Summary – September 2014
On 6 August 2014, HMRC published for consultation draft guidance and legislation which will implement the changes to the pension tax rules announced in the Budget 2014. This Bill will amend pensions tax legislation to give individuals greater flexibility to access their Defined Contribution (DC) pension savings. The changes will affect not only DC schemes but also DC rights held within a hybrid or cash balance scheme. Most of the changes are intended to come into force on and from 6 April 2015, and will have effect in respect of pensions to which individuals become entitled on or after that date. The four week technical consultation closes on 3 September 2014. The Bill will be introduced into Parliament in the autumn. This Profile provides a summary of the draft clauses published so far (more will appear later).
Proposed Benefits from 6 April 2015
From April, having reached normal minimum pension age, members of DC arrangements will be able crystallise as much, or as little, as they want.
Proposed benefits available from a DC arrangement will be:
- A Drawdown Pension: comprised of:
– Capped drawdown
– Flexi-access drawdown
- A Lifetime Annuity
- An Uncrystallised Funds Pension Lump Sum (UFPLS)
- A Scheme Pension
- A Pension Commencement Lump Sum (PCLS) (available with the lifetime annuity, drawdown or scheme pension). Either a single PCLS or series of these can be taken.
Although individuals will be able to choose any combination of the above benefits, it will not be mandatory for schemes to offer members the new flexibilities.
Drawdown Changes
The most fundamental changes affect the drawdown rules.
Under the current rules, there are two types of drawdown:
- “capped drawdown” which is available to anyone over the age of 55 but the maximum annual income that can be drawn is limited to 150% of an equivalent annuity.
- “unlimited (flexible) drawdown” which is open to individuals who satisfy a “Minimum Income Requirement”, currently £12,000 a year.
The Bill will introduce a distinction between drawdown pension funds created before 6 April 2015 (to which the current tax rules may continue to apply) and those created on or after that date, to be known as “flexi-access drawdown funds” (“FADFs”). There will be no limit on the amount of withdrawals that can be made from FADFs, however any ongoing contributions will trigger the new money purchase annual allowance rules (see below for details).
All existing funds of those in unlimited (flexible) drawdown before 6 April 2015 will automatically convert into FADFs. Anyone who is in capped drawdown on 5 April 2015 will be able to either:
- convert their funds into an FADF or
- designate new funds to their capped arrangement. The limit on the maximum amount of pension they can draw each year will continue to apply to that fund.
It is important to note that that the new money purchase annual allowance of £10,000 rules (see below) will not be triggered whilst the capped drawdown restrictions are adhered to.
If the cap is exceeded, the excess will not be deemed to be an unauthorised payment, instead capped drawdown members will automatically become flexi-access drawdown members.
As with the current situation, short term annuities will still be able to be purchased by a drawdown fund for a period of up to 5 years. From 6 April 2015 they will be able to reduce in payment and the member need not be given the opportunity to nominate the provider (although schemes may still choose to offer this).
Annuity Changes
Notably, the definition of a lifetime annuity will be amended from April 2015. Some of the current restrictions on lifetime annuities will be withdrawn. Although annuities will still have to be paid for life and at intervals of 12 months or less, there will be a number of important changes:
- There will no longer be a requirement that the member or dependant must have been given an opportunity to select the insurance company which will provide their annuity (commonly known as the “open market option”), although schemes may still offer this.
- All annuities will be permitted to reduce as well as to increase in value.
- The maximum ten year guarantee period for a lifetime annuity will be removed. This will enable annuities to continue to be paid after the member’s death.
Anti Avoidance: Money Purchase Annual Allowance (MPAA)
The AA limits the amount of tax relief available on pension savings paid by or in respect of an individual to a registered pension scheme in a pension input period. Where pension savings exceed the AA, an AA charge applies at marginal rates of income tax.
The AA is £40,000 for the tax year 2014/15.
To ensure that individuals do not exploit the new system to gain unintended tax advantages, the Bill will introduce a reduced AA of £10,000 for DC savings (known as MPAA) which will be triggered when an individual flexibly accesses their pension savings. Trigger events include:
- Drawing downfunds from a flexi-access drawdown fund, including receiving payments from a short-term annuity provided from a flexi-access drawdown fund;
- Receiving an uncrystallised funds pension lump sum (UFPLS) – see below for details;
- Requesting that the scheme administrator converts their pre-6 April 2015 drawdown pension fund to a flexi-access drawdown fund and subsequently takinga drawdown pension from that fund;
- Taking more than the permitted maximum for capped drawdown from a pre-6 April 2015 drawdown pension fund; or,
- Receiving a stand-alone lump sum and not being entitled to enhanced protection.
- Receiving prior to 6 April 2015 a flexible drawdown payment from a pre-6 April 2015 drawdown pension fund.
Individuals who have already taken their DC pensions will not trigger the new MPAA rules, unless or until they take benefits flexibly under the new rules. As it currently stands, recycling from annuity income has been unaffected.
So a client could have £40,000 of annuity income and pay the whole amount into pension contributions, relevant earnings permitting, and this would be permissible.
Other payments aside from annuity/scheme pension payments that won’t trigger the MPAA rules are:
- Receipt of a tax-free lump sum (a pension commencement lump sum);
- Receipt of a trivial commutation lump sum;
- Receipt of a small pots lump sum;
- After 6 April 2015, taking no more than the permitted maximum for capped drawdown from a pre-6 April 2015 pension fund.
It will not be possible to utilise carry forward of any unused annual allowance where the £10,000 MPAA applies.
If a member was taking flexible drawdown prior to 6 April 2015, the £10,000 allowance will apply from that date (this is in stark contrast to the old rules when his/her allowance had been set at zero).
If an individual exceeds the £10,000 MPAA their annual allowance for the remainder of their pension savings is reduced to £30,000 (the “alternative AA”) plus carry forward and they will pay an MPAA charge on the excess over the £10,000 limit.
If the individual does not exceed the £10,000 MPAA in any tax year, their total annual allowance, including for money purchase and defined benefit arrangements, will continue to be £40,000 plus any unused annual allowance carried forward from the three previous tax years.
Example 1 from HMRC Guidance
“David is a member of a money purchase arrangement and a defined benefit arrangement and has flexibly accessed his money purchase arrangement in the tax year. David’s total savings to his money purchase arrangement for the tax year are £6,000. As this amount is not
more than £10,000 there is no test against the money purchase annual allowance for the tax year concerned.
His total pension savings are therefore tested against the £40,000 annual allowance. David’s total defined benefit pension savings are £32,000. This means his total pension savings for the tax year are £38,000. As this is less than £40,000, no annual allowance charge is due, and he has £2,000 unused annual allowance to carry forward to the next year. Assuming David had no other annual allowance to carry forward from other years, the next year he will have an overall annual allowance of £42,000 but his money purchase annual allowance remains £10,000”.
Example 2 from HMRC Guidance
“Isobel is a member of a money purchase arrangement and a defined benefit arrangement and has flexibly accessed her money purchase arrangement in the tax year. She has no available carry forward.
Isobel’s total defined benefit pension savings for the tax year are £28,000 and her total savings to her money purchase arrangement are £11,000. As this is more than £10,000, her tax relief for the money purchase pension savings may be restricted by the money purchase annual allowance.
Isobel must now work out whether she is liable for an annual allowance charge on a chargeable amount.
In this example, it is easy to see that as Isobel’s money purchase pension savings have exceeded £10,000 she is liable to an annual allowance charge on the excess of £1,000. However as her remaining defined benefits savings are less than £30,000, no annual allowance charge arises in respect of these.
Isobel is therefore liable to an annual allowance charge on £1,000 (her chargeable amount).
The legislation however sets this out in a number of steps which are as follows
The chargeable amount is the higher of:
- the default chargeable amount which is the excess of Isobel’s defined benefit pension savings plus money purchase pension savings over the annual allowance (£40,000), and
- the alternative chargeable amount which is the total of the excess of Isobel’s defined benefit pension savings over the alternative annual allowance (£30,000) plus the excess of money purchase savings over the money purchase annual allowance (£10,000)
That is:
The excess of £28,000 + £11,000 over £40,000 = £0 (the default chargeable amount) or, £11,000 – £10,000 = £1,000 plus the excess of £28,000 over £30,000 (nil) = £1,000 (the alternative chargeable amount).
In Isobel’s case, the alternative chargeable amount is more than the default chargeable amount so the alternative chargeable amount applies.
Isobel will therefore be liable to an annual allowance charge on her chargeable amount of £1,000”.
Measuring the AA against the tax year in which an input period ends is problematical due to the fact that pension input periods do not necessarily align with the tax year. The solution to this problem is that contributions paid after the trigger event would be counted against the money purchase AA. Therefore, if an input period of 12 months ends on 30 November 2015 and the trigger falls on 17 October, only contributions paid between 17 October and 30 November 2015 will be measured against 2015/16 tax year’s money purchase annual allowance.
Special rules will apply where an individual subject to the money purchase annual allowance rules is accruing benefits in a hybrid arrangement (for example one providing defined benefits with a money purchase underpin).
Although these rules are complex, they are likely to apply only in very limited number of cases.
Scheme Pays
Despite the introduction of these new money purchase AA rules, the Bill does not propose any changes to the scheme pays regime. Therefore a member will still only be able to require their scheme to pay an AA charge if their total pension savings in that scheme in any given tax year exceeds £40,000, and the AA charge is greater than £2,000. However, schemes may allow scheme pays on a voluntary basis, in return for a reduction in the individual’s benefits.
Recycling of a PCLS
Recycling of a pension commencement lump sum (PCLS) involves using that lump sum to significantly increase contributions to a registered pension scheme.
From 6 April 2015, the recycling rules will be amended to apply where the value of a PCLS, added to any other such lump sums taken in the previous 12 month period, exceeds £10,000 (and not the current
1% of the LTA (which would have been £12,500).
Uncrystallised Funds Pension Lump Sum
The Bill will introduce a new authorised lump sum payment, to be known as an “uncrystallised funds pension lump sum” (“UFPLS”).
This will enable individuals to access their DC savings flexibly, without
having to designate the funds for drawdown, subject to the following conditions and controls being met:
- It may only be paid from uncrystallised rights.
- Individuals under 75 must have sufficient LTA available to cover the full amount of the UFPLS.
- Individuals over 75 need only some lifetime allowance left at that time. If the payment exceeds the remaining lifetime allowance, the tax-free element is limited to 25% of the remaining lifetime allowance.
The rest of the lump sum is taxable as pension income.
- Individuals under 75 must be at least 55 or meet the ill-health early retirement conditions.
- 25% of the fund may be paid tax-free and the remaining fund is taxed as pension, but this means that the payment may not be accompanied by a PCLS.
- Once this payment is made, the member will be subject to the new MPAA of £10,000.
- It may only be paid to the member and not to a dependant on the death of a member. Provision in the draft rules ensure that a UFPLS cannot be paid if a bigger tax-free amount is available immediately before the lump sum is paid:
- The member may not qualify for a UFPLS if members have either primary or enhanced protection and the lump sum at 6 April 2006 was more than £375,000);
- The member has a lifetime allowance enhancement factor (due to primary protection, pension credits from previously crystallised rights, non-residence, transfers from recognised overseas pension schemes or pre-commencement pension credits) and the available portion of the lump sum allowance is less than 25% of the proposed uncrystallised funds pension lump sum.
Example of tax treatment
Bill has a fund of £100,000, and requests a UFPLS amount of £20,000.
Bill therefore receives £5,000 tax free and the remaining £15,000 is taxed at his marginal rate of tax. Each payment is a BCE.
An important implication of these new UFPLS rules is that as there will be no £30,000 caps post 6 April 2015, this will therefore consign the current trivial commutation lump sum rules for money purchase schemes to pension’s history
Scheme Rules Override
As many pension scheme rules will not permit payments to be made using the new flexible access provisions, the Bill will introduce a permissive “scheme rules override”. The override is intended to allow the trustees or managers of registered pension schemes to make the following payments within the new rules, without having to amend the scheme:
- drawdown pensions
- purchase of a short-term annuity
- dependants’ drawdown pensions
- purchase of a dependant’s short-term annuity
- UFPLS
However, the trustees or managers will be able to choose whether or not to make any of these payments.
Other Measures
The changes for dependant’s benefits are broadly the same as for members. However, the key difference is that that income from a dependant’s flexi-access account on its own will not trigger application of the MPAA rules.
There are no changes to the drawdown lump sum death benefit rules, however the Government has already stated that the 55% tax charge is too excessive and measures will address this in the autumn.
The Bill will also introduce measures to:
- reduce the age limit for taking trivial commutation and small pot lump sums from age 60 to the normal minimum pension age (currently age 55 or a member’s protected pension age).
- amend the definition of trivial commutation lump sum so that such lump sums will only be payable from DB arrangements.
- extend the trivial commutation lump sum death benefit rules to allow the remainder of a guaranteed pension (up to a value of £30,000) to be taken as a lump sum on death rather than continuing to pay it as a pension, and increase the maximum trivial commutation lump sum death benefit to £30,000.
- remove the facility to pay winding-up lump sum death benefits because all such lump sums may be paid as trivial commutation lump sum death benefits.
Impact on Government Finances and Numbers Affected
The tax information and impact note accompanying the legislation indicates that the government anticipates that these changes to raise £320m in 2015/16, rising to £1,220m in 2018/19 before reducing in 2019/20. It also suggests that whilst under the current rules around 5,000 people a year access their pension savings flexibly, this is expected to increase to around 130,000 a year from next April.
SUMMARY OF BENEFIT OPTIONS FOR DC PENSION SAVINGS
POST 6 APRIL 2015
Members, who are normally over the age of 55,will be able to pick one of or even a combination of the following options on their DC pension savings (obviously subject to the scheme rules permitting this):
TAKE PENSION SAVINGS AS A ‘UFPLS’
This allows a member to take their uncrystallised pension savings as cash in one go or in instalments. The first 25% of each payment will be tax free with the remainder being taxed at the member’s marginal tax rate. New MPAA rules will apply.
PURCHASE A LIFETIME ANNUITY AND TAKE TAX – FREE CASH
Members will continue to be able to use some or all of their pension savings to
purchase a lifetime annuity if they want to, after taking their tax- free cash. The rules surrounding annuities will be relaxed so that, amongst other things, annuities will be permitted to decrease as well as increase. New MPAA rules will not apply.
RECEIVE A SCHEME PENSION AND TAKE TAX – FREE CASH
Members will continue to be able to convert their money purchase savings into a pension from their scheme. Where an individual access their savings in this way, they will be able to take (normally) 25% of the amount as tax-free cash where they convert the remainder into a scheme pension. New MPAA rules will not apply.
TRANSFER FUNDS INTO A ‘FADF’ AND TAKE TAX – FREE CASH
Under this proposed mechanism, individuals will be able to keep their funds invested and draw them down as and when they want to. They could also use some of the funds in a drawdown facility to purchase a short – term annuity payable for a period of no more than 5 years. Individuals will be able to access
(normally) 25% as tax – free cash and transfer the remainder into a FADF facility. New MPAA rules will apply.
FOR THOSE IN CAPPED DRAWDOWN PRE 6 APRIL 2015:
Options for these individuals are:
- convert their funds into an FADF (new MPAA rules will apply)
- designate new funds to their capped arrangement (new MPAA rules won’t apply). The limit on the maximum amount of pension they can draw each year will continue to apply to that fund.
FOR THOSE IN FLEXIBLE DRAWDOWN PRE 6 APRIL 2015:
Such individuals will see their arrangements automatically convert to a FADF.
AA limit will rise from zero to £10,000.
TURN A SMALL POT INTO CASH
As per the current rules, where an individual has less than £10,000 worth of savings in a money purchase arrangement they will be able to take this as a single cash lump sum (subject to them only being able to exercise this right on up to 3 occasions under PP arrangements). The minimum age limit to do this will be changed from 60 to 55 from 6 April 2015. New MPAA rules will not apply.
Risk warnings
This document has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The opinions expressed herein are those of Cantab Asset Management Ltd and should not be construed as investment advice. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. As with all equity-based and bond-based investments, the value and the income therefrom can fall as well as rise and you may not get back all the money that you invested. The value of overseas securities will be influenced by the exchange rate used to convert these to sterling. Investments in stocks and shares should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. It is important to note that in selecting ESG investments, a screening out process has taken place which eliminates many investments potentially providing good financial returns. By reducing the universe of possible investments, the investment performance of ESG portfolios might be less than that potentially produced by selecting from the larger unscreened universe.
