Beat the pension schemes that save billions from your lump sums

Basically, there's something in it for them. Tens of billions of pounds, to be precise. Actuaries estimate UK pension schemes across the private and public sector stand to save £20bn to £30bn by tempting staff to take these lump sums, which all too often leaves pensioners out of pocket.

Companies are offering the deals primarily to cut the cost of running expensive pension schemes that already stretch their budgets to the maximum, and as a result many offer bad deals to staff that will make them poorer if they choose to commute pension income in exchange for the tempting one-off payout.

Pension schemes save money if workers swap some of their pension for a lump sum, because they can strip back on the prudently calculated reserves they keep to ensure all benefits can eventually be paid. And the less generous the lump sums, the greater the saving.

Actuaries say the average company running one of these schemes will save around 5 per cent of the value of every worker's pension if they opt to commute the maximum amount they are allowed to take.

But the pension schemes with the stingiest deals that pay out less than £10,000 in lump sum for every £1,000 deducted from annual pension income, allow pension schemes to save up to around 12 per cent of your total benefits.

Speaking confidentially to Investors Chronicle, a trustee that looks after the UK branch of an international company's £100m pension scheme, admitted people retiring from the company have no idea they are receiving a reduced rate. "It is usual to make a significant deduction from the right commutation figure because the individual has the cash up-front and therefore has no investment risk," he says. "I doubt many pensioners realise this. The right figure is necessarily a reasonably wide bracket and this itself is open to manipulation in either direction, although rarely to the benefit of the individual."

Current rules allow retirees to take up to 25 per cent of their total pension as a lump sum and most financial advisers recommend taking it up. Most people say yes to it, with eight out of 10 savers faced with the decision, choosing to take it, according to Prudential research.

Don't expect any help from the government

The practice of pension commutation has been around for years but the way the value of lump sums are calculated remains completely unregulated in the UK, despite legislation being introduced last year to prevent pension schemes saving money by luring staff out of DB schemes all together, and into less generous arrangements.

But Paul McGlone, partner at Aon Hewitt, believes it is unlikely there will be any political interest in forming new rules to curb bad practice on poor value lump sums. "The pensions minister Steve Webb knows the industry would be up in arms if he tried to curb this with policy, because British companies simply cannot afford tens of billions of extra debt at the moment. Because that is what legislating on this would mean," he said.

And John Lawson, head of pensions policy at Aviva, added the fact that most public sector defined benefit schemes are saving money by offering poor value commutation rates (around £12,000 in lump sum for every £1,000 of pension commuted) is another barrier to the Department for Work and Pensions (DWP) taking a hard line on the matter.

When asked why there is still no regulation to curb bad practice with lump sums, the DWP said: "The legislation doesn't sit with us but HMRC". And when contacted with the same question, HMRC said: "This would be something for the DWP to answer fully".

Beat your pension scheme and get the best deal

Calculating whether the lump sum your DB scheme is offering is good value for money is a tricky business - as pension schemes aren't exactly upfront about the reality of what they're offering you. If you've been paying into a 1/60th accrual pension scheme you'll receive a simple looking letter when you retire, asking you if you'd like to swap X of your pension for X amount of tax-free lump sum.

At a first glance this might look like an easy choice - but don t be deceived. Because underlying this tempting looking offer are a bunch of complicated calculations, some of which will benefit your pension scheme - not you.

Confusingly, some schemes offer different commutation rates for different bits of your pension, depending on whether these bits of pension will rise in line with inflation when they are turned into index-linked income, or whether they are flat benefits that are fixed. But these rates will not be disclosed in the letter you receive - never mind telling you whether you are getting a raw deal.

Last week, pensions experts warned Investors Chronicle that commutation rates that give retirees less than £15,000 of lump sum for every £1,000 of pension they commute, are potentially bad value for money. This is because you'd be better off saving the bits of income you would have given up to get the lump sum if you reach or exceed your life expectancy.

Use your annual voluntary contributions to build the tax-free lump sum

If you've got a few years to go until retirement and you fancy a nice big cheque the taxman can't touch when you finally do get there, instead of swapping annual income from your DB scheme for your lump sum, you can use your Additional Voluntary Contributions (AVCs). Or you could set up a self invested personal pension (Sipp) to build up pension contributions that you can use to fund a tax-free lump sum.

This way, depending on how much you've saved through AVCs or in a Sipp while you're working, you could have your tax-free lump sum without giving up valuable income and falling prey to potentially stingy deals.

A tax-free lump sum sounds exciting but if you do decide to grab it, be careful, because as soon as you get it, the sum is vulnerable to both capital gains and income tax. Some people want to spend theirs straight away, which is fine, but if you're going to hang onto it you need to be smart if you want to shelter it from the taxman's bite.

How much is your lump sum worth?

■ The best way to protect large lump sums worth more than £100,000 is to pop them into offshore bonds. By doing this you'll protect your money from capital gains and income tax and could draw a 5 per cent tax-free income from it every year, a more efficient alternative to buying an annuity. But offshore bonds come with significant charges - set up fees of 0.5 to 1 per cent and ongoing fees of up to 1.5 per cent - and cannot be purchased without advice. Due to this, Chris Aitken, head of financial planning at Investec Wealth & Investment, says that while offshore bonds are an excellent way to shelter large lump sums from tax, they don't make sense for lump sums under £100,000 as they aren't good value.

■ Smaller lump sums worth less than £50,000 can be conveniently stuffed into individual savings accounts (Isas), which will protect them from income and capital gains tax. Over two years, a couple could use up their Isa allowance to shelter up to £46,080 of their lump sum from the tax man.

■ Lump sums worth between £50,000 and £100,000

A couple could shelter £46,080 of a lump sum by using up their Isa limit over two years, but unfortunately there isn't a tax-efficient vehicle to protect amounts above this and below £100,000 from the tax man. You can still invest your lump sum in the stock market or save it in a bank account or a fixed bond, but the income you receive from it will be taxed, and this is especially annoying if you are a higher rate (40 per cent) taxpayer. If you are unclear what to do with your lump sum, then taking it might not be a good move, so consider seeing a financial adviser.

Commutation rates the current 1.2m active members of defined benefit schemes are on track to receive