In George Osborne's March 2014 Budget, he announced some far-reaching measures to relax the requirements on how individuals access their defined contribution (DC) pension savings when they retire and in particular the abolition of the requirement to have to purchase an annuity. These changes have become known as the "Freedom and Choice" flexibilities.
The details have gradually been emerging following the 2014 Budget and are primarily in two pieces of legislation – the Taxation of Pensions Act 2014 and the Pension Schemes Act 2015. This update focuses on the changes brought in by the Taxation of Pensions Act 2014 (the "TPA"). The changes mainly come into effect from 6 April 2015.
The new rules on accessing DC pension savings
An individual with DC pension savings will be able to "draw on this funds whenever and however they wish after the age of 55" (HM Government's Freedom and Choice Paper). DC pension savings means savings in a DC scheme but also pension savings in a cash balance scheme.
There will be no requirement for the individual to choose a particular product to access this fund and particularly no requirement to purchase an annuity. There will be four ways to access their fund:
- By purchasing a lifetime annuity
- By taking a scheme pension (if the pension scheme offers such an option)
- By choosing to enter drawdown (either a drawdown product or a short-term annuity)
- By withdrawing the fund in one or more cash lump sums
Where an individual takes an annuity, scheme pension or drawdown, the current entitlement to take a tax-free pension commencement lump sum (approximately 25% of the value of the savings) will remain in place. The rest of the amount the individual receives is subject to income tax at the applicable marginal rate at the time. Where an individual takes a cash lump sum, 25% will be payable tax free and 75% will be subject to income tax at the individual's marginal tax rate.
The TPA abolishes the existing flexible drawdown regime from 6 April 2015 – so the minimum income requirement and other conditions for flexible drawdown are being withdrawn from that date. Capped drawdown will also be relaxed for future payments – so the annual withdrawal limit applying to capped drawdown will be abolished to new drawdown funds.
The definition of "income withdrawal" will be expanded to include the new concept of "flexi-access drawdown" fund ("FAD"). Existing drawdown funds will automatically become FADs on 6 April 2015.
The TPA creates a new kind of "authorised lump sum" – the "uncrystallised funds pension lump sum" (UFPLS) which will be paid where the individual withdraws cash from his DC pension fund. There is no limit on the amount that can be paid as an uncrystallised funds pension lump sum but it will be subject to the lifetime allowance (currently £1.25m). Certain members with either enhanced or primary protection - which protects members against lifetime allowance charges - will not be able to take an uncrystallised funds pension lump sum.
If an individual who has flexibly accessed their pension rights makes further pension contributions in any tax year after 6 April 2015, they will be subject to a new annual allowance charge on DC savings over £10,000 and the annual allowance for the DB element of the individual's pension savings will be reduced to £30,000 (although they can also utilise any unused annual allowance carried forward from the previous three tax years).
Relaxing restrictions on annuities
The new rules will:
- Allow annuities either lifetime or short-term to decrease year on year
- Allow lump sums to be taken from annuities provided this was in the contract when it was taken out
- Remove the current 10 year maximum guarantee for lifetime annuities thereby allowing longer periods
- Remove the requirement for an "open market option" for purchasing annuities
These changes are aimed at encouraging life insurers to innovate in the retirement savings products that they offer.
Changes to requirements on death
The taxation of death benefits from DC pension savings is also changing. Currently, if a member dies before reaching age 75, without having taken their pension/leaving uncrystallised funds, any lump sum death benefit is not subject to tax provided it is paid within 2 years of the death. If the member dies after age 75, a lump sum death benefit payable from uncrystallised funds is liable to a special lump sum death benefit charge set at 55% of the value of the fund. Death benefits payable as a pension, for example, a survivor's pension or annuity are subject to income tax in the survivor's hands. They may only be paid to an individual who qualifies as a "dependant" as defined in the tax legislation, for example, a spouse or person financially dependent on the member.
The TPA makes some significant changes to the current position. Firstly, it allows the ability to pass on DC savings after death to nominees and successors in a tax efficient way which in theory could extend down the generations.
A "nominee" of a member means an individual nominated by the member (or nominated by the Scheme's administrator in the absence of any dependant or member nomination). A "successor" of a member means an individual nominated by a dependant, nominee or successor of the member (in relation to their death) or nominated by the Scheme's administrator where the beneficiary has not made a nomination. A successor can nominate a further successor thereby potentially allowing transfers down the generations.
Secondly, the following death benefits can now be paid from 6 April 2015:
- Lump-sum death benefits – paid from crystallised or uncrystallised funds
- Beneficiaries' drawdown (new FAD) – a member's surviving beneficiary (who no longer has to be a dependant of the member) – a successor or nominee - will be able to inherit the member's unused drawdown funds or uncrystallised funds through a new "beneficiaries' FAD" account
- Beneficiaries' Annuity – a member's surviving beneficiary (who no longer has to be a dependant of the member) can receive further payments under a joint life or guaranteed period annuity
Where a member dies before age 75, all lump sums from DC schemes (both from crystallised and uncrystallised funds), payments from a Beneficiaries' FAD and Beneficiaries' Annuity will be payable free of income tax. However, the Lifetime Allowance Charge may still apply in certain circumstances.
Where the member dies after age 75, all lump sums attract for the 2015/16 tax year the special lump sum death benefits charge of 45%. From the 2016/17 tax year the Government plans to make the lump sum subject to the member's marginal income tax rate. Where the member dies after age 75, from the 2015/16 tax year, payments from a Beneficiaries' FADs and Beneficiaries' Annuity will be subject to income tax at the beneficiary's marginal rate.
The changes apply to payments made on or after 6 April 2015, rather than deaths that happen on or after that date.
Permissive Scheme override
A statutory override is also introduced for schemes to use where their rules stop individuals from taking advantage of the new flexibilities. This allows the trustees or managers of schemes to ignore the particular rules and pay benefits in line with the new tax framework without having to amend their rules. The measures that the override applies to includes payment of a drawdown pension, an uncrystallised funds pension lump sum, a sum paid to purchase a short term annuity and a flexi-access drawdown lump sum death benefit.
Revised limits for the amount individuals could commute on grounds of triviality came into effect on 27 March 2014. The maximum trivial commutation amount was increased to £30,000 across all the individual's pension savings and the maximum small lump commutation was increased to £10,000.
However, under the TPA, from 6 April 2015, a trivial commutation lump sum will no longer be possible from a DC scheme and so it will only be payable from a DB scheme. Members of DC schemes will be able to take an uncrystallised funds pension lump sum instead. DC schemes can still pay small lump sums under £10,000. Also a trivial commutation lump sum from a DB scheme and a small lump sum from both DB and DC schemes will be payable from normal minimum pension age (55) rather than age 60 as previously.
New requirements will ensure that registered pension schemes must report to HMRC when a member flexibly accesses their DC pension savings for the first time. This is to ensure HMRC is provided with sufficient information to ensure the correct tax is paid.
In addition, the scheme administrator of a registered pension scheme must provide a statement to a member, within 31 days of the member first flexibly accessing their DC pension savings, confirming how they have done so and explaining that the annual allowance charge will be reduced to £10,000 in any future tax year. The administrator must also tell the member that they must, within 91 days, pass on the fact that they have flexibly accessed their DC pension saving and the date to the scheme administrator of every other registered pension scheme to which they are accruing further benefits.
The TPA contains provisions to maintain the comparability between the tax treatment of pension savings under a registered pension scheme and pension savings in a qualifying recognised overseas pension scheme (QROPS).
Clyde & Co Comment
The Freedom and Choice flexibilities are radical and mark a big departure from the current position. The details set out in the TPA have been developed in a short space of time which has left the industry and in particular the life insurers and other pension providers with little time to implement the new requirements and design new systems and products. The changes also demand a rethink to saving strategies for retirement as lifestyle funds in particular lose some of their appeal. We can expect to see pensions providers launching new products in the months to come, but as with any major change on this scale, it seems almost inevitable that there will be teething problems that will need ironing out in the coming weeks/months and perhaps years.