Why did my pension capital have to come from the inflation-protected portion?

My question is a question of fairness. I have just received a pension from a defined benefit scheme.

It’s only a small annuity, but I was impressed by what I consider to be ‘hard training’, so I wanted to ask what you think.

My total annual pension was £4,110 split between £1,810 before 1997 and £2,300 after 1997. I opted for the lump sum of £19,779.

Sharp exercise? My pension lump sum came from inflation-protected part – should I complain

I was surprised to see that the total reduction in pension was applied to the post 1997 amount, bringing it down to £1,156 a year.

Therefore, a future pension increase would affect a significantly smaller amount. I would have thought that the reduction would be applied to both pre- and post-processing.

This system never pays voluntary increases in pre-1997 pensions and appears to limit increases to 3 percent after 1997.

I know these corporate plans always hide behind the tick “all at the discretion of the trustees,” but that strikes me as a bit perceptive. What do you think? Do I have reason to complain?

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Steve Webb responds: Many salary-based or defined-benefit pension schemes offer you the option of taking part of your pension entitlements in the form of a lump sum.

While you might choose to take your full pension entitlements in the form of a regular monthly annuity, you could instead opt for a one-off lump sum payment combined with a lower regular annuity, and you’ve done just that.

The question then arises as to how much should be deducted from the annuity in return for paying a lump sum.

This is done through a process known as “commutation”.

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

This is a ratio of about 17 to 1 (sometimes called the “commutation factor”).

One way to think about it is that if you were expected to receive an annuity for 17 years, (disregarding factors like taxes and inflation) it would be about the same between receiving a regular annuity and receiving an equivalent amount as a lump sum .

But the question, as you pointed out, is not just how much they cut your total pension, but what part of your pension they cut.

Put simply, from 1997 most occupational pension schemes were legally required to provide some inflation protection from retirement, but before 1997 the rules were less generous.

I covered this in more detail in a recent column: Why aren’t occupational pension schemes forced to give people a “triple” annual increase?

I totally understand your point that you would have preferred the pension system to cut your “pre-97” pension in exchange for the lump sum rather than your “post-97” pension, because it is the post-97 pension that gets the pension most generous protection against inflation.

However, there are a few reasons why things aren’t quite that simple.

The first is that the scheme can take this difference into account when calculating the commutation factors.

In other words, if it had applied the deduction to your pre-1997 service, it might have been able to deduct a larger amount for the same lump sum.

This is because the system would save less money if that part of your pension was cut. So it’s not necessarily the case that you’re on the wrong side of what the system has done.

Secondly, you should be aware that there are rules for pensions before age 97 which may include an obligation on the system to provide you with a guaranteed minimum pension.

It is possible that the full application of the deduction to the pension prior to 1997 would have resulted in that amount falling below the statutory minimum, which would not be permissible. Then they would have had to do a mix of deductions from pre- and post-1997 pension portions, which gets pretty messy.

Ultimately, many of these things are determined by the rules of the system, and these can vary from system to system.

If your system rules say that those who receive lump sums get a deduction from post-97 service first, then I’m afraid there’s not much you can do about that decision. However, as explained above, you did not necessarily lose out with this rule.