Hundreds of thousands of workers each year are becoming tangled up in pension rules that make it difficult for them to buy an annuity.

With an increasing number of workers changing jobs several times in their career there is a growing body of people who are reaching retirement with small amounts in a string of different pension schemes. However, new rules introduced last year are limiting the options for these people when they retire.

The Association of British Insurers (ABI), the industry trade body, estimates that there are about 164,000 pension pots worth less than £10,000 each that are exchanged for annuities each year.

The rules introduced in April last year were a positive move that opened up the prospect of being allowed greater flexibility when saving for retirement, but for some of those holding a number of small pension pots the new regime is proving more of a hindrance than a help.

Background

• Threat of fresh pension scandal

• Pensions savings cap set at £3,600

• Peers back pensions crisis fund

• Savers just forget about their pensions

• Plight of the A-Day pension prisoners

Retirement savings gone to pot?

Mark Atherton says that new rules for people with small sums in several pension schemes are more of a hindrance than a help

At first glance the latest rules on what are known as trivial pensions appear more generous than the old ones. Previously you could convert a pension pot into cash (and not take an annuity) only if the lump sum did not exceeed either £2,500 (where all contributions were the individual’s) or about £5,000 (where they included a government “sweetener”). The updated provisions allow for pension savings worth up to £16,000 to be converted into cash, which should be music to many pension savers’ ears.

But there are several stings in the tail. The old rules allowed savers to convert any small pension pot into cash, regardless of any other pension savings. They could also take the cash when they turned 50 in some cases.

Now savers can take a cash sum only if all their combined pension savings total less than £16,000 – and they cannot touch the money until they are at least 60.

As an extra hurdle they have to include in their final total the current cash equivalent of any company pension scheme from which they will eventually benefit, as well as the equivalent cash sum required to generate any pension they are currently receiving. Since this is calculated by multiplying the value of any such pension by 25, an annual pension of only £640 would be enough to bar anyone from converting any additional small pension pots into cash.

Even if pension savers find that they qualify for the cash conversion, things are not as simple as they may hope. They cannot simply take their entire combined pot of, say, £12,000 tax-free. They are allowed only the first 25 per cent tax-free, with the remainder classified as income and taxed as such.

Those with small savings pots that add up to more than £16,000 will have to use their money to buy an annuity – or several annuities – but they may have a problem obtaining a decent rate. Stuart Bayliss, of Annuity Direct, the independent financial adviser (IFA), says: “The company with which you built up your pension pot is obliged to offer you an annuity, but those with small lump sums to convert will often find that they are given a poor deal.”

Shopping around, which is what advisers generally recommend, may prove less fruitful than expected because many annuity providers say that they make no profit on pots of much less than £10,000 and set this as the minimum amount that they will accept. Savers seeking to circumvent this threshold by grouping several pots together will find that some insurers do not accept small pots, even bundled together, and insist on a £10,000 minimum for each pot.

Among the more flexible insurers are L&G and Scottish Equitable. Both will accept combined pots worth as little as £5,000, including individual pots of only £1,000. Standard Life will deal with individual pots worth at least £5,000, but Prudential, Norwich Union and Scottish Widows all insist on a minimum of £10,000.

Jerry McLouglin, of Punter Southall Financial Management, the IFA, says that one way to get round the problem is to transfer the small pension pots them into a single personal pension and then buy an annuity.

Those who decide to switch their money from one financial group to another should bear in mind that there may be entry and exit penalties. Tom McPhail, of Hargreaves Lansdown, another IFA, says: “Exit penalties often cost between 5 per cent and 10 per cent of your pension pot, but they can rise as high as 25 per cent. Entry charges are rarer but some providers impose a start-up fee of £100 or £200, which is a big cost for someone with a small pension pot.”

On top of that they may feel they need expert advice to steer them through the pensions maze. But this does not come cheap. Some advisers charge £150 per pension pot, or a minimum of £400 where there are several pots, which would make the cost prohibitively expensive in some cases.

A number of organisations are now lobbying for the rules to be changed. Mr McLoughlin says: “At first glance the new triviality rules seem straightforward, but establishing the total value of pensions is complicated. A simpler structure would be welcome.”

Jon French, pensions spokesman for the ABI, adds: “We believe that the new rules are not working in the best interests of customers and need to be reexamined as soon as possible.”

Action plan

Work out how much your pension pots are worth in total, counting both personal and company pensions.

You will need to include the cash value of any final-salary pension schemes, plus the lump sum that is required to generate any occupational pension payments that you are already receiving.

If the total comes to less than £16,000, you are normally eligible to take your pension pots in cash, rather than having to buy annuities.

You are not obliged to take the cash option simply because you fall within the £16,000 limit. Remember that you will receive only 25 per cent of any cash sum tax-free. The remaining cash will be added to your income and taxed accordingly.

If you find that you are above the £16,000 threshold, you will have to purchase an annuity. But do not assume that the insurer you have saved with, and which is obliged to offer you an annuity, will offer a good rate, so shop around.

Not all annuity providers will welcome customers with very small pension pots. Many will not accept pots of less than £10,000 so you have to do some homework to find a good deal.

If you don’t want the hassle of searching, you will have to pay an adviser to do the work for you.

Whatever the size of your individual pots, you are likely to secure a better deal by combining them into one pot and taking this enlarged pot to an annuity provider.

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