How to boost small pension pots

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• People who accrue total benefits of less than £18,000 in registered pension plans can take the fund as a lump-sum commutation if they are aged 60-75 and their pension funds’ total value does not exceed £18,000.
• However, there are complications around this practice, and employers should refer enquiries back to the scheme administrator.
• The accumulation of small pots will be common under auto-enrolment, so the government is looking at ways to ease the transfer of small pots.

Auto-enrolment will boost the number of very small pension nest eggs, and the rules on what to do with them are tricky, says Ceri Jones

Pensions legislation is never simple, but some of the trickiest regulations govern what can be done with a pension fund that is very small too small, perhaps, to be successfully converted into an annuity. This is known as trivial commutation, and applies to pots that are valued at up to £18,000, which is 1% of the current £1.8 million lifetime limit. If funds are deemed to be trivial, they can be taken in cash provided the individual is aged between 60 and 75. Several separate pots may be taken as long as they do not total more than £18,000 and it is all done within a 12-month period.

Under a different rule, the de-minimis provision, people aged 60-75 who have small funds of £2,000 or less arising from occupational schemes only, can cash them in regardless of whether they have more than £18,000 in total, or other pensions.

The responsibility for dealing with trivial amounts lies with the scheme administrator. Ian Neale, director of Aries Pensions, says: “If an employee has heard about trivial commutation, then almost certainly what they will have heard will be wrong. The best strategy is to refer them to the administrator. An employer that talks to staff about this could rapidly get itself in a position where it is seen as giving advice.”

One of the complications for employers is that people often think these lump sums are tax free, but in fact only 25% of the value is tax-free and the rest is taxed as income under pay as you earn (PAYE). Many defined contribution (DC) plans do not have a PAYE scheme, so will need to contact HM Revenue and Customs and open one before paying any trivial lump sum.

Small pots may not be commutable

One problem with small pension pots is that they may not be commutable if the member has benefits elsewhere that take his or her total above £18,000, but the value of the fund is often too small to buy an annuity. The government is currently consulting on what can be done to make the transfer of small funds more cost-effective. John Lawson, head of pensions policy at Standard Life, says: “The pension transfer market is messy, complicated and expensive.

For example, there is no standard discharge form. They are different for each insurer, and a standard set of agreed words would make the process easier.”

The industry is keen to develop alternatives to annuities. Alistair Byrne, principal at investment management consultancy Investit, says: “There is a now need to shift the focus to the point of retirement, to help members make the right decision and to provide alternatives to annuities. This is still in an environment where advice is hard to come by.”

The forthcoming auto-enrolment will boost the number of small pots. Someone on a salary of £25,000 with a combined employer/member contribution of 8% will accumulate a fund of £17,432 after seven years, assuming investment growth of 7%, charges of 1% and salary growth of 1% each year. But the period required to accumulate £18,000 rises to 19 years if the figures are based on minimum contributions to the national employment savings trust (Nest) until 2017, because employers will be allowed to contribute lower amounts until this date.

Lee Hollingworth, head of DC consulting at Hymans Robertson, says: “We can foresee a situation where tens of thousands of members come up to retirement taking trivial commutation, and in many cases it will be the right thing to do. The competitive position for an annuity for a fund of less than £18,000 is already pretty poor.”

Read more articles on occupational pension schemes