By Debbie Harrison
FT.com
July 23 2004

If you are in a salary-linked company pension scheme and are coming up to retirement, check carefully before you opt for the tax-free cash. It might represent poor value in exchange for the amount of annual income you have to give up.

The cash option looks attractive because it is tax free. To calculate the lump-sum schemes, apply a commutation factor, which is a ratio that expresses the cash value of each 1 of income.

So a ratio of 1:10 means that each £1 of income is worth £10 in cash. However, many schemes are using outdated factors that do not represent the real cash value of the income. Although it is not an accurate benchmark, the market rate is represented by the cost of annuities sold by insurance companies, as these also provide a guaranteed income in return for a lump sum.

Annuities have become more expensive in recent years due to falling yields on gilts. As a result the cash value of each £1 of annuity income is considerably more than it was a decade ago. If your scheme is using an outdated factor and you take the cash then it gains at your expense.

An underfunded scheme with a poor commutation factor has much to gain by encouraging members to take up-front cash payments in order to offload the more expensive long-term income liabilities.

Scheme members do not have any rights to specific commutation factors, says Hyman Wolanski, senior partner with the consulting actuary Wolanski & Co. Moreover, there are no formal guidelines for the scheme actuaries, who recommend the commutation factors the trustees should use.

Having a poor commutation rate reduces the cost of the pension scheme where members take this option. With the current pressure on pension funds, this is a useful hidden way of reducing pension liabilities.

If the commutation factor is not in your scheme booklet or provided in the most recent benefit statement, ask the pension manager or trustees, says Raj Mody, principal consultant at Hewitt Bacon & Woodrow.

"Request an up-to-date statement including details of how taking tax-free cash will reduce your pension. This should tell you how much cash you get for each 1 of pension you give up, although bear in mind the pension figures will be gross, so you need to allow for tax to give you the full picture."

Comparisons with annuity rates only provide a rough guide to value. In practice schemes will be partly invested in equities and therefore can expect to earn much higher rates of return than annuity providers, which hold gilts and other fixed interest instruments for this purpose. Therefore schemes can argue that it costs them less than the market annuity rate to provide pension income.

There are other reasons for these poor rates, however. Robert Ivey, European partner with Mercer Human Resource Consulting Ivey, says that pension schemes have a duty to protect the scheme and balance the interests of members. If scheme commutation rates moved to market rates this could cause even more members to commute at a greater cost to the scheme.

Wolanski provides the following example to illustrate the disparity between market rates and scheme rates.

Suppose you can take a tax-free cash sum of £100,000. If the scheme's commutation factor is 10 - that is, each 1 of pension income provides a cash sum of 10 - then the reduction in income would be £10,000 per annum.

However, a typical market annuity rate might require £16 to buy each £1 of pension, so only £6,250 per annum should be given up. An index-linked annuity would cost even more at about £19 per £1 of income, giving an income conversion figure of £5,250.

Ivey points out that the Inland Revenue will apply a conversion rate of 20:1 for final salary pensions after it introduces pension tax simplification in April 2006. It will use this rate to check scheme members are not exceeding the ceiling for pension funds that can be held in tax-favoured arrangements.

This is not to suggest that 20:1 represents a new market benchmark, but it does indicate how the Revenue calculates the value of a guaranteed income. Under simplification, the maximum cash will be a straight 25 per cent of the fund in most cases, but where this would increase the level currently provided by an occupational scheme the trustees have discretion to retain their existing rules.

If you are delaying retirement in the hope of increasing your tax-free cash then do check if the trustees plan to apply the new rules in full, as you may well be disappointed.

The cash versus income decision is complex and will depend on your circumstances. If you have a health condition that is likely to reduce your life expectancy you should consider taking maximum cash, Ivey says. You might also consider taking a transfer out of the scheme in order to buy an impaired life annuity, as this may provide a larger income.

Ivey stresses that inflation-linked pensions are valuable benefits which should not be given up lightly but points out that using the tax-free cash to repay debt that otherwise is serviced out of taxed income is very attractive.

Where your pension position is complex, talk to an independent pensions adviser with actuarial expertise.

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