An important option that is available under all self-employed pension plans is to take part of the benefits as a tax-free cash sum at retirement. The amount taken can be up to three times the remaining annual pension - a complicated sum to work out but one usually provided in companies' illustrations. The policyholder can take a smaller sum of cash if he wishes.
It will normally be worth the policyholder's while to take the biggest possible tax-free sum at retirement. The reason is that any pension payable under the pension plan will be taxed as earned income, while if cash is taken and invested in a purchased annuity, then part of the return will be tax-free as a return of capital. Except for those paying very high rates of income tax and/or investment income surcharge in retirement, commutation offers one method of boosting their income.
For example, assume that an individual's retirement pension under a personal pension plan has reached £14,500 by the time he wishes to retire at the age of 68. The maximum sum he can commute for cash will be £19,000, leaving a pension of £13,000. Assuming the £19,000 can be invested in an annuity yielding 16%, it will produce £111,440 p.a. of which £1729 will be tax-free. If only basic rate tax is payable (and no investment income surcharge) this will increase net income by almost 10% .
Given the investment advantage of the personal pension plan, it is odd at first sight that many self-employed people continue to purchase endowment policies. Other than the lack of knowledge of the benefits of such a plan there is one possible reason for this, which is that pension plans cannot be used as security for loans. The benefits under a personal pension plan cannot be assigned to any other person; once the contributions have been paid, moreover, even the plan-holder may have no access to them until retirement. Thus, although it is possible to stop paying premiums and to receive a reduced pension at retirement, it is not possible to surrender the policy. In most cases this factor will not weigh heavily against the benefits of the pension plan, but it should always be borne in mind.
Another alternative is to take a pension increasing by a fixed percentage each year. Companies will quote different rates of initial pension based on the "escalation" rate. The higher the rate proposed, the lower the initial pension will be, and so this alternative suffers the same disadvantage as the pure "unitised" pension.
Yet another option is to make the pension payable during the policyholder's wife's life as well as his own. Since women usually live longer than men, this will usually mean a reduction in the annual pension, the exact amount of reduction depending on the wife's age relative... see: Unitised pension