Cashing out small pensions, the lifetime allowance and the law of unintended consequences

Helen Powell

Quite a few of our clients have already cut scheme administration costs by cashing out low value benefits, including pensions in payment which in some cases cost more to pay out each year than the annual pension is actually worth.  Other clients are still thinking about it – but change is in the wind and it would be sensible to act sooner rather than later.

Apart from the new small lump sum option introduced in 2009 for payments of £2,000 or less, most of the ways schemes can cash out benefits hang to a greater or lesser extent on the value of the lifetime allowance (currently £1.8 million).  So, for example, under the standard trivial commutation rules you can cash out pensions with a commutation value of up to 1% of the lifetime allowance (£18,000).  Trivial commutation can work for dependant’s pensions, too, provided your scheme rules allow it and conditions relating to the member’s age are met.  The payment is taxable as pension income and can’t exceed 1% of the lifetime allowance on the date it is paid. 

In some circumstances (for example, if the relevant member’s death occurred within the last two years) you might be able to go one better and pay their dependant a defined benefits lump sum death benefit instead (though bear in mind that contracted-out benefits can’t be cashed out under this route, only via trivial commutation).  The plus side (and potential incentive) for the dependant is that this type of lump sum is tax-free, provided it’s within the deceased member’s unused lifetime allowance. 

Well, we know where we stand on all this with the lifetime allowance currently fixed at £1.8 million.  But here’s the thing:  imagine a not-too-distant future in which the lifetime allowance is radically reduced.  The Government is contemplating this as part of its plan to scrap the 2011 restrictions on tax relief for high earners’ pension contributions.  The annual allowance is to be cut to around £30,000 to £45,000 and the Government’s consultation paper says that ‘there are arguments for simultaneously reducing the level of the lifetime allowance so that there is more coherence between the two’. 

What might that mean?  Applying a parallel reduction would lead to a lifetime allowance of around £212,000 to £318,000.  Clearly, a limit of 1% of either of those amounts wouldn’t be all that useful, so we’d hope that the Government would set a separate limit for trivial commutation and for defined benefits lump sum death benefits.  Then, of course, there’s the question of what that limit should be, compared to the new leaner and meaner allowances, and how it might increase in the future. 

It’s too early to say how all this will work out, as the Government hasn’t finalised its proposals or published any suggested new limit for the lifetime allowance – but when change happens, it’s likely to happen fast (for April 2011).  If you’re paying out benefits which would be just within the commutation limits at the moment, it might well be worth looking at conducting a cashing-out exercise before next April.

Helen Powell is a senior professional support lawyer at Allen & Overy LLP.

Comments published on Pensions Talk do not necessarily reflect the views of Allen & Overy or its clients.

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