Saving for a pension at retirement used to be relatively straightforward. For those who were lucky enough to be a member of an occupational defined benefit pension scheme (where pensions paid were typically a function of final salary and completed years’ service) provided by their employer, pension rules were a doddle. However, ‘Pensions Simplification’, as it was dubbed when introduced by the Government in April 2006, was anything but and introduced a new level of complexity for the unwary or, simply, unlucky.
With effect from 6 April 2014 the Lifetime Allowance (LTA) will reduce from £1.5 million to £1.25m. It will then be considerably lower than the level of £1.8 million it reached in 2010/11. HMRC estimate that 30,000 people will be immediately affected by the reduction and a further 360,000 people are predicted to break this limit over the longer term.
Although one could hope that the reduction in the LTA is a short-term measure and part of the Government’s austerity measures, it is sensible to assume that it might be frozen for a long period and could even be cut further. It is therefore important to start planning now.
The financial consequence of exceeding the new limit and not having appropriate protection in place could be substantial. At the point of commencing your retirement benefits their value will be assessed and any value in excess of the LTA (or higher threshold if protection has been secured) will be subject to an immediate tax charge of up to 55%. Therefore, the forthcoming reduction could increase the prospective tax charge for some pensioners by up to £137,500.
The rules for assessment of tax are complex and if you have a range of pension benefits accrued, it is important to appreciate how these interact. The threshold is perhaps the easiest to interpret for a money purchase pension fund as the assessment is based on the fund value at the point benefits commence. However, for defined benefit arrangements or annuities already in payment it can be much harder to assess the current and future position.
In some cases, the value of a defined benefit pension or annuity already in payment is deemed to be 25 times the gross annual amount received. For example, an individual in receipt of an occupational pension of £50,000 per annum (that commenced before 6 April 2006) will be deemed to have used all of the forthcoming LTA limit of £1.25 million in the event that an additional pension arrangement were to commence. There are many people who might be in receipt of an occupational pension but have since made contributions to a personal pension arrangement as a result of part-time or consultancy work. When their new pension arrangements begin, they could find that the majority of the fund is consumed by tax.
A further complication relates to those who have pension funds in drawdown. Although the payment of pension benefits has already commenced and, if this took place after 5 April 2006, an assessment against the LTA (at the time) has already taken place, a further assessment will take place at either the point of annuity purchase or attainment of age 75. In such circumstances, any growth in the pension fund whilst in drawdown is assessed against the residual LTA.
Let’s look at a simplified example.
An individual retired in January 2014 at the age of 60 with a money purchase pension arrangement valued at £1.4 million and opted to draw pension benefits using drawdown rather than annuity purchase. In January the LTA was £1.5 million. Commencement of their pension benefits therefore used 93.3% of their LTA, leaving 6.7% of the LTA to carry forward.
10 years later they find that annuity rates have significantly improved as a result of a general increase in gilt yields, which have risen to reflect rising base interest rates. They have also been fortunate in that their pension-fund has continued to grow in value despite the amounts withdrawn as pension income. The fund value is now £1.6 million; in other words it has grown by £200,000. On purchasing an annuity a further assessment against the LTA takes place. If the LTA has not moved from the forthcoming limit of £1.25 million the available amount is £83,750. As a consequence, £116,250 of the growth is not covered by the available LTA and will therefore be subject to a tax charge at 55%, which would amount to £63,938.
There are two main types of protection available for those who might be affected by the reduced limit. For those who do not intend to make any further pension contributions (or accrue any further entitlement in a defined benefit pension scheme) it is possible to protect your LTA at the current rate of £1.5 million. However, time is running out fast and you really ought to seek specialist advice before you act. For those with pensions already over £1.25m a second form of protection allows them to continue their pension savings as tax effectively as possible.