decent guaranteed income, which would go up with RPI annually. I’m taking a risk investing in my ISAs and SIPPs so the DB pension is my safety net, which won’t be subject to the ups and downs of the stock market.

    However, I won’t get to access mine until age 65 and there are severe penalties for taking it early. But depending on my other income, this might be something I would consider, ie taking it a year or two earlier perhaps.

    I look forward to reading how you will blend your DB pension into your planning as it’s something I’m doing!

    PS – hope you don’t mind all these comments, I’m just catching up on my blog reading and you are a prolific writer! 🙂

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    • comments are great – it’s a nice way to interact and if it means there’s one reader then I’m happy. 🙂

      I’m not going to cash in the pension anytime soon – being fully responsible for my total pension fills me with a little bit of dread. But it’s a nice choice to have.

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