July 2008

Not a trivial issue

When we approach retirement age many of us start to think about how much pension we will receive and how we will receive it - an annuity, income drawdown or something in between. Problems arise if people have very small pension pots as their options are limited and, in some cases, it may not be worthwhile taking an annuity let alone even thinking about income drawdown. The Government recognises this and allows very small pension pots to be paid out as a cash sum at retirement, 25% of which is tax-free and the rest is taxed as earned income. This is known as the triviality commutation rule.

The option to swap a small pension fund for a cash sum, instead of taking a retirement income, has been around for a long time. Up until 2006 pensions of less than £260 a year payable from an occupational scheme could be converted into a cash sum and it was possible to do this on a scheme by scheme basis, so individuals could potentially cash in small pensions from several schemes. Generally the limit for personal pensions was £2,500 for non protected-rights funds.

Pension tax simplification, introduced in April 2006, turned the triviality rules upside down and inside out. New rules came in, which applied to both trust-based and contract-based pension schemes, levelling the playing field. Following pension tax simplification everyone can now cash in their small pensions if they are over the age of 60 and have total pension funds of less than 1% of the standard lifetime allowance, (currently £16,500) - providing they cash in all their pensions within a 12 month period. As before, 25% of the cash sum is tax-free. In theory, the new triviality rules mean that more people with small pots have the flexibility of taking a cash sum instead of buying an annuity. It also means that scheme administrators can off load these pensions, saving administration costs.

It is arguable whether the new triviality rules have actually been helpful for people and schemes, or made the whole process so much more complicated. The triviality rules moved from a scheme basis to one of measuring total pension funds, holistic on the individual. People have to make sure they are aware of all the pension schemes they had ever joined and still have benefits under, including defined benefit schemes, defined contribution trust schemes, personal pensions and stakeholder pensions. Then they have to find out the value of their pensions, making sure that the total value is under 1% of the standard lifetime allowance in force, sign disclaimer forms confirming they are eligible to trivialise their benefits and do this within a year. It's likely people who have small pensions don't have access to a financial adviser, so they are left to their own devices to decide whether taking the triviality option is the right thing for them to do and manage the whole complicated process of collating their pension benefits.

Issues around trivial commutation

From the scheme administrator's point of view, the new triviality rule probably moved more small pensions off the books.

However, it hasn't solved all the problems. The issue comes back to the fact that people can only cash in their pensions if the total value of all their pensions is less than 1% of the standard lifetime allowance. If someone has four pension pots of £2,000 each, this is less than the current trivial limit of £16,500, so it's possible to cash all of these in. However, if someone has one pension fund of £30,000 and another one of £2,000, as the total amount is above the triviality limit, both funds have to be used to buy a retirement income.

This issue is likely to escalate as more and more people are expected to gather numerous pension pots, many of which will be small, as they change jobs more frequently and are increasingly likely to be in defined contribution pension schemes. Peoples' options at retirement will either be to take tiny annuities from small pension pots with potentially uncompetitive annuity rates or, to turn to a financial adviser, consolidate their pensions before retirement and get a better annuity deal. This is a very real problem for many people. Very few annuity providers offer external rates for funds of less than £10,000, even fewer offer external rates for funds of less than £5,000. So in some cases, if people are unable to trivialise their small pension pots, or lack the knowledge or help to consolidate these funds, they may be stuck with buying an uncompetitive annuity from their pension provider.

These concerns have been regularly raised by the pension industry. Earlier this year, the Revenue carried out discussions with the pension industry and customers to increase its understanding of how the trivial rules worked in practice, how many people are affected and to get the members' perspective on how the triviality rule affected pension savings.

The Revenue's response came in this year's budget with the announcement of a new, additional triviality level, probably of £2,000 per scheme. This is on top of the current triviality rule.

However, it's only for members of trust-based schemes, members of personal pension arrangements won't be able to benefit from the new rule neither will people with section 32 policies, deferred annuities or FSAVCs. The Revenue has worked hard for the past seven years to remove the anomalies between different types of pension schemes. Now it's surprisingly introduced new rules differentiating between some trust-based schemes (but not others) and contract-based schemes.

Need to be aware

What does this mean in practice? Assuming someone at retirement has three pension schemes, and the total value of the funds is more than the current universal trivial level, their options will depend not only on the value of the funds, but also on the type of pension arrangement. The knock on effect will mean that people will need to be aware of the different types of their pension arrangements, so they can be fully informed of their pension options. This is fine if they have a financial adviser, but some will not.

The Revenue has argued that the reason it hasn't extended the new triviality 'per scheme' limit to all types of pension arrangements is because it's concerned some people may take advantage of this rule and set up numerous personal pension schemes, all with £2,000 in them. So at retirement, they cash in say, 20 personal pensions, giving them a cash sum of £40,000, 25% of which will be tax-free. It's hard to believe people and their advisers would go to this length just to avoid setting up an annuity. A simpler way would be, perhaps, to restrict the number of schemes instead.

Another, perhaps more welcome, announcement in the budget is it will be possible to cash in 'stranded pots'. Scheme administrators and providers have always faced problems about how to deal with these if the individual's total pension benefits are above the standard triviality limit. Pensions can be 'stranded' in cases where the pension has already been paid out, perhaps as a transfer or an annuity, or already commuted under the triviality rules. Then later on, the administrator discovers the individual is entitled to further pension rights, such as additional units, which had not been taken account of. The additional amount is too small for the receiving scheme or annuity to accept and cannot be cashed in. The actual limit of the new 'stranded pot' rule is unknown, but is expected to be between £500 and £1,000 per pot.

Full details of the new additional triviality limit of £2,000 and the stranded pots are expected to be set out in the regulations attached to this year's Finance Bill. At this stage, we're not expecting the new triviality limit to apply across the board to all pension arrangements. The Revenue has made its position very clear and this won't change in the foreseeable future. However, we urge the Revenue to think again, to think about the benefits to the customer and to think about what it was trying to achieve under pension tax simplification in the first place.

Rachel Vahey
Head of Pensions Development
AEGON Scottish Equitable