Abolition of the Lifetime Allowance – draft Finance Bill clauses
On 18 July 2023, draft clauses for inclusion in the next Finance Bill to deal with abolishing the lifetime allowance (“LTA”) from 6 April 2024 were published for technical consultation by HM Revenue & Customs (“HMRC”) and HM Treasury (“HMT”). The proposals include changes to the Finance Act 2004 (“the FA04”) and the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”) to replace the LTA regime with a new “lump sum allowance” and an overall “lump sum and death benefit allowance”, based on the current standard tax-free lump sum limit and the standard LTA.
This follows the pensions tax changes made by the Finance (No. 2) Act 2023, the changes made by which included removing the LTA charge.
In this response
- Given the number of and significance of the changes being made as a consequence of removing the LTA, the suggested timeframe for doing so is extremely tight. In addition, draft legislation has not yet been published for all of the measures set out in the policy paper. This includes the legislation to change the tax treatment of beneficiary drawdown vehicles or annuities provided through uncrystallised funds when a member dies before age 75. Schemes will need to change their administration practices, communicate with members about the changes, and in many cases will need to carry out rule amendments (subject to any transitional provisions that may be introduced) and involve other parties such as sponsoring employers, all before 6 April 2024.
- As HMRC and HMT will appreciate, the work by pension schemes and the wider industry to implement the changes can only be carried out fully once final legislation is available. We note that other major pensions tax changes, such as the replacement of the “Inland Revenue limits” regime with the LTA and annual allowance in 2006, and the 2015 tax changes introducing defined contribution (“DC”) flexibilities, were introduced with significantly more notice to give the industry time to prepare and adapt their processes and scheme rules.
- Given the interaction with DWP policy areas, we expect HMRC and HMT will be looking to commence discussions with the DWP sooner rather than later. Some of the proposed pensions tax changes might cut across existing scheme design and the rules of some schemes may restrict the ability to make consequential amendments easily (or at all). We therefore wonder whether regulations to introduce a resolution making power under section 68 of the Pensions Act 1995 are also being considered with the DWP. Such a power has been introduced when past tax changes have resulted in knock-on effects on scheme design, including in the run-up to 6 April 2006 (“A-Day”). See further under “Interaction with scheme rules” below.
- We are grateful for the opportunity to comment on the draft legislation and we welcome further engagement with HMRC, HMT and the DWP in relation to the changes. However, in our view, the full set of final legislation, including transitional provisions, must be published at the earliest possible opportunity to make the 6 April 2024 timeframe feasible.
Complexity of the changes
- In our view, the proposed changes will introduce new complexities to the pensions tax regime. This includes requiring more information to be stored and obtained by trustees to calculate the tax treatment of benefits going forward, as well as the need as things stand to try to pin down the amount of tax-free sums taken in the past. See “Information and disclosure requirements” below.
- The changes will inevitably add a further administrative burden on trustees. The timeframe for implementing the changes is tight, as mentioned above, and comes at a time when pressure on scheme resources is particularly acute. Many schemes continue to grapple with GMP equalisation, and there are also a number of other significant developments which are imminent, such as new DB scheme funding and investment obligations, a new general code of practice, further DC disclosure requirements, pensions dashboards and the proposals put forward generally as part of the Mansion House reforms. We expect that the upfront and ongoing administrative burden associated with the proposed tax changes will increase the cost of providing benefits. This appears contrary to other policies such as the new DC value for money framework.
- One of the policy drivers behind the pensions tax changes announced at the Spring Budget in March 2023 was to encourage inactive individuals to return to work, particularly those aged over 50 and doctors employed by the NHS. The proposed changes appear to have a broad impact, and we query whether the policy objective could be achieved in a more targeted and less complex manner. Alternatively, could this be an opportunity to simplify the pensions tax regime rather than add further complexity? Streamlining pensions tax could help increase member understanding and engagement and reduce the cost of providing benefits, ultimately improving retirement outcomes for members.
Pension commencement lump sum (“PCLS”)
- We have provided our feedback on the basis of the current drafting of the clauses, although, as discussed further below, we wonder whether this entirely reflects the policy intention.
- Currently, a PCLS paid in connection with a scheme pension will be an unauthorised payment (and subject to unauthorised payment tax charges) if it exceeds, broadly, 25% of the value of the PCLS and scheme pension, or 25% of the individuals’ available LTA.
- Draft clause 24 appears to remove the limit on the maximum PCLS that can be paid as an authorised payment by deleting paragraph 1(2) of Schedule 29 to the FA04. Although the tax-free element of the lump sum is limited, the potential amount of the lump sum is not, with any “excess” simply being taxable at an individual’s marginal rate. In other words, any excess over the tax-free element, ie the “lump sum allowance”, will no longer be treated as an unauthorised payment.
- We are particularly concerned about the impact on defined benefit (“DB”) schemes and members, where a member’s scheme pension is commuted to provide the PCLS. As drafted, the proposed changes would enable a member to commute almost all of their scheme pension in a DB arrangement for a PCLS, leaving a nominal amount of pension, without being an unauthorised payment.
- HMRC’s newsletter 152, published on 20 July 2023, comments that “it is not the government’s intention to significantly expand pension freedoms” and that the changes are “designed to accommodate” the removal of the LTA excess lump sum. In our view, the proposed changes to the PCLS would be a significant expansion of pension freedoms. If this is not intended, we wonder if this policy aim might be better achieved, perhaps by restricting the circumstances in which an “excess” PCLS could be paid by reference to entitlements in scheme rules.
- We are aware that some industry bodies have raised or will be raising this point in response to this consultation. We echo that it would be helpful for HMRC to confirm at the earliest opportunity whether the policy intent is to remove the limit on PCLSs in the way set out in the draft clauses.
- We discuss some practical consequences for schemes and members below.
Interaction with scheme rules
- Although many public service pension schemes calculate a member’s lump sum entitlement by reference to a specific formula, this is not typical in private sector pension schemes. In our experience, it is common for scheme rules to give members the ability to commute some of their scheme pension for a PCLS, up to the authorised payment limits in the FA04, without the need for trustee or employer consent. In other cases, scheme rules may “hard-code” a maximum PCLS (normally in line with the tax restrictions), and/or provide that the member’s ability to commute their pension is subject to trustee or employer consent.
- If the authorised payment limit for a PCLS is removed in the way the current drafting suggests, many scheme rules would not limit the PCLS available to members. As a consequence, trustees and employers may not be able to prevent members commuting almost all of their scheme pension (save for a nominal amount, as mentioned above) for a lump sum. Although some scheme rules may be more restrictive, as things stand, the draft Finance Bill clauses could create a “scheme rules lottery”.
- If the draft legislation is introduced, we suggest the statutory power for trustees to modify scheme rules by resolution in certain circumstances is extended to include an ability to introduce or change restrictions on PCLSs. It may be appropriate to make any such changes subject to employer consent, given the potential impact on scheme funding (see “Impact on scheme funding and investment” below). To allow schemes to make such adjustments, where required, comfortably in advance of 6 April 2024, such a power needs to be put in place sooner rather than later.
- Currently, if a DB member wishes to commute more than 25% of the value of their scheme pension, they normally have to transfer their benefits to a DC scheme to take advantage of the pension freedoms. Various protections apply on making such a transfer, such as the requirement to take independent financial advice before a member is able to transfer “safeguarded” (broadly, DB) benefits worth more than £30,000 to a DC scheme. These protections are intended to recognise a DB pension as a very valuable asset offering a guaranteed income, and to address the risks of pension scams and poor or uninformed decision-making. In support of this view, the FCA and TPR have stated that they “believe it’s in most people’s best interests to keep their DB pension”.
- Removing the authorised payment limit for a PCLS without introducing safeguards and protections for members appears contrary to this clear and longstanding DWP policy intention. If the proposed changes are made, we suggest suitable protections are put in place at least equivalent to those that apply on a DB to DC transfer. We would be pleased to discuss this further with HMRC, HMT and the DWP.
Impact on scheme funding and investment
- Allowing members to take more cash from their pension will impact schemes’ liquidity requirements. It may require schemes to hold a higher portion of their assets in cash and liquid assets, reducing the potential to allocate funds to growth assets, contrary to the policy intent of the recent “Mansion House” reforms.
- There could be significant implications for scheme funding and benefit security. Some schemes will benefit from a liability reduction when pension is commuted. However, for underfunded schemes, allowing members to commute large amounts of pension could reduce the funding level of the remaining benefits. This potentially increases the strain on the PPF.
- Trustees are able to reduce transfer values in underfunded schemes in some circumstances, to help maintain the security of the benefits remaining in the scheme. However, there is no equivalent option to reduce a PCLS.
Changes to LTA excess lump sum
- As mentioned above, some pensions tax changes announced in the Spring Budget took effect from 6 April 2023 under the Finance (No. 2) Act 2023. This includes removing the LTA charge that previously applied under sections 214 to 226 of FA04 and providing for benefits above the LTA to be taxed at the individual’s marginal income tax rate under section 579A of ITEPA.
- An LTA excess lump sum currently remains an authorised lump sum payment, payable if certain conditions are satisfied under paragraph 11 of Schedule 29 to FA04, and subject to the rules of the pension scheme. In our experience, it is common for pension scheme rules to provide an option to pay benefits as an LTA excess lump sum only if the LTA charge is triggered. As the LTA charge no longer applies, such rules may no longer clearly allow for payment of an LTA excess lump sum, although flexibility in other provisions may assist in the continued payment of such lump sums. From 6 April 2024, under the proposed changes, payment of an LTA excess lump sum will not be possible, and scheme rules may not cater for an alternative. This could restrict payment of benefits.
- We expect that the proposed changes from 6 April 2024 will create other issues and inconsistencies in scheme rules, and it would be helpful for this to be addressed in transitional provisions in keeping with the transitional provisions in relation to the tax changes introduced on A-Day. We suggest that any modification power (see “Interaction with scheme rules” above) is sufficiently broad to allow a range of scheme rule design inconsistencies to be addressed.
Information and disclosure requirements
- The operation of the new “lump sum allowance” and “lump sum and death benefit allowance” will require trustees to make calculations based on information about a member’s past benefit payments, including benefits paid from other pension schemes. As explained below, based on current information and disclosure requirements, trustees may not hold the necessary information required to make these calculations. Similarly, for the reasons explained below, this information may not be available directly from members or their other schemes, and may be particularly difficult to obtain where the member has died or a scheme has wound up. We suggest new record-keeping and disclosure requirements are introduced to help overcome some of the practical issues, and to protect trustees from liability where the calculations are carried out in good faith.
- Trustees are currently required to provide members with certain information about benefit crystallisation events (“BCEs”), such as payment of a PCLS. However, these reports may not specify the amounts of any tax-free payments – for example, if BCEs are aggregated and reported annually rather than individually. Some of the lump sums which count towards the allowances, such as winding-up lump sums and trivial commutation lump sums, do not currently trigger BCEs. For such payments, the reporting requirements are more limited and members may not have been given details of the tax-free element. Where members do have records, there may not be an incentive to disclose them to trustees since doing so could reduce their tax-free entitlement.
- Pension schemes are required to keep records for tax purposes of amounts paid for at least six years from the end of the relevant year the payment was made. Details of recent payments should therefore be available to share with the member and/or trustees of another scheme, subject to data protection consideration. In contrast, information about payments made more than six years ago, and payments from schemes which have wound up, may no longer be to hand.
- The statutory requirements to keep records and disclose information will clearly need adjusting in light of the proposed tax changes, so as to help trustees obtain the information needed to carry out the calculations and to enable trustees to rely on the information they receive. This should include addressing:
stalemate situations: enabling benefits to be paid where the necessary information is unavailable. For example, in relation to the LTA charge that applied before 6 April 2023, HMRC considered that a scheme administrator could assume a member had already used up all of their LTA in the event the member failed to disclose their available LTA.
trustee protection from liability: scheme administrators (typically trustees) should not be liable for incorrectly paid tax where they have acted in good faith in relying on information provided by a member or another scheme. For example, in relation to the LTA charge, a scheme administrator can apply to HMRC to have their liability discharged if the scheme administrator reasonably believed the liability was not actually due, and as a result it would not be just and reasonable for all or part of that liability to be borne by the scheme administrator.
- To the extent possible, transitional provisions should address the position in relation to benefits paid before the changes come into force.
Drafting comment: definition of “permitted maximum” and “tax-free element”
- It seems to us that the use of the term “the individual” in the new sections of ITEPA (for example, in the various definitions of “permitted maximum” and the definition of “tax-free element” in section 637F) should be amended so that it is clear whether the reference is to a member or to a recipient of a death benefit, to clarify which allowance is being tested. As currently drafted, “the individual” is used interchangeably to refer to both. It would be clearer to use the term “member” when referring to the member of the pension scheme, and/or “recipient” when referring to the recipient of a death benefit.
Expansion of tax-free limits to include trivial commutation and small lump sums and winding-up lump sums
- Our understanding is that the tax-free elements of trivial commutation lump sums/trivial commutation lump sum death benefits and small lump sums under Part 2 of the Registered Pension Schemes (Authorised Payments) Regulations 2009 (“the 2009 Regulations”) will count towards and be limited by both the lump sum allowance and the lump sum and death benefit allowance.
- If this is the intention, we think it would be useful to clarify draft sections 637U and 637W to reflect this. In particular, draft section 637W specifies that “the previously-used amount” is calculated by reference to “relevant benefit crystallisation events” which include an individual becoming entitled to an “authorised lump sum”. It would be helpful to make clear that for these purposes, “trivial commutation lump sum” includes any small payment under Part 2 of the 2009 Regulations.
- Finally, we expect that including these small lump sums alongside winding up lump sums in the new allowances will increase the administrative burden on schemes, and also on members who may need to retain records (see above). This burden may be disproportionate to the tax impact given the small size of such benefits. In addition, such benefits are typically paid out without member consent and so members are not able to control or manage the tax impact of such payments (albeit the tax impact is relatively small given the general size of the benefits).