Up to 3.6m retirees in line for 'rip off' lump sums

Playing on workers' willingness to sacrifice a chunk of their pensions for an instant lump sum worth 25 per cent of their pension pot to spend how they like, thousands of workplace pension schemes are cashing in by cutting disproportionately bigger chunks off annual pensioner incomes to cover the one-off payments and make extra profit.

A tax-free lump sum doesn't just sound tempting - it actually sounds like a sensible option. Especially when most financial advisers recommend you take it because of the tax break. This explains why eight out of 10 retirees end up taking a lump sum when they are offered one, as Prudential's figures show.

But in spite of the tax-break, Investors Chronicle research can reveal if you say 'no' to the lump sum and save the money that would have been docked from your annual income instead, you could easily save two or three times the value of the lump sum you were offered if you reach your life expectancy - and even more if you live longer.

Exactly how long it would take you to do this depends on how stingy your pension scheme is. Let's start with the worst.

If you've been paying into one of the least generous schemes you'll only get around £10,000 tax-free cash for every £1,000 a year pension income you give up. Let's say you retire at 60. If you saved the income you would have had to give up in return for the lump sum (assuming a 3 per cent interest rate on the savings account), it would only take you 10 years to save the equivalent amount if you're a basic-rate taxpayer (if your pension is big enough to make you a higher-rate taxpayer it will take you 13.5 years).

But life expectancy forecasts calculated by actuaries at Aon Hewitt predict a man retiring aged 60 today will live to be 87, while a woman will live to be 90, giving them 27 and 30 years - in which time they could save up to three times the lump sum that the pension scheme originally offered them. And by investing it in the stock market it could amass to significantly more. And that's why these lump sums are such bad value.

Last year the Department for Work and Pensions introduced new rules that came down hard on companies trying to rip off workers by offering them cash bribes to leave DB schemes altogether. But there are no laws in place to protect savers when it comes to lump sums. Paul McGlone, partner at Aon Hewitt, said: "These deals operate virtually under the radar. Since there are no laws to regulate it, companies can choose to give people bad deals and there's little they, or the trustees who look after the schemes, can do about it."

But some companies are offering (although still bad) much better deals than others. If you're in a more generous scheme and you're retiring aged 65, taking the lump sum still doesn't look like great value, but it certainly starts to look a lot better. In an average scheme that pays out £15,000 tax-free cash for every £1,000 of annual income you give up, it would take a basic-rate taxpayer 14.9 years to save the equivalent to their lump sum they were offered (and 18.7 years for a higher-rate taxpayer). But given that a man retiring aged 65 today is expected to live another 22.5 years, while a woman has an estimated 25.1 years left, it would still be easily possible for most people to save significantly more than the lump sum.

What you need to ask your employer

The key figure you need to ask your employer about is called the 'commutation factor'. The lower the commutation factor the more they will take from your pension pot to pay for the lump sum. For example, in a scheme with a commutation factor of 15, if you took a cash lump sum of £15,000, your annual retirement income would fall by £1,000 (£15,000 divided by 15). Actuaries say the stingiest rates they've seen go as low as 10, while the most generous can sometimes exceed 20. Malcolm Mclean, a consultant at Barnett Waddingham, says anything below 15 indicates the scheme might not be offering you good value for money.

Calculating real value of £1 of pension income

Andrew Tully, pensions technical director at MGM Advantage, says: "Some defined benefit schemes offer as little as £10,000 for every £1,000 a year of income given up, yet the cost of buying that income through an annuity could easily be £20,000, or higher."

Typically pensions schemes offer between £12 and £15 of tax-free lump sum for every £1 of pension you give up and most of the time this looks like bad value. But what is £1 of pension really worth?

John Lawson, head of policy at Aviva, says £1 of pension is only worth 80p in your hand, because it is taxable. And if you are a higher-rate taxpayer it is really worth only 60 pence.

However, to buy an inflation-linked pension of 60 pence a year, (the sort of pension paid by DB schemes) on the open market, would cost a male aged 60 with a spouse aged 57 £23.28. (This is for a joint-life RPI annuity with 50 per cent spouses pension, postcode EH42, according to current data from the Money Advice Service).

So, in taking a tax-free lump sum, you are giving up a pension that is worth £23 (net of tax) for a lump sum worth only £12 or £15.

When taking the tax-free lump sum might be a good idea

Although lump sums aren't designed to provide you with good value, for some people they could actually be a good idea:

■ If you're in poor health choosing the tax-free lump sum could make financial sense. You might be able to qualify for an enhanced annuity that could get you an annuity rate up to 60 per cent higher than other people - which might even get you more income than your DB scheme. Or, if your life expectancy is especially short, spending a lump sum while you can still enjoy it might feel like the right thing to do.

■ If you have debts (particularly anything paying a high rate of interest) you may decide to take the cash to pay off the debt as it will save you paying the interest, which may make the deal work out better overall.

■ If you don’t have any other lump sum savings you may decide you want some cash in case you need to pay a major unexpected bill.

■ If you want to spend a big sum of money on a holiday, a car or even a property, you may decide you don't care about the value-for-money aspect of taking the lump sum.

How long you can expect to live after retirement age

Source: Aon Hewitt

How long it would take you to save your lump sum equivalent

Source: Barnett Waddingham