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‘Beware trap of higher tax-free cash’

Tax-free cash lump sums should not be the automatic choice of workers in final-salary schemes, says Standard Life’s John Lawson.

Scheme members risk slashing their pension income because commutation rates, which determine how much cash they get for each pound of pension given up, have not moved to reflect falling annuity rates.

The problem is most prevalent in private sector schemes but even the police scheme has a 13:1 commutation rate for 60-year-olds, with members taking tax-free cash losing £1 of pension income for each £13 of tax-free cash. The true cost of buying a £1 a year index-linked pension annuity with 50 per cent spouse’s death benefits is nearer £29, giving up a pension worth more than double the value of the tax-free cash taken.

This problem could worsen from A-Day when many staff in DB schemes can take bigger tax-free lump sums than the current maximum one and a half times final earnings. The blanket 25 per cent of fund value allowance could double some tax-free cash entitlements.

The one silver lining in the new rules is that all tax-free cash can be taken from AVCs if available rather than pension pots.

Lawson says: “Although superficially attractive, the new rules mean employees can compound the poor choice they are already making.”

Informed Choice managing director Nick Bamford says: “It can be incredibly inefficient for some individuals to take tax-free cash.”

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