The smaller your pension pot, the worse the annuity deal From our television screens to Twitter to the Houses of Parliament, there's barely a place where annuities - and questions over their value for money - is not being debated. But the true extent of the poor value offered to pension savers may have been significantly underplayed. Waiting a lifetime for returns Small-pot pensions Analysis for the Financial Times suggests that one in three savers are offered deals worse than officially acknowledged, with the battle cry to shop around and consider all the options unlikely to release them from poor value. At the heart of the debate are the rates offered to people exchanging their pension pot for a guaranteed annual income in the form of an annuity. As annuity rates have declined in recent years - they are based on gilt yields, so have suffered from worldwide quantitative easing - the cash income generated by annuities has dwindled. Pensioners must now live much longer to see a return on their capital outlay. Much of the discussion about value has focused on rates offered to savers with the "average" pension pot (according to the Association of British Insurers) of about £33,000. But far greater numbers are buying with smaller capital sums and these attract significantly lower rates. Data from the ABI shows that in the first three-quarters of 2013, 41,010 customers bought an annuity with less than £5,000. There were a further 36,925 who bought an annuity with a pot of between £5,000 and £10,000. Combined, these make up nearly one-third of all annuity sales in 2013. Less than one in 10 annuities sold were for funds of £30,000-£39,000. Analysis undertaken for the FT suggests savers with "small" pots of less than £10,000 are offered very low rates by insurance companies. That leaves them with little or no chance of living long enough to even recoup their initial investment, let alone achieve a return. Ros Altmann, an independent pensions expert and former adviser to Downing Street, looked at rates offered for small pots of less than £10,000, of which 121,000 were sold in 2012 and 77,000 over the first three-quarters of 2013. At current annuity rates, according to Altmann's analysis, a 65-year-old saver with a "benchmark" pot of £30,000 would have to live to about 90 to see a return on their outlay, with the insurance company earning 3.5 per cent interest on the fund over time. However, the same customer with a pension pot of £3,000 (nearly one in five sales) would need to live to beyond 100 years to receive a return. Even for a £5,000 pot, they would need to soldier on to 99 years. A man retiring today at age 65 will, on average, live to 86, according to the Office of National Statistics. For women, the figure is 90. "The analysis shows clearly that smaller pots have the lowest annuity rates," says Ms Altmann. For £3,000 the insurer would still have plenty of their fund left even if the customer lived well beyond 100. There is no value in the small annuity (for the saver) - it's just pure profit for the insurer. Cliff edge The reason why small pots get such a raw deal is that insurers turn their back on the market below £10,000 as the fixed costs of setting up and running the annuity outweigh any investment return from the backing assets. While up to a dozen providers will compete for pension pots above £10,000, the market falls off a cliff below that figure. One industry expert who gave evidence to the Financial Services Consumer Panel for its recent annuities investigation went as far as describing the rates offered for very small pots as "terrible." In the Annuity Bureau's analysis of the market for the FT, only two providers, Legal & General and Standard Life, were quoting for purchase prices below £10,000 - and the market was even worse for sums below £3,000. "The open market effectively shuts down at the £3,000 point with customers having little choice other than to stick with the rate offered by their savings provider, or the company they have tied up with to offer a deal," said Mark Wood, chief executive of JLT Employee Benefits, which owns the Annuity Bureau, a retirement income specialist. Competition doesn't really exist at this end of the market, so rates are much poorer. Narrower options for small pot savers The government has recognised the plight of small pot savers and put in place measures to give them options other than being locked into a poor value annuity. "Trivial commutation" rules allow savers aged 60 and over with total retirement savings of less than £18,000 to take their pots as cash. In addition, small pension pots of under £2,000, and up to two small personal pension pots under £2,000, can be taken as a lump sum for those aged 60 or over, even when people have savings in excess of the aggregate limit. "All those options add flexibility," David Gauke, treasury minister, told a debate in parliament last week. However, many pension savers are not able to take advantage of this flexibility and are forced to annuitise pots of less than £2,000. "We receive numerous complaints about insurers being unwilling to release pension pots of less than £2,000 under the "stranded pot" regulations," said Michelle Cracknell, chief executive of The Pensions Advisory Service, an independent service providing pensions information and advice. "Pension savers may wonder whether insurers prefer to build up their "inherited estate"; rather than allow the release of those small pots to their policyholders." Ms Cracknell says current rules are complex and it is difficult for savers to work out whether they qualify for trivial commutation rules. Most who come to us with small pots are aware that there are trivial commutation rules, but some have a fundamental misunderstanding of the threshold (s). That is, their small pots are too big for triviality. Industry response Insurers have taken steps to increase awareness of trivial commutation and the benefits of consolidating pension pots to get a better annuity rate. But there are concerns that the significance of these options are being lost in pre-retirement packs sent to customers, which can run to more than 10 pages. But some insurers are going further. Phoenix, a closed life and pension fund consolidator, has just launched a pilot scheme to allow customers with low-paying annuities to receive their small annuity as a lump sum instead. Under the pilot deal, a 75-year-old customer receiving an annuity of £110 per year, or about £9 per month, could convert this into a cash lump sum of £1,100. "Many of our customers have annuities which provide small regular income payments but which may not suit their needs," said Phoenix, where one in six of its 2.25m customers saving have funds worth less than £5,000. This scheme offers them a choice - to take a one-off lump sum now or continue with the small annuity they previously selected. Equitable Life is making the option to convert to cash much more prominent in marketing material sent to retiring customers whose average pot size is £10,000. Problem of size Savers with small pots can obtain a better rate by pooling their savings into one pot to attract a better annuity rate by shopping on the open market. Once above the £10,000 mark, pension pots attract better rates. But it is much harder for savers with small pension savings to find a financial adviser who will fully set out their options or search the market. A new online directory, Pick-A.org, will help savers in these situations get in touch with advisers and brokers interested in their business. But experts warn that shopping around will not be much help to small-pot savers in an uncompetitive market. "I think we are in danger of importing solutions for people with larger savings as the shop around market fades away below £10,000," says Clive Boulton of Aviva, one of the country's leading pension providers. What we actually need to do is think of small pots as a separate group and work out a simpler way for customers to access their funds as cash. The current rules are too complex," he adds. The plight of the small pots has not gone un-noticed by consumer groups, who want regulators to probe more deeply into the issues as this end of the market. They have concerns that the small band of competing insurers that retain most of their pension customers at retirement have no incentive to offer better rates. "We are in effect seeing a two-tier market where many consumers with small pots might find it very difficult to get a good deal even if they shop around," says Debbie Harrison, a member of the Financial Services Consumer Panel and visiting professor at the Pensions Institute with the Cass Business School. We have called on the government to change the trivial commutation rules. In particular, for people with less than £5,000, there simply isn't a competitive open market. Relax lump-sum rules Under "trivial commutation" rules, individuals can take pension benefits as a cash lump sum as long as the value is less than £18,000 and conditions are met. A quarter of the lump sum can be taken tax-free, with the rest taxed, providing an alternative to turning a small lump sum into an annuity where rates become dramatically less competitive for funds of less than £10,000. Members of workplace pension schemes have the additional flexibility to take very small benefits of £2,000 or less under "standalone triviality rules." This perk was extended to personal pensions plans in 2012; however, members of these schemes are restricted to only taking two small pots of £2,000 or less as a cash lump in their lifetimes. While these options provide an alternative to a buying a poor-value annuity, many in the industry suspect the options are not being fully utilised because the rules are too complex. Individuals do not have the power to demand their pension provider allows them to take small sums as cash under the "standalone" rules. Andrew Tully, pensions technical director with MGM Advantage, a pension provider, says: "Why would someone with £3,000 in pension savings want an income of £13 a month (£10 if they are paying tax) which they won't notice? I believe they would prefer £3,000 to use as they see fit. Mr Tully says the rules should be much simpler for people to understand with the current "standalone" triviality amount raised substantially from £2,000. I believe any pot below £10,000 should be taken as a lump sum without reference to other savings. I think government should move forward and do it quickly. Triviality is not just a headache for those baffled by how the rules work, but those left with micro pots even after they have made the most of triviality. Legal & General is one of the few companies which offers to annuitise pension pots as small as £1,000 for its customers, saying the service is needed. "There is demand for this facility particularly where customers can't take triviality and don't have other funds that they can consolidate together," the company says. This can be the case where someone has defined benefit/final salary pension and a small pot on the side from another employment or additional pension saving - although the number of customers that this impacts is low and only represents approximately 3 per cent of all external annuity sales by volume. Individuals whose total benefits are just above the trivial commutation limit of £18,000 have to accept the prospect of exchanging their pot for small income for life in the form of an annuity. The Pensions Advisory Service (TPAS), an independent non-profit organisation, can provide free information, advice and guidance on options for individuals with small pension pots. Three key rules of trivial commutation Commutation cannot be made before the age of 60. Total capital value of the pension benefits to cash in, plus all of the other pensions to which you are entitled, must be within the definition of "trivial," which is currently not more than £18,000 All trivial commutations must be made within 12 months of the date on which you cash in the first of them. You do not need to cash in all of the pensions you have, but you must cash in the whole of each individual pension.