Government loosens rule for small pension pots

High-level lobbying on behalf of Britain's richest individuals has persuaded the Government to increase to £1.5 million the maximum tax-free amount that people can accumulate over their working lives under the new pension regime, which begins in 2006.

Rather less attention has been focused on the millions who will be lucky if their pension fund reaches just a fraction of this amount.

Nevertheless, the Budget announcement of the £1.5m limit has a knock-on effect at the lower end of the scale, since for pension pots of less than 1 per cent of this sum the normal rules on buying annuities are to be waived. Anyone who has pension policies worth less than £15,000 will be able to cash them in on retirement.

Currently, only personal pension funds worth less than £2,500 qualify for this 'trivial commutation' concession. According to the Department for Work and Pensions, as many as one in two people with personal pension policies could become eligible once the new rules come in.

Predictably, there are conditions. For example, only 25 per cent of the cash sum will be tax-free, with income tax chargeable on the remainder of the pension fund taken as cash.

The change, which has still to be approved by Parliament, will bring a huge sigh of relief from the financial services sector, which claims that it is not cost-effective to process small annuity purchases. In principle, the advice if you are converting a personal pension into an annuity is to exer cise your right to shop around between suppliers, using the open-market transfer option. But in practice few financial advisers rush to help people with small pension pots since the commission (typically £100-£150 on a £10,000 annuity) is seen as poor recompense for the work involved. One specialist annuity adviser, Annuity Bureau, only takes on clients with at least £20,000 in their pension. Another, Annuity Direct, asks those with small funds for a £150 'commitment' fee.

Insurance companies, too, are less than enthusiastic. The annuity comparison tables produced by the Financial Services Authority and available on the FSA's website show just one company (Scottish Equitable) publicly stating that it is prepared to offer pension annuities for £5,000. Some companies with official £10,000 or £20,000 minimum thresholds are known to be prepared to offer smaller annuities. Yet the trend, according to Stuart Bayliss, managing director of Annuity Direct, is for insurers to withdraw from this market. 'A number of companies have recently increased their minimum,' he says. In practice, he goes on, the open market option is increasingly disappearing for those with pension funds of less than £10,000-£15,000. They must rely on the annuity offered by their pension fund company and hope it is good value.

Or, of course, wait until 2006. With more than 50 per cent of maturing personal pensions worth less than £15,000, the numbers of people affected could be high. 'I think this is one of the most significant bits of the simplification of pensions process,' says Tom McPhail of financial advisers Hargreaves Lansdown. He points out that the way the rules on the Government's new pension tax credit have been drawn up favour those who convert their pension fund into cash, rather than those who elect to receive income through an annuity.

The trivial commutation change might seem to be good news all round - but there is another way of looking at it: the new rules will lead many people to convert into cash the money that they had supposedly been saving up for retirement. Even where people manage to resist the temptation for a massive retirement splurge, the options for investing the cash will be limited.

Bayliss points out that risk investments such as equities are unlikely to be appropriate: 'They would be better off reducing their outgoings by paying off credit card debts or residual mortgage,' he says.

Ironically, the new rules could mean that even fewer people have a steady stream of income to see them through retirement.

The small print of the recently published Finance Bill also includes some disappointing news for better-off investors. Originally, the £15,000 concession was going to be available to all, even those with a lot more in total in pension funds. They could have taken out an additional pension policy worth just under £15,000 to benefit from what would have been a massively tax-efficient arrangement. No such luck. The Government has changed its mind, so that trivial commutation will apply only to those whose total pension pot is below £15,000. But this change does mean that some people who will now not be able to use trivial commutation will find themselves at retirement with very small personal pension policies.

Pension simplification, it seems, may not be so simple after all.