Analysis: When a small DB pension busts the client’s LTA
Paul Darvill, director, Talbot and Muir, provides a practical solution to a case where an undervalued DB pension takes a client over his lifetime allowance
Having a pension fund in excess of the lifetime allowance is a nice problem to have but there are many who will be caught out because of smaller defined benefit schemes they didn’t realise the value of before they accessed them. They are then left trying to decide what to do about the money purchase funds they have but don’t want to lose to the tax man.
Let’s take one such example, and look at a possible solution to the dilemma.
Peter has a defined benefit pension that he built up many years ago, he worked at the firm for only a small proportion of his working life and hadn’t really considered the pension would be worth much when he came to retire because he thought of it as ‘frozen’. In fact it wasn’t frozen and had been growing with generous in deferment increases for many years. The reason they were so generous is because he left the scheme such a long time ago. He hadn’t received his statements because he had moved over the years but thankfully the company managed to trace him in the run up to his 65th birthday.
Peter had been diligently funding a pension for many years now, and taking advantage of employer pension contributions before becoming his own boss later in life. He hadn’t taken into account the value of his defined benefit scheme, instead just ignoring it. He has build up a sizable pot over the years so he could have a comfortable retirement, the pot now totalling in the region of £750,000. As he is still working he doesn’t believe he will need to access it any time soon and plans to continue funding the scheme until he retires, mainly using employer contributions because they are very tax efficient for both himself and his company. Employer contributions can be treated as a business expense, meaning they should receive corporation tax relief and because they are not treated as income, Peter and his company won’t have to pay national insurance contributions on them. Although Peter earns a decent wage he won’t be classed as a high earner under the new tapered annual allowance rules, so would be able make contributions up to the maximum of £40,000 if he wanted.
The defined benefit scheme’s letter states that he will be entitled to around £20,000 per annum when he reaches age 65 and that they don’t offer late retirement. They also only allow transfers out of the scheme if there is more than a year before normal retirement date. This means that he will be forced to take the pension, although he could commute some to a pension commencement lump sum.
The defined benefit scheme will be tested against Peter’s lifetime allowance, which is £1m because he hasn’t applied for protection, because he assumed the value of his benefits wouldn’t be high enough. He has been making contributions regularly to date so isn’t entitled to apply for Fixed Protection 2016. The value set against the lifetime allowance for the defined benefit scheme will be twenty times the value of the pension, which equates to £400,000. This along with his SIPP will take him over the £1m without even considering the growth on the fund and possible future contributions.
Peter consults the firm’s accountant who refers him swiftly to one of their professional connections in the financial adviser market. The financial adviser reviews all the paperwork and believes that Peter might be entitled to Individual Protection 2016. The adviser also considers the option of Individual Protection 2014 but thought it was unlikely that Peter’s benefits would have been sufficient at the time to meet the criteria.
Peter contacts all his pension providers and asks for information to complete his Individual Protection 2016 application. This will give him a lifetime allowance of the value of his funds at the 5 April 2016. Once all the information is received, Peter logs into his Government Gateway account with his financial adviser and completes all the information including the scheme valuations. He then receives an email with his personalised lifetime allowance on it and a reference number for use with the scheme.
Peter must pass the Individual Protection 2016 reference and information onto his defined benefit scheme before they crystallise the funds for them to be able to apply his personalised lifetime allowance.
Individual Protection 2016 allows Peter to continue to contribute, should he wish to, without the fear that he may invalidate the protection. Any funds in excess of his personalised lifetime allowance will be hit by a lifetime allowance charge, so he ceases to contribute and uses the pension contributions elsewhere in his remuneration package. Peter also decides to crystallise his defined contribution scheme at this time. He takes his maximum pension commencement lump sum, as it is tax efficient to do so, but no income. The reason he does this is to set the current value against his lifetime allowance before it grows any further.
Over time the crystallised defined contributions scheme grows and Peter withdraws a small amount each year to avoid it building up. The funds, if still in drawdown, will be tested against their original value at age 75 and he doesn’t want to have to pay any additional lifetime allowance charge but prefers to pay a little income tax each year on the small withdrawals. They will still attract income tax at 40% because of his other earnings but he is happy with this.
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