Should savers with large pension funds elect to protect their assets? Paul Garwood discusses.
On 6 April 2006, the Government replaced eight separate tax regimes governing UK pensions with one. As a result, the majority of savers enjoyed greater flexibility. However, a small number were disadvantaged by the new rules and, in particular, by the statutory lifetime allowance (SLA).
The SLA is the limit an individual can accumulate in a pension fund without incurring a recovery charge. If this limit is exceeded, a tax charge of 55% of the excess is payable when taken as a lump sum; a charge of 25% of the excess is payable if it is used to provide additional taxable income. The SLA currently stands at £1.65m. It will increase to £1.75m in 2009/10 and £1.8m in 2010/11.
To make sure individuals with large pension funds accrued before 6 April 2006 were not penalised by the new regime, the Government devised two methods of protecting funds from the recovery charge – primary and enhanced protection.
Primary protection is available to individuals whose total funds were valued in excess of £1.5m on 5 April 2006. The individual is given a lifetime allowance enhancement factor (LAEF) according to the extent that his/her fund exceeded £1.5m. The LAEF is then used to calculate his/her personal lifetime allowance (PLA) on retirement. Funds in excess of the PLA are liable to a recovery charge. While primary protection does not provide complete protection from the recovery charge, the individual can continue to make pension contributions without losing this cover.
Enhanced protection provides full protection and is available irrespective of the value of the investor's funds on 5 April 2006. However, if pension contributions are made, or defined benefits accrue, after 5 April 2006, the protection cover is forfeited.
Those individuals whose funds will exceed the SLA should take advice on which form of protection, if any, would be best for them. Transitional protection elections must be made before the Government's deadline of 5 April 2009.
When assessing whether a pension is likely to exceed the SLA on retirement, it is essential to note the different valuation methods.
For instance, a pension already in payment on 5 April 2006 is multiplied by a factor of 25. An unvested defined benefit pension is given a notional fund value by multiplying it by 20 and then adding any tax-free cash at face value.
Income drawdown plans established before 6 April 2006 use the same factor of 25. However, this formula is applied to the maximum income available, rather than the income being drawn, so it can produce some unwelcome anomalies against the plan's actual fund value. For money purchase funds that were unvested on 5 April 2006, the fund value itself is tested against the SLA on a 1:1 basis.
The decision whether to elect for protection – or to retain no protection at all – is far from clear cut, particularly in light of the complicated valuation factors outlined above.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.