Maximising the benefits of pension protection
Summary All individuals with large pension funds who completed HMRC form APSS200 prior to the 5th April 2009 should by now have received their certificate of protection, stating the type of protection, ‘enhanced’, ‘primary’’, or ‘enhanced (dormant primary)’, that is currently in place. Used correctly, this essential document helps protect individuals from incurring a penal tax charge of 55% for exceeding the standard lifetime allowance (SLA).
For those considering drawing (crystallising) their pensions, this Insight sets out essential information that will ensure they are certain i) that they understand how to make best use of the protection that has been put in place and ii) whether they fit into a group that may be able to draw a greater proportion of their pension fund as tax free cash than they had previously expected.
Enhanced versus Primary Protection When applying for pension protection, enhanced protection was described by some as ‘total’ or ‘complete’ protection as it allowed an individual’s pension fund to grow to any size without facing a possible tax charge. And assuming that no further contributions to pension plans were made, this form of protection was the more heavily subscribed.
Far from offering unlimited growth, Primary Protection only protected the value of the pension fund in line with the predetermined statutory allowable growth rates. However, in light of recent stock market performance and with it the likely reduction in pension values, it is the manner in which the chosen protection calculates the tax free cash (TFC), rather than the protection’s allowable growth rules, that will determine which form of protection maximises the benefits under the ‘pension simplification’ rules.
Formula for tax free cash when protection is in place:
A-Day: 5th April 2006 SLA: Standard Lifetime Allowance TFC: Tax Free Cash PV: Pension Value
Example: Mr Hanks’ pension fund was valued on A-Day at £4m, £1m (25%) of which was available as tax free cash. He ceased working in 2008 and wants to crystallise the pension in the current tax year, the SLA for which is £1.75m. Due to the drop in financial markets, Mr Hanks’s pension fund is now valued at only £3m. He has ‘enhanced (dormant primary)’ protection in place and he wants to know which protection option will offer him the largest lump sum.
Despite a drop in the pension value, the protected lump sum with primary protection has increased in line with the standard lifetime allowance, from £1m at A-day to the higher value of £1.167m.
Capital Extraction from Pensions You may feel that in the above case, Mr Hanks should avoid drawing the tax free cash from his pension until markets recover. We disagree. Extracting the full value from pensions is extremely difficult and in many cases impossible. Therefore, once a decision has been made to extract the tax free cash, a plan to extract the maximum amount of pension capital should then logically follow.
Most individuals enjoy the advantage of pensions in reducing an annual income tax liability and investing funds in a tax wrapper that allows capital growth almost free of tax. For the period of ‘accumulation’, pensions remain an attractive option, particularly for higher rate tax payers. However for ‘decumulation’, the period of time during which individuals enjoy the accumulated capital, pensions are less attractive. Once the tax free lump sum has been drawn, the annual income is restricted to rigid government actuarial department (GAD) tables, influenced by the yield on 15 year Gilts, and taxed at marginal rates of income tax.
The after-tax benefits of savings in or out of a pension wrapper can be measured by comparing net present values of the two cash stream after their different tax treatment. We find many people who have previously focused on the tax advantages of accumulation are shocked to discover how small is the net present value gain from pensions. However, even this calculation ignores the uncertainty about the amount of capital that can be enjoyed either as lifetime spending or as a bequest. This is a serious oversight as there is in practice a large degree of inefficiency in the extraction of value from a pension account under current tax rules, aggravated by the penal taxation of residual funds after the deaths of both member and spouse. The rules are also designed to ensure that there is likely to be a residue if the second death occurs after age 75. The intention of these rules may have been to make the option of drawing down after age 75 unappealing. The effects of these rules can be mitigated by selecting a personal pension from age 75 that operates under occupational scheme rules rather than personal pension rules.
In practice, the risk of not extracting full value from the pension fund can be avoided by buying an annuity at some stage, as the potential loss of early death is offset by an equivalent gain from outliving one’s actuarial expectancy. However, this calculation is not a satisfactory explanation of the welfare benefit of capital in our out of pensions where there are children and a significant value is placed on a bequest motive.
A further general consideration is the flexibility of capital uses when access to it is constrained by pension rules. This is highly relevant when a large proportion of the assets assigned to retirement spending is in the form of pension capital. This effectively prevents one from meeting large unplanned capital payments, for whatever reason.
The actual mechanics of delivering a stable real income stream are also hampered by pension rules, as the monetary limits are reset on the basis of valuations of the assets no less frequently than every five years.
Finally, the pension rules may prevent one from ‘front-loading’ the income stream to reflect the typical time preferences of enjoying the funds whilst younger, fitter and healthier.
However, these flexibility factors fall away if vesting all segments immediately to maximise the tax free cash and then drawing the maximum allowable income each year thereafter.
These considerations are also somewhat specific to the assets held. When constructing and managing portfolios for known future income needs such as draw down, we use a technique similar to that of ‘liability driven investment’ (LDI) that is increasingly used in the institutional space by defined benefit occupational pension schemes. LDI involves a constant choice, within the context of an overall ‘risk budget’, between matching investments perfectly to a known future liability, or hedging, and bearing and managing risk in the form of holding investments with uncertain outcomes relative to the known liability.
Hedging requires a risk free asset that genuinely matches the cash flows of the liability and so makes the investor indifferent to the asset’s volatility. For individual retirees, this risk free asset is duration-matched index linked gilts.
These are very lightly taxed when held directly and outside a wrapper, as most of the inflation compensation element of the interest rate is added to the redemption value rather than to the coupon, and is untaxed. Contrast this with nominal interest rates, where most of the rate paid is inflation compensation and is then taxed as income, and with equity returns, where the inflation compensation is partly via income and partly gain, with both subject to taxation.
Anomalies of final salary (defined benefit) pension scheme:
1. Order of pension crystallisation
For those fortunate enough to have a final salary (also known as a defined benefit) pension scheme, a further complication may apply.
Upon crystallisation, some final salary pension schemes offer tax free cash lump sums that equates to less than 25% of the overall pension value. In this circumstance, only by vesting all personal pension benefits first, can one be certain of retaining the full level of tax free cash that had been secured at A-Day.
Example Dr Healy has worked in the NHS and private sector building up two pension funds. His NHS pension is due to pay £70,000 p/a as income with a tax free lump sum of £210,000, overall this pension is valued at £1,610,000. He has also paid into a SIPP which has a value of £2m, from which 25% can be potentially drawn as a tax free lump sum. He is looking to vest both pensions in the current tax year, the SLA for which is £1.75m.
If Dr Healy draws from the NHS Pension first, (which we think is what most people in his position would do), he will be restricted to how much can be taken from the personal pension as tax free cash.
Percentage of standard lifetime allowance used upon crystallisation of his NHS pension = (PV @ crystallisation / SLA @ crystallisation) * (100/1) = (1.61m / 1.75m) * (100/1) = 92% of the standard lifetime allowance used
Therefore, when Dr Healy comes to draw on this private pension of £2m he will be eligible to take only 8% of his personal pension fund (£160,000). This is the percentage of the lifetime allowance remaining and is significantly less tax free cash than the typical 25% (£500,000) that one would expect. The balance of the pension fund can be then be drawn, but as income that will be taxed at his highest marginal rate.
If no form of pension protection is in place, Dr Healy will face a significant lifetime charge of 55% on the funds valued in excess of the standard lifetime allowance. This would represent £1.023m.
If Dr Healy relied upon enhanced protection, no tax charge of 55% will be incurred, but significantly more tax will be incurred because of the reduced lump sum and therefore increased income tax charge.
If Dr Healy drew funds in the ‘wrong’ order, but had primary protection in place, he will not suffer. Primary protection, as mentioned earlier, locks in amount of tax free cash that can be drawn and will increase it in line with the SLA.
2. Commutation Rates and how to ‘beat the system
The commutation option, once described by the former Chancellor, Nigel Lawson, as ‘anomalous but much loved’ because the lump sum it pays is tax free, is available to almost all people who retire.
For defined benefit schemes, the lump sum generally operates on the basis that members can exchange part of their pension for a cash sum. Under simplification rules, and for those schemes that have chosen to implement it, the allowable limit increased in line with that of personal pensions to 25% of the deemed value of the overall pension fund.
However, the commutation rate is often seen as an opportunity by some pension schemes to reduce their overall costs and future liabilities, offering unattractive commutation rates. The NHS, for example, will increase the tax free lump sum by only £12 for each £1 of income surrendered. This is far from generous, and when assessed for the majority of individuals, proves deeply unattractive.
If, as in our earlier example, the value of the personal pension has dropped, Primary protection can be called upon to draw the protected level of tax free cash which, as a percentage of the overall fund value may be significantly higher than it had been, offering a further opportunity to extract capital from the pension tax wrapper.
Transitional protection is a complex area of pension planning that requires expert financial advice. Contrary to the political claims made for pension simplification, the complexity has increased the range of possible outcomes with good and bad decision making, which at least means the cost of taking the best possible advice can be justified. If this article has caused you to question your understanding, please feel free to make contact.