Why did my pension lump sum have to come out of the inflation-protected portion?

My question is one of fairness. I’ve just taken a pension from a defined benefit scheme.

It’s only a small pension, but I was struck by what I thought looks like ‘sharp practice’ so I thought I’d ask what you thought.

My total annual pension was £4,110, split pre-1997 £1,810 and post-97 £2,300. I opted to take the lump sum of £19,779.

I was surprised to see that the total reduction of pension was applied to the post-97 amount reducing it to an annual £1,156.

Therefore going forward any increase in pension would apply to a much smaller figure. I would have thought that the reduction would have been applied across both pre and post.

This scheme never pays any discretionary increases on pre-97 pensions and seems to cap the post-97 increases at 3 per cent.

I know these company schemes always hide behind the catch all of ‘at the discretion of the trustees’ but this seems a bit sharp to me. What do you think? Do I have cause for complaint?

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Steve Webb replies: Many salary-related or ‘defined benefit’ pension schemes offer you the opportunity to take some of your pension rights in the form of a lump sum.

Whilst you might choose to take your full scheme rights as a regular monthly pension, you might instead opt for an up-front lump sum combined with a lower regular pension, and this is what you have done.

The question then arises as to how much they should knock off your pension in return for paying a lump sum.

This is done by a process known as ‘commutation’.

They take the lump sum figure – in your case just under £20,000 – and convert that into a deduction from your regular pension – in your case around £1,144.

This is a ratio of around 17 to 1 (sometimes called a ‘commutation factor’).

One way of thinking about this would be that if you were likely to draw a pension for 17 years, it would come out roughly even (ignoring things like taxation and inflation) between taking regular pension and taking an equivalent amount as a lump sum.

However, as you have pointed out, the question is not just how much they knock off your total pension, but which part of your pension they reduce.

In simple terms, from 1997 onwards there was a legal duty on most company pension schemes to offer some inflation protection once the pension started, but before 1997 the rules were less generous.

I covered this in more detail in a recent column: Why aren’t company pension schemes forced to give people ‘triple locked’ annual increases?

I entirely understand your point that you would have preferred the pension scheme to have reduced your ‘pre-97’ pension in exchange for the lump sum rather than your ‘post-97’ pension, because it is the post-97 pension which gets the most generous inflation protection.

There are however a few reasons why things aren’t quite as simple as that.

The first is that the scheme may take account of this difference when it works out the commutation factors.

In other words, in exchange for the same lump sum it might have deducted a bigger amount if it had applied the deduction to your pre-97 service.

This is because it would save the scheme less money to reduce this part of your pension. So it’s not necessarily the case that you are out of pocket because of what the scheme has done.

The second thing to be aware of is that there are rules around pre-97 pensions which can include a duty on the scheme to provide you a Guaranteed Minimum Pension.

It is possible that applying the deduction entirely to the pre-1997 pension could have taken that figure below the legal minimum, which would not be allowed. So they would then have had to do a mixture of deductions from pre and post 1997 slices of pension which starts to get quite messy.

Ultimately, a lot of these things are determined by the rules of the scheme, and these can vary from scheme to scheme.

If your scheme rules say that those who take lump sums see a deduction from post 97 service first, then I’m afraid there’s not much that you can do about that decision. However, as explained above, you haven’t necessarily lost out as a result of that rule.