TECHTALK. MAR 2014 ISSUE 3 Volume 13. Capped drawdown: the full picture

Transcription

1 TECHTALK MAR 2014 ISSUE 3 Volume 13 at retirement special edition Capped drawdown: the full picture

2 Contributors Sandra Hogg Sandra is the senior tax manager within Scottish Widows with 17 years of hands on experience dealing with HMRC and advising owner managed businesses as an accountant and tax adviser. She has over 15 years insurance industry experience as a financial planning expert within the group. She represents Scottish Widows at industry forums and at the ABI s Investment Product Tax Panel and is Scottish Widows expert spokesperson on Tax and Financial Planning. Ian Naismith Ian is a senior manager in retirement income & planning. He also writes and presents extensively on pensions as well as representing Scottish Widows on trade bodies and in consultations with Government. David Anderson David joined the group in He has over 20 years industry experience which includes a regulated role as a pension transfer specialist along with a number of technical advice based roles covering life and pensions business. Bernadette Lewis Bernadette joined the group in 2006 and has over 30 years experience in the financial services sector working for both providers and intermediaries. Her earlier roles, including resolving technical complaints, provided her with a broad experience across both life and pensions. She now specialises in pension planning and automatic enrolment, while keeping up to date with tax and trusts. Thomas Coughlan Tom has spent over 13 years in technical roles. He has wide experience including the provision of technical support to financial advisers covering life, pensions and investment compliance. He currently specialises in pension planning and automatic enrolment. Chris Jones Chris joined the group in He s worked in a number of technical roles in marketing, product development and technical support. After many years specialising in life and investment products his recent focus has been on Pensions Reform. Jeremy Branton Jeremy has over 25 years experience working for financial services providers in a number of technical and advisory roles. Having joined the group in 2006 he now specialises in corporate pensions, with particular focus on Pensions Reform. Colin Clark Colin has built up a wealth of pensions knowledge over more than 20 years. His industry experience includes life office based administrative and technical/management roles as well as a regulatory risk role at a national IFA. Contents Building the foundations State Pension reform Ian Naismith Radical state pension changes are planned for April This article details the transition arrangements and possible winners and losers. Constructing at retirement solutions David Anderson A look at some key areas for advisers to consider when using pensions as part of a retirement income solution. Securing a retirement income: lifetime annuities Bernadette Lewis This article provides advisers with a reminder of the key technical features of lifetime annuities. Capped drawdown: the full picture Thomas Coughlan A look at the some of the technical issues that affect drawdown from outset until the contract concludes. Understanding the Lifetime Allowance Charge Chris Jones As the Lifetime Allowance reduces once again from 6 April 2014 more clients will be affected. A good understanding of how and when the charge may apply will help you advise clients whose retirement planning is becoming increasingly complex. In sickness and serious ill health Jeremy Branton Summarising the circumstances where a pension can be payable on the grounds of ill health and the benefits available. Pensions and Succession Planning A case study Colin Clark Looking at how a good understanding of the Lifetime Allowance, Individual Protection and pension drawdown rules can help with business succession and inheritance tax planning. 2 techtalk

3 Welcome to the MARCH edition of techtalk Welcome to the March 2014 at retirement special edition of techtalk, in which we ve brought together a collection of articles focussed on explaining the key areas of this important topic. The value of having a plan for retirement is highlighted nowhere better than by the findings of the 2014 Scottish Widows Savings Report, which uncovers that the number of people in the UK with no savings at all has risen year-on-year from eight million to over nine million, or 1 in 5 of the UK adult population. This brings the proportion of people who have savings (67%) back down to a level not seen since Ian starts off this comprehensive edition by looking at the impacts of the radical state pension changes planned for April 2016 on retirement income planning. David provides sound guidance on how to construct at retirement solutions and what to watch out for when looking to consolidate existing pension plans. Bernadette explains the key technical features of lifetime annuities. Tom takes an in-depth look at the technical issues that affect capped drawdown from outset until the contract concludes. Drawdown is a complex product aimed at sophisticated investors and so technical questions will inevitably arise. As the Lifetime Allowance reduces once again from 6 April 2014 more clients will be affected. Chris uses examples to help explain this complex topic. Jeremy summarises the circumstances where a pension can be payable on the grounds of ill health and the benefits available. The opportunity to draw pension benefits early could make a significant difference to a client s standard of living and future financial plans. And Colin rounds of this jam packed edition with a useful case study on pension and succession planning. He illustrates how a strong working knowledge of the annual and lifetime allowance rules, Individual Protection and drawdown, along with estate planning expertise can provide added value for clients in helping them to achieve their objective. I hope you will find this at retirement special edition both a useful guide and an interesting read and that we will have helped you in your discussions with your clients on this important topic. And for more information on pension death benefits, please also take a look at our article Don t let death benefits tax you on our Adviser Extranet: Doc/FP0423 Enjoy the read. Sandra Hogg P.S. Please also take a look at our extensive range of automatic enrolment support material, at: techtalk 3

4 Building the foundations: State Pension reform Ian Naismith The starting-point for most people s retirement income is their state pension. The age when it becomes available may determine when they can retire, it will often be the largest single component of income, and even where there is significant other provision is it likely to be a worthwhile supplement. 4 techtalk There was a major reform of state pensions in 2010, with even more fundamental changes due in In both cases, the intention is to make the pension fairer, in the sense that more people receive enough to provide a basic standard of living, and entitlement depends less on working patterns and pre-retirement earnings. Ultimately it will be simple too but, as always, the transition arrangements mean it will become more complicated first. Alongside these changes, the age when state pension becomes available is due to increase much more rapidly than was previously expected. State pension Age changes SPA was set at 65 for men and 60 for women in 1948, and didn t change until 2010 when equalisation arrangement from Pensions Act 1995 started to take effect. In recent years there have been several changes announced, which are summarised in the table opposite. The current Pensions Bill includes a requirement for SPA to be reviewed formally in every Parliament, and the general principle will be that people should be expected to receive state pension for, on average, up to one-third of their adult life. clients should know their likely SPAs and plan accordingly

5 The 2010 changes The key change in 2010 was to reduce the number of years of National Insurance contributions or credits (together referred to as NICs from now on) required for a full basic state pension (BSP) to 30 qualifying years. Previously it was 44 years for men and 39 years for women. The changes also removed the need for 10 years of NICs to qualify for any BSP, introduced weekly credits for carers, including giving some carers entitlement to State Second Pension (S2P), and, from April 2012, removed contracting-out on a defined contribution basis. Finally, it linked BSP (but not S2P) to earnings rather than prices, though the Coalition Government subsequently introduced the triple lock for the current Parliament, giving an increase of the highest of earnings inflation, price inflation or 2.5% each year. These changes represented a step-change in pension entitlement, especially for many women who have spent significant periods out of the paid workforce. It would have led to a rapid rise in those entitled to receive the full BSP, to over 90% of both men and women by However, they left the major issue that BSP is not enough to provide a satisfactory living standard, so many people would still be dependent on the means-tested Pensions Credit. This would particularly affect those who couldn t build up S2P pension, including the self-employed and carers who didn t meet the requirements for S2P credits. The 2016 changes Table 1 State Pension Age Changes Change Current legislation Government proposal From 60 to 65 for women From 65 to 66 for men and women From 66 to 67 for men and women From 67 to 68 for men and women From 68 to 69 for men and women Between 6 April 2010 and 6 November 2018 (Pensions Act 2011) Between 6 November 2018 and 6 October 2020 (Pensions Act 2011) Between 6 April 2034 and 6 April 2036 (Pensions Act 2007) Between 6 April 2044 and 6 April 2046 (Pensions Act 2007) Not currently legislated for As in current legislation As in current legislation Between 6 April 2026 and 6 April 2028 (Pensions Bill) Likely to be mid- 2030s (Autumn Statement 2013) Likely to be by late 2040s (Autumn Statement 2013) From 6 April 2016, the Government is planning a single-tier state pension (STP) above the basic level of means-tested support, which in tax year 2013/14 is a week (just over 7,500 a year). This will increase at least in line with average earnings, and perhaps in line with the triple lock over the next Parliament (though that s unlikely to be sustainable indefinitely). S2P will be scrapped, so that the self-employed and those qualifying for credits have the same entitlement as employees. The number of qualifying years of NICs will increase to 35 for the full pension, and a minimum of between seven and ten qualifying years will be required to have any entitlement. Contracting-out through defined benefit pensions will be discontinued. As part of the trade-off to ensure affordability, entitlement to inherit state pension from a partner will be removed. It will also no longer be possible to defer receiving the pension and subsequently take a lump sum, and it s likely that the terms for deferring and receiving an increased pension will be less generous than at present. The change will be a cliff edge one, with those reaching state pension age (SPA) before 6 April 2016 unaffected by it, even if they defer receiving their pension until after the new regime starts. Transition arrangements As always with any change to pensions, there are complex transition arrangements to protect those who would otherwise lose out. However, the protections only apply to what has already been built up, and not to what the individual might have accrued in the future. This means that many people, particularly those in mid to late career with above-average earnings, will receive significantly less than they otherwise would have. techtalk 5

6 (a) Contracted-in Ignoring the complexities of contracting-out, there are essentially two possible positions an individual could be in at April 2016, and these are summarised in the table below: Table 2 Transition arrangements (contracted-in) Accrued state pension at 5 April 2016 Less than the STP More than the STP State pension entitlement at outset of new regime The higher of accrued entitlement and n/35ths of the full STP, where n is the number of past qualifying years The accrued entitlement Subsequent growth in entitlement 1/35 of STP for each qualifying year until the full amount is accrued, increasing in line with STP The part up to the level of the full STP increases in line with that pension. The excess increases in line with prices (CPI) Accrued entitlement can include BSP, Graduated Pension (pre-1975), SERPS and S2P. Example Helen is 52 years old at 6 April 2016, and she has 32 years qualifying of NICs, having started work after finishing university in 1986, with an additional two years of credit up to age 18. She has built up a combination of BSP, SERPS and S2P as follows: BSP SERPS to 5/4/ SERPS from 6/4/ S2P Total Helen s accrued STP entitlement, based on a full level of , is 32/35 x = So her entitlement is protected at the accrued level under the old system of above the standard level. When Helen reaches her SPA of 67 in tax year 2030/31, STP is a week and prices have increased by 40%. Helen s initial STP is: Standard STP Protected amount ( x 1.40) Total Under the current system, Helen would have continued to accrue S2P benefit up to her SPA if she was employed, and in addition her existing SERPS/S2P would have increased in line with earnings up to retirement. Assuming her earnings were around the national average, and that earnings inflation averages 1% a year above price inflation, this could have resulted in a pension of around 314 a week over 40 more. Amounts shown in the examples are only indicative to illustrate the principles. The initial level of STP has not yet been announced. (b) Contracted-out For those who are contracted-out, the basic principle that they get the higher of current entitlement and STP entitlement still applies, but with deductions to allow for periods contractedout. There are three periods to consider: Before 6 April 1997, employees built up entitlement to SERPS, but with a Contracted-out Deduction (COD) equal to the guaranteed minimum pension (GMP). At SPA, the GMP would exactly equal the SERPS pension given up assuming the individual had not moved to an alternative revaluation basis (for example, after transfer to a Section 32 plan). This applied to both defined benefit and defined contribution contracting out. However, after SPA SERPS would provide some or all of the escalation of the pension in payment, so the COD was less than the SERPS entitlement. Between 6 April 1997 and 5 April 2002, the contractedout benefits were deemed to match SERPS and there was no addition to or subtraction from SERPS for those who were contracted-out. Since the introduction of S2P on 6 April 2002, lower earners who have been contracted-out have also built up some S2P entitlement. However, there is no ongoing link between the two, so again no addition or subtraction for the S2P given up. The three periods need to be considered separately when calculating how much should be added to accrued BSP on the old basis or subtracted from STP on the new basis. Table 3 outlines the position. Table 3 Pension entitlement for those who have been contracted out for all or part of period Period of contractingout 6 April April April April April April 2016 Addition to BSP accrued SERPS - COD Nil when contractedout, SERPS entitlement when contracted -in Residual S2P for low earners when contracted-out, full S2P when contracted-in Subtraction from STP accrued COD SERPS entitlement given up when contracted-out S2P entitlement given up when contracted-out This is a very broad-brush approach to adjusting benefits, and individuals who have been contracted-out could lose or gain in comparison with those who were contracted-in. They could lose because: 6 techtalk

7 With hindsight, the defined contribution rebates for much of the contracting-out period were insufficient to give a good chance of matching the benefits given up; and The post-spa indexation of pre-1997 pension through SERPS is not replicated in the new system. However they could gain because: If their accrued state pension at 6 April 2016, after all the adjustments, is lower than the standard STP, they will have the chance to build additional STP benefit in future years. In broad terms, those close to SPA at 6 April 2016 are most likely to lose out compared to contracted-in counterparts, while those with a good number of years to go are most likely to gain. Example Graeme is 52 years old at 6 April 2016 and has an identical career history to Helen, except that he was contracted-out through a personal pension between 6 April 1988 and 5 April His state pension position is: Given Up Remaining Entitlement Standard STP SERPS to 5/4/ SERPS from 6/4/ S2P Total Graeme s accrued state pension based on the old system is Based on STP entitlement, his accrued pension is (32/35 x ) = So at 6 April 2016 Graeme has STP entitlement of (the higher of the two), which is equivalent to 130/156 x 35 = years accrual. However, he is able to increase this accrual in future years, and assuming he has at least another six qualifying years he will be entitled to the full STP. At his SPA in tax year 2010/31, Graeme s contractedout pension is a week, which is 80% of the pension he would have given up on the old basis. His initial pension is: Standard STP Contracted-out pension Total If the old system had remained in place, Graeme s weekly income would have been around 297, so he has gained about 7 a week from the change. This is because he has the ability to accrue additional STP, which Helen doesn t. (c) Inherited pension Under STP, the current system where a spouse or civil partner can receive state pension based on their partner s contribution record will be scrapped. This applies to: Category B(L) pension, where spouses and civil partners with no or low personal entitlement (dependants) can receive BSP of up to 60% of the full level based on their partners NICs, if they have both reached SPA. Category B pension, where dependants can inherit BSP based on their partners NIC records if these are better than their own. Up to 50% of a deceased partner s SERPS/S2P can also be inherited, subject to an overall maximum level. Category A pension (substituted), where an ex-partner s NIC record can be substituted for the dependant s own on divorce or dissolution of a civil partnership. All of these are being scrapped following the implementation of STP, but where both partners reach SPA before 6 April 2016 the current system will continue to apply. Transition arrangements in other circumstances are quite complex, but can be summarised as follows: Where the dependant reaches SPA before 6 April 2016 (but the partner does not), they will still be eligible for inherited / derived pension, but only based on their partner s NIC record up to 5 April Any NICs paid by the partner after that will not count. Where the partner reaches SPA or dies before 6 April 2016 (but the dependant does not), the dependant will not be eligible for any BSP based on their partner s NICs. However, they may still inherit SERPS/S2P as at present, subject to a cap on total state pension. Where neither partner reaches SPA before 6 April 2016, the dependant will not be eligible for any BSP based on their partner s NICs. However, they may still inherit 50% of their partner s protected payment (the amount above the standard level of STP based on accrual up to 5 April 2016). Advice Implications The complexities of the new system make planning difficult, and it will be some time before any pension forecasts are available for the new regime. However, advisers may be able to make an initial assessment of whether clients are likely to gain or lose from the change, and if they are worse off there is the opportunity to make additional savings to eliminate the shortfall. For those who would previously have expected a state pension increase on their partner s death, consideration could be given to some additional life insurance. The other key consideration is that clients should know their likely SPAs and plan accordingly. This could include a period between when they intend to stop work and their SPA. Detailed Government guidance on the changes is available at techtalk 7

8 Constructing at retirement solutions David Anderson Pension plans will typically form the backbone of most at retirement solutions and advisers need to have a thorough understanding of existing pension rules. Although we are now almost 8 years on from A-day, there are still a number of transitional rules as well as product specific features advisers need to be aware of. INTRODUCTION Customers may have several different pension pots built up over a number of years covering different periods of employment and/or self-employment. As well as pension arrangements, other available assets should also be considered as part of any solution. These could include ISAs, collective investments and investment bonds amongst others. It s important not to solely focus on the customer s pension arrangements simply because their objective is to generate an income in retirement. Having said that, existing pension arrangements will generally have a degree of complexity linked to how benefits can be taken that makes them a good starting point as part of any solution. CONSOLIDATION OF EXISTING PENSION PLANS It s probably at this stage the adviser will look to consolidate existing pension plans when building a solution, particularly where income drawdown is being considered. As always, it s important to carefully consider any protected benefits or penalties which may result from a pension switch or transfer. It s worth looking at some of the main areas to watch out for. DEFINED BENEFIT (DB) SCHEMES It s probably fair to say that in the vast majority of cases, transferring a DB pension is unlikely to be in a customer s best interest. Where a transfer is being considered and benefits are not being fully crystallised, any advice will need to be undertaken or overseen by a suitably qualified pension transfer specialist. So in most cases the adviser will be building a solution around the benefits available from the DB scheme. The DB benefit structure will largely be fixed with the member possibly having the choice of commuting some of their scheme pension for tax free cash. Depending on the commutation factors used by the scheme, opting for tax free cash can prove poor value for money. Other than pre 06/04/1997 non-gmp benefits, the remainder of the pension will be subject to statutory increases as a minimum. So in most cases the member will be exchanging an increasing pension in return for a one-off tax free lump sum. A fairly simple analysis would involve establishing the fund required to purchase an annuity to replicate the pension being given up, allowing for any pension increases and spouse s / dependants benefits. DB members with money purchase AVCs Where a member of a DB scheme has funded money purchase AVCs as part of a DB scheme, it s worth checking the scheme rules in relation to tax free cash. Where the AVC falls under the same rules as the main scheme, it may be possible to take all of the tax free cash from the AVC pot, thus preserving the full DB pension from the main scheme. 8 techtalk

9 SCHEME SPECIFIC PROTECTED TAX FREE CASH Where an existing plan has scheme specific protected tax free cash, this will be lost on transfer unless the transfer qualifies as a block transfer. Another aspect to consider is that the protected tax free cash must be taken in one go, so phased retirement is not possible. If the member is looking to use income drawdown and this is not an available option under the existing scheme, the only way of maintaining an entitlement to the protected tax free cash is via a block transfer. Taking the protected tax free cash and transferring the balance fund to a drawdown arrangement is not possible. In these circumstances the tax free cash would be treated as an unauthorised payment. PLANS WITH GUARANTEED ANNUITY RATES (GARs) These will normally only be found on retirement annuity contracts and some older occupational schemes such as EPPs. Some plans will impose a rigid structure on how the annuity must be structured to secure the GAR. For example, the annuity may have to be purchased at a certain age and may only be available as a single life level annuity with no guarantee. Here the adviser will need to make a judgement call on the value of the GAR compared to the alternative options. Where an annuity is being considered, it may be possible to secure a better rate than the GAR via an enhanced annuity. BUILDING THE SOLUTION In many ways, this simply requires a logical approach. Building up a picture of the customer s essential and discretionary expenditure during retirement is key. Where there is a spouse or other dependant, it s important to consider how expenditure requirements would change in the event of either death. Despite relatively low levels of inflation in recent years, the impact of this shouldn t be overlooked. Someone retiring today could easily be spending 20 or more years in retirement. 3% inflation will reduce the spending power of 1,000 to 744 after 10 years and to 553 after 20 years. Once the income requirements have been established, looking at existing pensions which will remain intact is the next logical step. Here the adviser will look to factor in any State pension entitlement, DB benefits and other pensions where protected benefits mean that consolidation is not an option. GAP ANALYSIS Identifying gaps in income requirements and using the available assets to fill those gaps is the next stage. Modern point of sale systems can be a huge help here, allowing the adviser to examine numerous solutions, look at the tax efficiency of those solutions and model what if scenarios such as death. USING PENSIONS TO FILL THE GAPS Annuities, income drawdown and phased drawdown can all form part of this solution. With the abolition of contractingout under money purchase arrangements, there are generally no longer specific requirements on the way these benefits are turned into an income, be it via an annuity, drawdown pension or a combination of both. Often solutions are built around either an annuity or drawdown. Where a customer is not willing to accept any investment risk, an annuity will be the only option for taking benefits from their pension plan. And there s also the need to consider the fund size which may be too low to consider drawdown. However for those with larger pension pots who are willing to accept investment risk, using drawdown shouldn t be at the exclusion of an annuity. Annuities still provide great value for those who live longer and it s worth remembering there are no enhanced drawdown rates available the same GAD rates apply to everyone. In conjunction with any DB benefits and State pension entitlement, an annuity is a good way of providing enough secure income to cover the customer s essential expenditure, giving them peace of mind in retirement. DRAWDOWN v PHASED DRAWDOWN Phased drawdown is often overlooked in favour of full drawdown in order to release the maximum tax free cash at outset. The main disadvantages of fully crystallising the fund at outset are: No more tax free cash is available from the pension pot, and Any lump sum death benefits are subject to a 55% tax charge. Phased drawdown can be an extremely tax efficient method of taking benefits. The main advantages are: Tax free cash can be taken in stages over a number of years to meet some income needs, and Death benefits on the uncrystallised portion of the fund are preserved. In the event of death, the uncrystallised portion of the fund can normally be paid free of IHT. If the objective is to maximise the uncrystallised portion of the fund, the income required each year can be made up of 25% of the amount being designated to drawdown with maximum GAD income being drawn from the remaining 75%. CONCLUSION With many transitional rules to consider, legacy product rules and the fact that retirement planning often involves one-off decisions, customers are more likely to turn to an adviser for help. A skilled adviser can add real value and unlike planning over the medium to longer term, the customer will be able to see the benefit immediately. techtalk 9

10 Securing a retirement income: lifetime annuities Bernadette Lewis Lifetime annuities offer the benefit of a retirement income for life, but at the price of inflexibility. This article provides advisers with a reminder of the key technical features of lifetime annuities. Lifetime annuities meet many clients needs by providing an income for life, no matter how long that is. The more flexible alternatives, including fixed term annuities, pre- and post-75 drawdown, aren t suitable for everyone. Whether an annuity is the whole or just part of the retirement income solution, a client has to engage at the outset with irrevocable decisions which shape their annuity. This article reminds advisers how the main technical features of lifetime annuities operate post 6 April All the examples are for illustrative purposes only. Main types of lifetime annuity Conventional annuities Conventional annuity rates align to long-term interest rates, although providers now look beyond the traditional gilts and corporate bonds to back their liabilities. Providers rates vary, depending on factors including mortality experience, financial strength, appetite for risk and whether they re actively pursuing market share. Providers take the annuitant s age at outset into account, but haven t been able to allow for gender since 21 December As shown later, the annuity shape also affects income (all examples are for illustrative purposes only). Example Robin has 30,000 to purchase an annuity after taking tax free cash. Choosing an annuity on a single life, level, monthly in arrears, no guarantee basis secures different levels of monthly income, depending on Robin s age at the outset. Age at outset Monthly income Enhanced annuities Enhanced annuities offer those with medical and/or lifestyle factors which may affect their mortality a higher income than a conventional annuity. These factors commonly include smoking, high blood pressure and cholesterol, diabetes, chronic asthma, stroke, heart attack or angina. 10 techtalk

11 Providers use the ORIGO Electronic Common Quotation Request Form (ecqrf) or the manual equivalent (CQRF) to gather the information necessary to provide a quotation. Automated underwriting processes mean guaranteed quotations can be produced near instantaneously. Providers deal with the risk of clients overstating the severity of their condition by using medical sampling of in-force business. This can result in income being reduced if it s not possible for the provider to verify the information given at the outset. Post code based annuities Post-code based annuities have become more common, as life expectancy varies at this level, reflecting differing levels of affluence and related socio-economic factors. Compared with a conventional annuity, this approach tends to enhance a retired manual worker s income, but reduce an ex-stockbroker s. Investment linked annuities With profits and unit linked variations are available. The income from an investment linked annuity varies to reflect changes in the value of the underlying investments. The purchaser hopes this ensures they can continue to benefit from stock market growth as they take their retirement income. There is a risk of the amount of income falling, although there is usually a guaranteed minimum income. Payment options for lifetime annuities Level, escalating and index-linked With conventional annuities, the annuitant has to opt at outset for a level annuity, or for their income to increase each year. They can opt for fixed percentage escalation or an index-linked annuity tied to an index such as RPI inflation. Escalation and index-linking provide lower initial income than a level annuity. It s difficult to predict whether this is likely to offer value for money, although official life expectancy tables available from provide a starting point. The England & Wales interim life tables for 2010 to 2012 show a 65 year old male had an average life expectancy of 18.3 years, but those who d already survived to 83 could expect to live a further 6.7 years to just under 90. A 65 year old female could expect to live 20.9 years, while an 86 year old could expect to live 6.3 more years to just over 92. techtalk 11

12 Example Alex is 65 and has 50,000 available to purchase an annuity after taking tax free cash. This could secure a level, single life annuity, with no guarantee, payable annually in advance of 2,830 a year. The initial income reduces to 1,922 a year with 3% escalation. Alex would have to wait 15 years for the escalating annuity income to outpace the level annuity; and 26 years to receive more income in total from the escalating annuity. These cross-over points will vary for different scenarios. Year Age Annual income level annuity Annual income annuity escalating at 3% Cumulative excess income from level annuity ,830 1, ,830 1,980 1, ,830 2,039 2, ,830 2,100 3, ,830 2,163 3, ,830 2,228 4, ,830 2,295 5, ,830 2,364 5, ,830 2,435 5, ,830 2,508 6, ,830 2,583 6, ,830 2,660 6, ,830 2,740 6, ,830 2,823 6, ,830 2,907 6, ,830 2,994 6, ,830 3,084 6, ,830 3,177 5, ,830 3,272 5, ,830 3,370 4, ,830 3,471 4, ,830 3,575 3, ,830 3,683 2, ,830 3,793 1, ,830 3, ,830 4, Advance or arrears A monthly in advance annuity is paid from the set up date and monthly thereafter. If an annuity is set up annually in arrears, the annuitant has to wait a year for their first payment. The underlying rate will be slightly higher for an annually in arrears basis than for monthly in advance. Annuities can usually be set up to be paid monthly, quarterly, half-yearly or annually. With and without proportion Annuities payable in arrears are set up with proportion or without proportion. The choice matters more for annual than monthly payments. If Sal has an annuity payable annually in arrears with proportion and dies 11 months into the year, almost a full year s proportionate final payment is due. If the circumstances are the same but the annuity is without proportion, there s no final payment. Death benefits from lifetime annuities Dependant s pension The annuitant has to decide whether to include a dependant s pension when they purchase an annuity. Doing so reduces their own income. It s possible to provide for a named individual or, at a higher cost, for any dependant at the time of the annuitant s death. Providers determine who s regarded as a dependant within the following legislative framework: the annuitant s spouse or civil partner the annuitant s ex-spouse or ex-civil partner, provided they were the spouse/civil partner when the annuity was taken out someone financially dependent on the annuitant someone financially interdependent with the annuitant someone dependent on the annuitant because of mental or physical impairment the annuitant s child up to age 23. The specified relationship applies as at the date of the annuitant s death. Trivial commutation lump sum death benefit If the annuitant dies from 6 April 2011 and the remaining value of a dependant s pension is a maximum of 18,000 (from 6 April 2012), the provider can buy out the dependant s rights with a trivial commutation lump sum. The recipient is taxed through PAYE. Provided the payment is at the administrator s discretion, there s no IHT liability for the annuitant s estate. Guarantee periods, with and without overlap A lifetime annuity can be set up with an optional guarantee period of up to 10 years. Both 5 and 10 year guarantee periods are common. Payments continue for the specified period if the annuitant dies sooner. The recipient is taxed through PAYE. If the provider has discretion over who receives the guarantee payments, they re paid free from IHT. If the annuitant assigns the rights to the guarantee payments via their will, the open market value at the date of their death is in their IHT estate. If an annuity is set up with a dependant s pension, a guarantee period and on a without overlap basis; and the annuitant dies before the end of the guarantee period, the dependant s pension doesn t start until its end. On a with overlap basis, the dependant s pension starts immediately even where guarantee payments are being made. 12 techtalk

13 Example Jess has a level annuity, payable annually in advance and dies after receiving the first three annual payments. Sam is the surviving dependant. Year No dependant s annuity, no guarantee No dependant s annuity, 5 year guarantee 50% dependant s annuity, no guarantee 50% dependant s annuity, 5 year guarantee, without overlap 50% dependant s annuity, 5 year guarantee, with overlap Jess Sam Jess Sam Jess Sam Jess Sam Jess Sam 1 5,531 5,516 5,058 5,054 5, ,531 5,516 5,058 5,054 5, ,531 death 5,516 death 5,058 death 5,054 death 5,050 death 4 0 5, ,529 5, ,050 2, , ,529 5, ,050 2, ,529 2,527 2,525? death death death death death Capital protection A capital (or value) protected annuity pays out a lump sum if the total of the annuity payments to the date of the annuitant s death were less than the purchase price. Some providers include capital protection for a limited period such as on death within 90 days of purchase. Provided the annuity provider has discretion over who they make payment to, it doesn t form part of the annuitant s IHT estate. As this is a lump sum death benefit paid from crystallised funds, it s taxable at 55%. both 5 and 10 year guarantee periods are common It s possible to combine capital protection with a dependant s annuity. On a first death basis, the lump sum is paid immediately on the annuitant s death, whether or not there s a surviving dependant. If there is a dependant, their income starts immediately. On a second death basis, the lump sum isn t paid until after any dependant s death and it s reduced by the amount of any payments to the dependant. Divorce Pension earmarking orders Outside of Scotland, a pension earmarking order can apply to the annuity income. The annuitant remains liable for income tax on the whole of the income. Pension sharing orders A cash equivalent transfer value (CETV) of the annuity is calculated. The ex-spouse can use their share of the CETV to continue with a dependant s annuity with the existing provider or transfer to another. The annuitant s own income will reduce to reflect the share of the CETV used to provide a pension to the ex-spouse. If their annuity was originally set up with dependant s benefits, the provider might recalculate the income on a single life basis. Example After taking tax free cash, Kim purchases a capital protected annuity at age 65 with 100,000. The income is 460 a month. Kim dies 7 years 6 months later, having received 90 payments totalling 41,400. An annuity protection lump sum death benefit of 58,600 is payable ( 100,000-41,400). After paying 55% tax, this provides a net benefit of 26,370. techtalk 13

14 Capped drawdown: the full picture Thomas Coughlan The parameters for capped drawdown rarely stand still but in 2013 underwent significant revision. In March, the 120% limit returned and towards the end of the year the rise in gilt yields to levels not seen for two years prior compounded the potential benefit. Both factors will increase the available income, provided that they are not offset by negative investment performance, enhancing drawdown s appeal. Drawdown is a complex product aimed at sophisticated investors and so technical questions will inevitably arise. We focus on a selection of the questions that commonly arise at the various stages of the life cycle of a capped drawdown contract. Testing a drawdown pension against the lifetime allowance How is the benefit crystallisation value calculated? When a pension arrangement is first put into drawdown (i.e. a designation takes place) the fund is tested against the member s lifetime allowance. The amount tested is simply the value of the pension allocated to drawdown at that date. If only a part of the fund is put into drawdown only that part is tested against the lifetime allowance. If any later additions are made to the drawdown fund they are tested against the lifetime allowance at that time. Example Leonard, 58, has an unvested personal pension worth 800,000. He designates half of the fund into drawdown when the lifetime allowance is 1.5m and the rest ( 450,000) a year later when the allowance is 1.25m. The first designation uses 26.66% of the lifetime allowance ( 400k/ 1.5m). The designation of the remaining fund uses 36% of the allowance ( 450k/ 1.25m). Leonard has used 62.66% of his lifetime allowance by taking this approach. If he had crystallised his entire fund initially, he would have used 53.33% of the allowance ( 800k/ 1.5m). 14 techtalk

15 How is a pre A-day drawdown contract tested against the lifetime allowance? It isn t. A drawdown contract that was started before 6 April 2006 is not itself subject to the lifetime allowance. If there are other pensions that are vested after A-day or the member reaches age 75 holding uncrystallised funds, then the value of the pre A-day drawdown (or other pension in payment) will need to be taken into account to determine the member s available lifetime allowance. The amount of the lifetime allowance used up by the pre A-day drawdown is 25 times the maximum income when the first pension benefit crystallisation event occurs after A-day. Example In the example of Leonard above, if he also had a pre A-day drawdown pension (maximum income 15,000) his lifetime allowance calculation would have been different. When he first designated 400,000 into drawdown, the available lifetime allowance would be reduced by the pre A-day drawdown. The drawdown in payment would have used 375,000 of the lifetime allowance (25 x 15,000) or 25% ( 375k/ 1.5m) and the first drawdown designation, 26.66% as above. This leaves 48.34% of the lifetime allowance available for the designation of the remaining funds into drawdown. Calculating and reviewing the maximum income How is the maximum income calculated? The product provider calculates the maximum income using the 2011 Government Actuaries Department s (GAD) tables. The maximum income is based on the member s age, fund value and the long term gilt yield from the 15th day of the month before the calculation date. The figure arrived at is fixed until the next review after 3 years, but certain events can trigger an earlier review, which is dealt with below. For new drawdown contracts starting on or after 26 March 2013, the maximum income is based on 120% of the GAD rate. Existing drawdown contracts automatically move to 120% of the GAD rate at the start of the first pension year on or after 26 March Drawdown is a complex product aimed at sophisticated investors Example Zoe designates her personal pension fund to drawdown in February The provider calculates her maximum income (or basis amount ) as follows: The calculation date is the date the funds are designated to drawdown, at which time the fund is worth 65,000. She is 67 at that date and the gilt yield for January is 3.25%. The provider looks up the maximum income for a 67 year old male (following anti-gender discrimination legislation, from December 2012 the male tables must be used for both males and females) using a gilt yield of 3.25% and determines that the maximum income is 64 per 1,000 of fund. For a fund of 65,000, the maximum income is, therefore: 64 x 65 x 120% = 4,992 techtalk 15

16 When is income reviewed? For pensioners under 75, the maximum income that can be withdrawn is reviewed every 3 years for drawdown plans starting on or after 6 April For plans starting before that date, the reference period is 5 years, but will switch to a 3 year reference period for reviews after 5 April In the interim certain events can also trigger a review of the maximum income. They are as follows: the member requests an earlier review, part of the fund is used to purchase an annuity, more funds are added to a drawdown arrangement, where a drawdown fund is reduced by a pension sharing order. Those in receipt of drawdown can request a review of their maximum income before the end of their current reference period, commonly referred to as an ad hoc review. The earlier review must be agreed by the product provider and the new maximum income level will apply from the start of the next pension year i.e. 1 or 2 years after the previous review in the case of a 3 year reference period. Where part of a drawdown pension is used to purchase an annuity, there will be a recalculation of the maximum income. The maximum income will be calculated at the date of annuity purchase and will apply from the start of the next pension year. There will also be a benefit crystallisation event to test against the lifetime allowance any growth in that part of the drawdown fund since it was first designated to drawdown. Where only part of a fund was originally designated to drawdown, moving further unvested funds into drawdown will trigger a review of the maximum income. There will also be a lifetime allowance test. The maximum income will be recalculated at the date of the additional designation, not at the start of the next drawdown year. The new maximum income limit will apply immediately, unless the review determines that the maximum income is lower than it was previously, in which case it will apply from the start of the next pension year. Drawdown after 75 What happens when the member reaches age 75? Where a drawdown member reaches age 75, there will unless the drawdown is a pre-commencement pension (i.e. one that commenced before A-day) be a second lifetime allowance test to account for any increase in the value of drawdown arrangement since funds were first designated into drawdown. See the article Understanding The Lifetime Allowance Charge in this edition for an example of how this works. Members aged 75 or over will also have their maximum income reviewed annually. The reviewed income will normally be calculated at the start of the first pension year after reaching age 75, however if the member and provider are in agreement the date used for the calculation can be immediately before the member s 75th birthday. Alternatively, the provider can opt to use any date falling within the 60 day period that ends on the start date of the next pension year after reaching age 75. The above only applies to the first review after reaching age 75. Subsequent recalculations will take place at the start of the next pension year, or on any date falling within the 60 day period ending on the start of the next pension year as chosen by the provider. In addition, where the member has multiple arrangements under the same scheme, upon reaching age 75 they have the opportunity to bring the review dates into line. This can only be done once and must be agreed by the scheme administrator. Members aged 75 or over have their maximum income reviewed annually Death Benefits What death benefit options are available? Lump sum death benefits paid from a drawdown fund are subject to a 55% income tax charge. The lump sum can be paid to a bypass trust or to an individual and will normally be paid at the trustee s discretion. If the member left dependants behind, they may opt to take dependent s drawdown if offered by the provider or purchase an annuity. The 120% of GAD limit When does the 120% limit apply? The 120% limit applies for pension years starting on or after 26 March Therefore, the last date that the enhanced limit can start to apply from is 25 March Summary The expectation as markets continue to recover and gilt yields improve is that the number of funds moving into drawdown will increase. The decision as to whether to opt for annuity or drawdown is a complex one and is not addressed here; but once in drawdown, many of the technical questions that will arise are. For more detailed information on the drawdown rules, particularly around the 120% limit please see our article Please sir, I want some more: the new drawdown limit. The HM Revenue & Customs guidance is also very helpful (see RPSM onwards). 16 techtalk

17 Understanding the Lifetime Allowance Charge Chris Jones As the Lifetime Allowance (LTA) reduces once again from 6 April 2014 more clients will be affected. A good understanding of how and when the charge may apply will help you advise clients whose retirement planning is becoming increasingly complex. When does the Lifetime Allowance Charge apply? The charge will only apply when the value of the benefits exceed the client s available lifetime allowance following a benefit crystallisation event (BCE). There are now 11 BCEs numbered from 1-9 and 5a and 5b. As you would expect, most of the events occur when the member takes some benefit from their pension plan i.e. when they buy an annuity, move into drawdown, start to receive a scheme pension or take tax free cash. There are also three possible events (BCE5, 5A and 5B) that can occur when a member reaches age 75 without taking all of their benefits. This will include clients who still have funds in drawdown who will face a second BCE which is covered later in the article. The payment of certain death benefits and where members transfer their benefits to an overseas pension scheme are also BCEs. The full list of events can be found here RPSM htm techtalk 17

18 When a BCE occurs the amount crystallised is expressed as a percentage of the standard lifetime allowance or higher lifetime allowance where clients have previously applied for protection. Example Pete has no pension protection and a personal pension worth 600,000. In February 2014 he took 200,000 tax free cash and moved 400,000 in drawdown. Both are BCEs and will result in using up 40% of the lifetime allowance at the time. He has 60% of the LTA remaining i.e. 900,000 based on the LTA before 6 April 2014 but would reduce to 750,000 from 6 April when the allowance reduces. This percentage is fixed so it will convert into a higher monetary amount if the LTA increases and a lower amount if the LTA reduces, as it has done in recent years. Where two or more BCEs occur on the same date it is up to the member to decide the order of the BCEs. The order will determine which benefits the LTA charge is taken from. However, when tax free cash (BCE 6) is paid in connection with a drawdown pension, scheme pension or lifetime annuity, tax free cash is always treated as occurring first. The charge The Lifetime Allowance charge broadly aims to recover the tax advantages pension contributions have received both through the tax relief on the contributions and the tax free environment the funds are permitted to grow in. The LTA charge is applied to the chargeable amount. The chargeable amount is the amount which crystallises at a BCE over and above the member s available lifetime allowance. The charge is applied at two different rates: 55% if the chargeable amount is taken as a lump sum before age 75 (known as a lifetime allowance excess lump sum); or 25% if the chargeable amount is retained within the scheme. Any subsequent pension income is then subject to income tax under PAYE. Example Katie s benefits in her money purchase scheme exceed her available LTA by 100,000. She has the choice of taking the chargeable amount as: a lifetime allowance excess lump sum of 45,000 or 75,000 could be retained in the scheme to provide her with pension income (which would then be subject to tax under PAYE). For a higher rate taxpayer, taking the income option will mean the total tax will be equivalent to the tax levied against the lump sum option of 55%. For an additional rate taxpayer the income option will be worse from an income tax point of view and for a basic rate taxpayer the income option is better. Subject to the scheme rules it is possible to take part of the excess as a lump sum and part as an income. Monitoring and reporting requirements When a member crystallises benefits under a registered pension scheme, the scheme administrator is responsible for determining whether a chargeable amount arises, so they will need to find out: details of previous BCEs for the member under other registered pension schemes (in which case they can use the statement of LTA used up issued by the scheme administrator at the time) if the member is entitled to an enhanced LTA (including primary protection), enhanced protection, fixed protection and from the next tax year, individual protection. Note that the member must inform the scheme administrator before the BCE if they are relying on any protection details of simultaneous BCEs under other schemes details of any pre A-day pensions in payment (precommencement pensions) and whether these have previously been tested against the LTA as a notional BCE. The scheme administrator must then provide the member with a statement confirming the total level of the LTA which has been used up under that scheme expressed as a percentage of the standard LTA. The statement must include details of the chargeable amount arising at the BCE(s) how the figure has been calculated the amount of the LTA charge whether the scheme administrator has accounted for the charge due, or intends to do so. The scheme administrator must also report and account for charges through the quarterly scheme reports provided to HMRC. The member needs to complete information on their selfassessment return confirming the value of the benefits taken in excess of the LTA and the tax charge paid by the pension scheme. Liability During the member s lifetime, the scheme administrator and the member are jointly and severally liable. In practice, the scheme administrator is obliged to pay the charge over to HMRC. If a chargeable amount arises on the payment of a relevant lump sum death benefit the liability rests with the recipient of the payment. A relevant lump sum death benefit is a lump sum payable from uncrystallised funds in the event of the member s death prior to age 75. The scheme administrator will pay the lump sum death benefit in full and the personal representatives of the member are responsible for determining whether a chargeable amount has arisen. If it has, they must report this to HMRC who will then assess the recipient of the lump sum death benefit. 18 techtalk

19 Note that lump sums payable from uncrystallised funds, in the event of death after age 75, are not subject to a lifetime allowance test. However, they are automatically subject to tax at the rate of 55% (called the special lump sum death benefits charge). The scheme administrator is responsible for the tax charge. Defined benefit schemes How the charge is applied to defined benefit (DB) schemes will depend on the scheme rules, so it s important the member checks their options with the scheme administrator. The DB benefits are normally valued using a factor of 20 (unless the scheme administrator has agreed a higher figure with HMRC) so the amount crystallising will be 20 x scheme pension plus tax free cash. Where this exceeds the member s available LTA the scheme needs to decide how it will meet the LTA charge on the chargeable amount. They may offer the member the option of a reduced scheme pension with the scheme meeting the LTA charge of 25% x chargeable amount. So if the chargeable amount was 100,000 the scheme could reduce the member s pension by 25,000 / 20 = 1,250. Alternatively, the scheme could allow the member to commute some of their scheme pension, which is then paid out as a lifetime allowance excess lump sum after deduction of the 55% LTA charge. The scheme can use their own commutation factors when calculating the reduction in the member s scheme pension. Subject to the scheme rules, a member of a DB scheme may be able to increase their tax free cash in order to reduce the value of their benefits for LTA purposes. However, it is important to consider the level of pension being given up, especially as many DB pensions are partially or fully protected against inflation. Example Adam is looking to retire in March He will be entitled to a scheme pension of 77,000. For lifetime allowance purposes this would be valued at 20 x 77,000 = 1,540,000; just over the LTA. Alternatively, he could take a reduced pension and some tax free cash. The rules of his scheme specify that a factor of 12:1 must be used. Adam decides to commute 7,000 of his pension for a lump sum of 84,000. This reduces the value to 1,484,000 meaning all the benefits are within the LTA. Second lifetime allowance test drawdown. When a client moves into drawdown a BCE arises. A second test against the LTA occurs when individuals use the funds to buy an annuity or reach age 75, whichever is sooner. The amounts crystallised are the annuity purchase price or value of the remaining drawdown fund, respectively. However, the amount crystallised at the second BCE is reduced by the amount originally crystallised. Example Simon, aged 65 has a fund value of 1,000,000. He takes 250,000 and uses 750,000 to provide drawdown in May 2014 when the LTA is 1,250,000. This uses 80% of the LTA 10 years on he has taken no income and the drawdown fund has grown to 1,100,000. At age 75 there is a second BCE. The crystallisation amount is the fund value less the original drawdown designation: 1,100, ,000 = 350,000. If the LTA remains at 1,250,000 this will lead to a Lifetime allowance charge on 100,000 ie 350, ,000 LTA remaining. The rules encourage drawing down growth in excess of any lifetime allowance headroom as taxable income. To avoid the LTA charge Simon could have drawn down sufficient income to prevent the fund growing above the available LTA. If the member dies before buying an annuity and before age 75, the payment of the drawdown funds on death is not a second crystallisation event and no lifetime allowance tax charge can arise. If benefits are paid out as a lump sum on death, a special tax charge of 55% applies. However, there is no upfront tax charge if the funds are used to provide taxable income to a surviving dependant. Age 75 Uncrystalised funds Where a member reaches age 75 with uncrystallised funds in a money purchase arrangement the benefits will be tested at age 75 under BCE 5B. If there is a chargeable amount it is not possible for the member to receive a lifetime allowance excess lump sum as this must be paid before age 75. The scheme administrator would pay over 25% of the chargeable amount to HMRC and the balance would be retained in the scheme. Pre A-Day pensions and drawdown Pre A-day pensions in payment aren t themselves tested against the LTA. However, when a member crystallises other benefits for the first time after A-day it is necessary for a notional BCE to be applied to the pre A-day pension or drawdown. The notional value is based on 25 x the pension in payment at the point of crystallisation. For drawdown it is 25 x the maximum income in the drawdown year in which the event occurs. Example Emma has a pre A-day drawdown pension and the current maximum GAD income is 50,000 per annum. She is considering taking benefits under her personal pension before April 2014 which is now valued at 400,000. The notional BCE for her drawdown pension is 25 x maximum GAD = 25 x 50,000 = 1,250,000 This leaves her with a remaining LTA of 250,000 for her uncrystallised rights, so there would be a chargeable amount of 150,000. If Emma instead purchased an annuity first, this may reduce the LTA charge. The LTA calculation would be based on the actual annuity income received rather than the maximum GAD. If her annuity income was 44,000 the total benefits would remain within the 1.5m LTA (ie 44,000 X ,000 = 1,500,000). techtalk 19

20 In sickness and serious ill health Jeremy Branton Members of registered pension schemes suffering from ill health have an opportunity to draw pension benefits early. This could make a significant difference to their standard of living and future financial plans. Although pensions legislation provides the ability for registered pension schemes to pay benefits in the event of a member s ill health or serious ill health, it s important to establish what options the scheme rules will allow and offer to its members. Ill health provisions Pension benefits may be accessible before age 55 on ill health grounds where a registered medical practitioner (RMP) confirms the member is unable to continue their current occupation. A stricter definition of being unable to follow any occupation may apply within the scheme rules. Benefits paid on the grounds of ill health will be paid from an uncrystallised arrangement in the usual format of 25% taxfree lump sum (unless the member is entitled to a protected amount greater than 25%) with the balance providing a taxable income. There is no reduction in the standard lifetime allowance (LTA) where benefits are drawn on ill health grounds prior to age 55. The resulting pension benefits are tested against the LTA in the usual way. Serious ill health provisions If the member s health position satisfies the definition of serious ill health, their pension fund could be commuted as a potentially tax-free lump sum. HM Revenue & Customs (HMRC) define serious ill health as life expectancy of less than one year and to qualify this must be confirmed by a RMP. Further conditions are that: The member must not have used up all of their LTA at the time the lump sum is paid, Benefits need to be paid from an uncrystallised arrangement, and Tthe lump sum benefits must fully extinguish all of the member s benefits under the arrangement. Where the benefits are within the available LTA, the lump sum can be paid tax free; otherwise the excess above the LTA will suffer a tax charge of 55%. Following the removal of the need to secure an income by age 75, it is possible for a serious ill health lump sum payment to be paid after age 75 in which case a 55% serious ill health lump sum charge would apply. For the purpose of determining whether the member has available lifetime allowance, the benefit crystallisation event at age 75 in respect of the uncrystallised pension from which the serious ill health lump sum is to be paid is ignored. Any benefits already taken post age 75 that would have been tested against the LTA had they been taken before that age are treated as if they had been tested against the LTA. It s not possible to commute crystallised funds on the basis of serious ill health although they could be commutable on the grounds of triviality. IHT position Pension income received on ill health grounds is treated in the same manner as normal pension income provided by annuity or scheme pension. Where the scheme trustee or administrator has discretion over who any guarantee payments or lump sum death benefits are paid to, those benefits fall outside the deceased s IHT estate. If the member assigns any death benefits, whether via their will or under the intestacy rules, the capital value of those benefits falls into their IHT estate. A serious ill health lump sum will fall into the member s estate and will be subject to the usual IHT rules e.g. exempt if left in the will to a spouse or civil partner. Any tax implications may be outweighed by the benefit of obtaining the lump sum during the member s lifetime. 20 techtalk

21 Planning considerations Recovery from ill health If a member recovers after an ill health pension has commenced, the scheme rules may stop an ill health pension from being paid or allow for a reduction where recovery has been partial. Where an ill health pension has stopped or reduced, the pension could recommence or increase back to its former level, or to an intermediate amount this could be when age 55 is reached or the member again satisfies the condition for an ill health pension. Comparison of ill health and serious ill health benefits Main condition RMP confirmation Benefit payable Income tax position Ill health Member is medically incapable of continuing their current occupation and as a result ceases to continue that occupation Required in writing Normal benefits available Pension income subject to income tax in the usual way Serious ill health Less than one year life expectancy Required in writing 100% lump sum Tax-free where paid before age 75, otherwise subject to 55% charge Age Payable at any age Payable at any age Fund status Benefits tested against LTA? When does a scheme administrator need to report payments to HMRC? Payable from an uncrystallised arrangement Benefits taken before age 75 tested against LTA in usual manner On-line report following end of tax year in which a payment is made to: certain types of connected individuals or if an ill health pension reduces or ceases Payable from an uncrystallised arrangement Member mustn t have used all LTA. Serious ill health lump sums in excess of LTA suffer an LTA charge. On-line report following end of tax year in which a payment is made to: certain types of connected individuals or when the member is relying on an enhanced lifetime allowance resulting pension benefits are tested against the LTA in the usual way Understanding the relationship between the provisions Accessing an ill health pension would crystallise pension benefits which could not subsequently be used to provide a serious ill health lump sum. Understanding whether an illness could progress quickly and limit an individual s life expectancy may provide an entitlement to benefits on serious ill health grounds. Changes in life expectancy and the effect on serious ill health provision It s possible that a member originally given life expectancy of less than one year, entitling them to a serious ill health payment is later re-assessed as having a greater remaining life expectancy. Unfortunately there is no provision to reverse the position where a member has received a serious ill health lump sum due to genuine, written confirmation of life expectancy by a RMP and life expectancy has subsequently increased. IHT and transferring death benefits Finally, it s worth noting that for IHT purposes, a lifetime transfer of death benefits will no longer occur under the omission to act rule where a member who could draw benefits due to ill health chooses not to. A lifetime transfer of death benefits can arise, however, where a member in ill health assigns their death benefits to a trust or transfers their pension fund from one scheme to another. For these purposes where transfers/assignments are made more than two years before death, HMRC assumes the member was in good health at that time and so there is no transfer of value. techtalk 21

22 Pensions and Succession Planning A Case study Colin Clark Any business owner should consider an appropriate exit plan or strategy. Passing on their share in the business to the next generation as tax efficiently as possible often requires careful financial planning. Let s consider Jake, 70 years old, and a director and sole shareholder in Lightning Bolt UK, a manufacturer of locks and security devices. He is married with two children and has annual income in excess of 200,000, including pensions in payment. Jake s objective is primarily succession planning. He wants to pass his company shares to his children on his death and also leave them some capital. He also wants to ensure that both he and his wife have adequate provision for the remainder of their lifespan. Any solution should be focussed on preserving wealth and be as tax efficient as possible. The company holds surplus cash. Jake wants the transfer of ownership of his shares on his death to qualify for IHT Business Property Relief. He needs to reduce the cash holding so that Lightning Bolt UK is viewed as a bona fide trading company. Due to annual allowance restrictions, the preferred option seems to be a series of pension contributions through to age 75. These attract corporation tax relief and the pension fund is held in trust outside Jake s estate. On the other hand extracting cash via additional salary and/or dividends would attract the highest rate of income tax in Jake s hands, salary attracts additional employer national insurance contributions and dividends are paid from net profits after corporation tax. Are pension contributions the best solution? A possible problem is the lifetime allowance. The value of Jake s pensions is already assumed to be greater than 1.5 million, the current standard lifetime allowance (SLA). He has no lifetime allowance protection and realises that the SLA is set to reduce further to 1.25 million on 6 April Current pension income is considered to be sufficient for Jake s needs and those of his wife. Jake s pensions at 5 April 2014 age attained 70 Pensions in payment Pre 2006 annuity, joint life nonescalating Pre 2006 drawdown Unvested pension Personal pension (PP) Annual pension income Assumed lifetime allowance value (income * 25) 24, ,000 (depends when the first benefits are taken after 2006) 30,000 (maximum GAD withdrawal) Fund value 750,000 (depends when the first benefits are taken after 2006) Lifetime allowance value % of SLA % of SLA 200, , Total 1,550, Any unvested pension funds above the available SLA on Jake s 75th birthday would attract a 25% lifetime allowance excess tax charge. In addition lump sum pension death benefits are taxed at 55% from age 75, whether vested or unvested. If additional pension contributions attract 25% tax at 75 and 55% tax later on death, the total tax taken is effectively 66.25% on any funding in excess of the available LTA. Worse, by making further contributions after April 2014, Jake is prevented from applying for Fixed Protection 2014, meaning that the whole of his existing unvested PP could count as excess above the lower SLA of 1.25 million and attract a lifetime allowance excess tax charge, instead of just part of it. So the effective tax liability on additional pension contributions becomes potentially much higher. Is additional salary the better option after all? Not necessarily. Jake could consider Individual Protection 2014 (IP2014). The notional SLA value of Jake s pensions is greater than 1.5 million, so he will get a protected SLA under IP2014 of 1.5 million. And he can continue to make pension contributions. This still means that all additional funding might end up getting taxed at 66.25%. However the actual SLA value of his pensions won t be known until the earlier of Jake reaching age 75 or taking benefits from his unvested PP. This is because Jake has not taken any benefits since A-day, 6 April Pensions in payment before this date are taken into account at 25 times the annual income for annuities and 25 times maximum GAD withdrawal for drawdown, when the first benefits are taken or tested after A-day. Let s assume Jake decides to take the maximum GAD withdrawal from his pre 2006 drawdown. When he is 74 he buys an annuity with the remaining fund. This does not itself trigger a lifetime allowance test because it was a pre A-day drawdown. Jake chooses a joint life 50% annuity with 5% escalation, giving annual income of 16,000. He continues to leave the PP unvested. Remembering lump sum death benefits from unvested funds pre 75 are free of tax, if within the available lifetime allowance. However the tax charge is 55% from age 75 whether benefits are vested or unvested. 22 techtalk

23 At age 75 the pension position now looks as follows: Jake s pensions at age 75 Type of pension in payment Pre 2006 annuity, joint life non-escalating Pre 2006 drawdown, converted to annuity at age 74 Unvested pension Personal pension (PP) Annual pension income Assumed lifetime allowance value (income * 25) 24, ,000 (depends when the first benefits are taken after 2006) 16, ,000 (depends when the first benefits are taken after 2006) Fund value 400,000 (including additional employer pension contributions) Lifetime allowance value % of SLA % of SLA 400, Total 1,400, Benefits are within the IP2014 SLA so no 25% lifetime allowance excess tax liability arises. This leaves the 55% tax on future lump sum death benefits from the PP (although the pension is exempt from IHT). By now Jake s marginal tax on income has reduced to 40% and he decides to take benefits soon after age 75, including tax free cash, and give surplus income away to his children regularly. The intention is to use the IHT exemption on regular gifts out of surplus income. Using flexible drawdown could allow the PP fund to be fully exhausted in this way before he dies. Or if circumstances have changed and Jake now wants his wife to enjoy some benefit from the fund, assuming she will survive him, he could take less income allowing her to continue in drawdown or buy her own annuity with any residual funds. Summary The adviser s strong working knowledge of the annual and lifetime allowance rules, IP2014 and drawdown, along with estate planning expertise helped Jake achieve his objective. The plan was reviewed at regular intervals to ensure that it remained suitable either side of Jake s 75th birthday. Surplus cash was withdrawn from the business as tax efficiently as possible via the pension. On Jake s death the transfer of his shares to his children could attract IHT BPR. The tax liability on the pension was kept to a minimum. Jake s wealth was preserved for his heirs and dependants. Many individuals have pre A-day drawdown plans. Basing the lifetime allowance calculation on 25 times the maximum GAD withdrawal often uses up more allowance than is implied by the value of the underlying fund. This is particularly true if the maximum has not been reviewed for some time or any secured annuity income would need to allow for spouse s provision and inflation protection. This may work against the individual when taking benefits after A-day but can be in their favour when calculating the value of IP2014. techtalk 23