MILLIONS of workers in final-salary pension schemes are being short-changed by up to £7 billion a year because their companies are offering them derisory lump sums when they retire.

Members in private-sector final-salary schemes can typically take a tax-free lump sum worth one-and-a-half times their earnings on retirement, but they must give up part of their pension income in return.

The vast majority take the cash, often to pay off their mortgage or fund a once-in-a-lifetime holiday, but many do not realise that the pension they have given up is worth far more than the lump sum — even though the cash is tax-free.

Standard Life, the insurer, has calculated that workers are missing out on between £5 billion and £7 billion a year. It said that about 250,000 people retired from private-sector final-salary schemes every year, taking an average lump sum of £20,000 — or £5 billion in total. But, it said, they gave up pensions worth £10 billion to £12 billion.

John Lawson, head of pensions policy at Standard Life, said: “The decision to take a tax-free lump sum is one of the worst choices most people can make. Members who opt for the cash are being treated unfairly and, if more people realised this, the trustees of company pension schemes could find themselves in court.”

The problem is confined to the private sector: public-sector workers have the luxury of being able to take a tax-free lump sum without a corresponding cut in their pension income.

Private-sector workers are generally left in the dark about the true value of the pensions they have given up. Companies simply give staff the options — a full pension or a tax-free lump sum plus a reduced pension — with no explanation.

Gareth Jones of Punter Southall, a firm of actuaries, said: “Schemes do not advise members about the relative merits of the cash or pension option because this would need to be handled by an adviser regulated by the Financial Services Authority, the City watchdog.”

However, company pension schemes have an interest in members opting for a lump sum. They are grappling with the rising costs of regulation and longer life expectancy, and if more people took their full pensions it would simply add to the burden.

Mike Sarjeant of PPM, a pension consultant, said: “If all those eligible stopped taking their tax-free cash and opted for their full pensions instead, the solvency position of pension funds would be much worse.”

Suppose you retire at 60, after 40 years’ service, on earnings of £45,000. If your pension is credited with 1/60th of final salary for every year of service, your expected pension would be £30,000 (40/60th of £45,000). You could take a maximum tax-free lump sum of one-and-a-half times your final earnings, or £67,500. But you would have to give up some pension income in return.

The amount of pension given up is calculated using “commutation rates”. Most schemes have commutation rates of about 12, which means that for every £12 of tax-free cash, members must give up £1 of annual pension income.

So, in this example, if you took the maximum £67,500 tax-free cash, you would have to give up pension income of £5,625 a year (£67,500 divided by 12).

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