10 November 2016 - Post by:Helen Powell
The pension freedoms have created particular risks and hurdles for members with protected lump sum rights. In some cases, members may not be able to take their rights in the form they would prefer, except with assistance from trustees or other members.
As a reminder, protected lump sum rights relate to members who, before A-Day, had a right under the scheme rules to a tax-free lump sum worth more than 25% of their rights. Where the value of the prospective lump sum at 5 April 2006 was less than £375,000, that protection may stand alone; members did not have to specifically apply for it. However, it can only be protected on a transfer to a new scheme if that transfer is part of a block transfer – the member needs at least one other member to transfer at the same time.
Separately, where the value of the prospective lump sum at 5 April 2006 exceeded £375,000 (that is, more than 25% of the £1.5m lifetime allowance which applied at A-Day, whether or not this was more than 25% of the member’s actual rights), then protection for the lump sum is applied as part of the member’s enhanced or primary protection.
Cash lump sum withdrawal
Administrators need to be aware that cash lump sum withdrawal (UFPLS) under the pension freedoms is not available to members who have both enhanced or primary protection and lump sum rights exceeding £375,000 as at 5 April 2006. A purported UFPLS payment to a member in this category would be an unauthorised payment, triggering tax charges for both the member and the scheme. Enhanced protection can be given up voluntarily (though the tax consequences should be carefully considered); primary protection cannot be given up (though it can be lost).
A member with stand-alone lump sum protection could take an UFPLS (25% tax-free) – this would reduce the remaining uncrystallised rights against which the member’s higher tax-free pension commencement lump sum would be calculated.
Other ways to access the lump sum
It’s likely that members looking to take advantage of their higher lump sum rights will wish to designate their funds for drawdown (in preference to taking an annuity) in order to access the pension commencement lump sum. If their scheme does not offer an in-scheme drawdown facility, then the need for a bulk or ‘buddy’ transfer to maintain protected lump sum rights will be an obstacle.
Members may therefore look to their scheme to facilitate access via in-scheme drawdown, perhaps subject to particular restrictions (for example, as to the number of withdrawals/maximum period for which funds may stay invested in the scheme).
Trustees may be prepared to consider this, but should note the risks involved:
- For the scheme, there’s a risk that, whatever conditions are set, members decide to leave funds invested indefinitely. This may result in an unanticipated (and unwanted) additional burden of administration and expense, plus potential additional liability for the trustees in governance terms. A wider category of members may also request access to in-scheme drawdown on the basis that it has been provided for some individuals, so trustees should consider (taking into account the employer’s views) whether they want to offer drawdown, and if so, on what terms.
- Members need to be aware of the tax consequences of (a) taking the lump sum (although free of income tax, this would increase their estate from an inheritance tax perspective); and (b) taking further tranches of cash in the form of drawdown, particularly if this is offered on restricted terms over a limited number of years, potentially increasing their marginal rate of tax. Member communications should clearly flag the potential tax consequences and encourage members to seek independent advice.
Helen Powell is a PSL Counsel at Allen & Overy LLP