This ‘Back to Basics’ guide lays out some of the fundamental facts needed to understand the different types of protection a member can have on their pension scheme benefits and how these are calculated.
Since the introduction of the new pension legislation on 6 April 2006 (A-Day) there have been a variety of different protections introduced designed to protect benefits that members of a pension scheme may have already had before the changes in legislation. This originally stemmed from the pre A-Day pension rules allowing for members to fund for larger tax free cash sums, potentially earlier retirement dates and larger pension funds. Since A-Day there have also been a number of changes made to the total amount a member may save in their pension schemes (Lifetime Allowance or LTA) during their lifetime. As many members would have been gearing their pension savings towards these higher amounts HMRC introduced further protections the member could apply to their benefits.
Please note that this is a basic guide and not comprehensive. More detailed information is available in other specific Knowledge Direct articles.
Primary Protection was introduced at the beginning of the new pension regime at A-Day. This protection was designed to help those individuals who had already accrued pension benefits in excess of the new lifetime allowance (£1,500,000 at A-Day) and wished to continue saving into their pension. The protection would give the client an enhancement factor based on their pension fund values at A-Day. For example, if the client had a pension fund worth £2 million at A-Day when the LTA was £1.5 million they would have been granted an enhancement factor of 0.33 to apply to the standard lifetime allowance that was applicable at the point they take benefits. The client could continue to pay into a pension scheme after they had got Primary Protection if they wished but only the level of benefits they had protected would avoid any excess LTA charges (see the final section entitled “Taxation of excess over protected LTA”). Primary protection must have been applied for by 5 April 2009. Once granted it cannot be lost or revoked by the member, although it may not apply if the members funds had fallen below the standard LTA at the point of taking benefits. HMRC would have issued a certificate to the client at the point protection was granted which stated their enhancement factor. If the client also had a right to tax free cash from their pensions which was more than £375,000 (25% of the LTA at A-Day) this could also be protected and would be recorded on the certificate as a monetary sum. This monetary sum would increase each year in line with any increases in the standard LTA.
Effects of the reduction of lifetime allowance in 2012 and 2014 to
Primary protection will continue to have the individual enhancement factor based on the £1.8 million LTA and so the new protection forms should have no effect. However, if the member does not have protection relating to their tax free cash this will mean that the maximum they will be able to take will be based on 25% of the new lower standard LTA of £1.5 million until April 2014 and then £1.25 million thereafter. If the client has some funds already in payment, the effect of recalculating the Primary Protection could have a potentially beneficial effect on the deemed crystallisation amounts used within the calculation. This is due to the complexities caused by the reduction in the LTA which can cause an effective devaluation in crystallised benefits.
Enhanced Protection was introduced at the beginning of the new pension regime at A-Day. This protection was designed to help those individuals who either had already accrued benefits in excess of the LTA, or felt that the underlying pension fund growth would be large enough to breach the LTA when benefits were taken in the future. Rather than give an enhancement factor to the member, like Primary Protection, Enhanced Protection protected the whole of the members benefits irrespective of what fund size they grew to. However, Enhanced Protection does have restrictions and rules that must be adhered to to prevent it being lost. The member would not be able to accrue any more benefits into their pension scheme after 5 April 2006. This covers both physical contributions into the pension scheme and also relevant benefit accrual under a final salary scheme. It should be noted that relevant benefit accrual under final salary schemes is only tested at the point benefits come into payment. The member can transfer benefits from one pension scheme to another but needs to be careful how this is done. Generally speaking transfers between money purchase arrangements or from final salary to money purchase schemes are fine but a transfer into a final salary scheme would be likely to lose Enhanced Protection. It is possible for a client to apply and be granted Primary Protection as well as Enhanced Protection. If this is done the Enhanced Protection will always take precedence with the Primary protection only coming into force if Enhanced is lost. It is possible for a member to elect to HMRC to remove Enhanced Protection if they feel it is no longer required. If Enhanced Protection is lost through any action the member must tell HMRC or they could be fined. If the client also had a right to tax free cash from their pensions which was more than £375,000 (25% of the LTA at A-Day) this could also be protected and would be recorded on the certificate as a percentage figure. As this is recorded as a percentage this would remain static throughout the term of the member’s pensions with no need to increase like the monetary amount recorded in Primary Protection.
Effects of the reduction of lifetime allowance in 2012 and 2014 to Primary Protection
Because Enhanced Protection protects the whole of the fund value plus any growth obtained, the reduction of the LTA will have no effect for any member with Enhanced Protection.
However, if a member has Enhanced and Primary Protection and loses or removes Enhanced Protection and has some funds already in payment, the effect of recalculating the Primary Protection could have a potentially beneficial effect on the deemed crystallisation amounts used within the calculation. This is due to the complexities caused by the reduction in the LTA which can cause an effective devaluation in crystallised benefits.
The LTA had risen over the years until it was at a level of £1.8 million for tax year 2011/12. However, It was announced that from tax year 2012/13 the LTA would reduce down to £1.5 million. Obviously as this was a drop in the LTA it meant that that many people could be caught out with their existing or potential funding plans and breach the new lower LTA. For this reason HMRC introduced a new form of protection called Fixed Protection. This would provide protection for members' pension funds up to £1.8 million as long as no further pension contributions or relevant benefit accrual took place after 5 April 2012. It should be noted that unlike Enhanced Protection, the test for relevant benefit accrual is an on-going test on the member’s benefits and not only at the point the benefits are taken (or transferred). Fixed protection is based on protecting the member’s pension fund value and, as such, tax free cash for the member will be 25% of the protected LTA. The member would have had to have applied for Fixed Protection before 5 April 2012 and would be unable to apply for this if they had already got Primary or Enhanced Protection.
Fixed Protection 2014
In a very similar fashion to 2012, HMRC announced that from 6 April 2014 the standard LTA will reduce again from £1.5 million to £1.25 million. As this was a reduction in the LTA, HMRC have again introduced protection for those members who had been funding for the higher LTA, in this case it has been called Fixed Protection 2014. In a similar way to Fixed Protection this will protect the members LTA at £1.5 million as long as no further relevant benefit accrual or contributions are made after 5 April 2014. Like fixed Protection, Fixed Protection 2014 will test for relevant benefit accrual on an on-going basis. Members have until 5 April 2014 to apply for Fixed Protection 2014. A member cannot apply for protection if they already have Primary, Enhanced or Fixed Protection.
Please note. The legislation for Individual Protection is still in a consultation stage with HMRC and the text below relates to our current understanding of the proposals and may change when the legislation is passed.
To run alongside Fixed Protection 2014 HMRC have declared that they will also introduce a different form of protection called Individual Protection. The idea behind this form of protection is to allow people to apply for protection on their current pension fund value as at 5 April 2014 at a level between £1.25 and £1.5 million. The protection will then be fixed at this monetary amount. The member will then be able to continue to fund into the pension scheme (or another if they so wish to) unlike Fixed Protection 2014. The rationale in allowing people to protect effectively part of their likely total pension fund whilst still making further contributions is based on the potential make-up of the contributions. It has been recognised that under these circumstances many employers will pay a pension contribution but not pay an enhanced salary in lieu of the contribution. HMRC are aware that to prevent someone benefitting from pension contributions is not fair. In these circumstances it would make sense for the client to continue to have contributions paid into their scheme on their behalf even if they are likely to suffer a lifetime allowance excess charge. In these circumstance the majority of the pension contribution is made up of employer funds and so it can be argued that although an excess charge of up to 55% will be levied on this excess, the member has paid in so little they are in reality still benefitting from the pension scheme at no cost to themselves.
It is possible to apply for Fixed Protection 2014 at the same time as Individual Protection. If this is the case the Fixed Protection will take precedence and be used unless it has been lost at any time, in which case Individual Protection will take over.
Taxation of excesses over protected LTA
In all cases described above, the client has protected a personal lifetime allowance that is in excess of the standard lifetime allowance. Any funds over this personal protected amount will be subject to a lifetime allowance excess charge. The amount of this charge will depend on how the excess benefits are taken. Should the excess benefits be taken as a lump sum, there will be a 55% tax charge applied to the excess. Where the excess is taken in the form of additional income payments via an annuity purchase or income drawdown, then the charge applied will be 25% of the excess.