I’ve written about this before, but it is getting close to doing it for me, hence a worked example. This is particularly useful for people with a legacy DB pension although the technique also works to smooth your income between retiring and getting the State pension, which is another defined benefit pension [ref]a company DB pension is defined after each year you work for the company – they can change the terms for future accrual but not retrospectively for defined benefits already accrued. Whereas the State pension is defined by government and can be redefined – as has been the case recently[/ref].
A DB pension is defined only at a particular retirement age, usually 60 or 65, or use this calculator in the case of the State Pension. With a company DB pension you can often retire earlier, but you will take an income hit called an actuarial reduction if you retire earlier than the scheme NRA. In my case the NRA for most of my DB pension is 60, I will eat the loss from ‘retiring five years early’ for the last three years accrued when it was shifted to 65.
When these schemes were designed in the 1970s and early 1980s there was more goodwill between companies and their workforce which was seen as more of an asset than now, the pension was part of aiming at staff retention, which is largely gone in a faster-moving, possibly more efficient and definitely more dog-eat-dog employer/employee relationship now[ref]until you get to the parasitic executive level, which seems to featherbed a ‘because we’re worth it’ layer of scum to loot shareholders more and more, because of course you have ‘pay the going rate’ to recruit top talent despite the fact that CEO pay used to be about 40 times that of the grunts (US study, Table 6), compared to over 200 times now and there’s been no notable increase in company profitability since then[/ref]. The actuarial reduction is rarely defined, and gives companies wiggle room to reduce their costs. As a result it’s usually best to take a DB pension at NRA, because it’s nailed down what you get. Individual circumstances can sometimes mean you’re better off to take it earlier, but that’s usually more to do with paying off debts with any tax-free lump sum.
What to do if you want to retire before NRA?
What you ideally want is a short pension to front-run the main pension until its NRA. This pays out between the date of your early retirement and the DB pension NRA. If you want to retire before 55 you also need to save enough money in an ISA or unwrapped to pay your way to the earliest date you can draw pension savings, currently 55 but scheduled to rise to 57 and further – a gotcha to watch.
When I retired in 2012 a short pension wasn’t an option – if I had used a SIPP I wouldn’t have been able to draw it down, but all this has changed now. So the question is now how much can I save into a SIPP such that I can run the SIPP flat in the (for me) 5 years between getting hold of it and the pension NRA, without paying any tax. There’s not much mileage[ref]but there is some – even if you pay 20% tax on all of your SIPP income the 25% pension commencement lump sum saves you a quarter of the BR tax you’d otherwise have paid[/ref] in a basic rate taxpayer saving tax on the way into a SIPP only to pay tax on the way out, although any sort of higher rate taxpayer will gain a useful amount drawing down a SIPP even above the tax-free personal allowance up to the 40% tax threshold.
Put another way, I want to know how much can I put into a SIPP, such that I can withdraw the 25% tax-free lump sum up front and then a personal allowance worth each year, for (in my case) five years, from 55 to 60. With a NRA of 65 that would be 10 years. It’s reasonable to hold a five-year amount in cash, a ten-year amount would need to have some investment component for inflation protection – either some exposure to equities or some fixed interest bond-like stuff.