The Government’s increased focus on enabling individuals to take their pensions flexibly has led to an ever-growing range of lump sum options intended to allow individuals to access pension benefits in a way appropriate to the level and type of benefit they have. In this article, we explore ways in which members of defined benefit (DB) and defined contribution (DC) schemes may take pension benefits as a lump sum, and some of the challenges faced by members, scheme trustees and employers in doing so.
Lump sum options
Trivial commutation lump sum (TCLS)
From 6 April 2015, a TCLS has been available to members of registered DB pension schemes whose total benefits from all registered pension schemes do not exceed £30,000 (increased from £18,000 in 2014). The Finance Act 2016 extends the scope of a TCLS so that a member’s pension which is in payment under a DC arrangement is also commutable as a TCLS.
The payment (now available from normal minimum pension age – usually age 55) must extinguish the member’s entitlement to defined benefits and/or an in-payment DC pension under the relevant scheme. Importantly, for a TCLS to be paid, either no other TCLS must have been previously paid to the individual, or else the first of any previous TCLSs must have been paid within the previous 12 months, meaning that every individual has a one-off 12 month window to take all benefits as a TCLS. Trustees wishing to offer a TCLS should check that the revised conditions are reflected in their scheme rules so that members can take advantage of this option.
Paying a TCLS requires a high level of member engagement and so is usually a member-driven exercise. This is because a member must provide information about all other pension arrangements of which they are a member for the trustees to assess whether the £30,000 threshold is exceeded. This assessment can raise a number of problems for the trustees, including trying to ensure that the member provides correct and sufficient information. Given the practical problem of relying on the member to inform the trustees correctly of the benefits he has in all pension schemes, HMRC has indicated that if trustees rely on information provided by a member that is inaccurate or false, discharge from the scheme sanction charge may be available on the basis that the trustees acted in good faith.
Small lump sum (SLS)
A SLS can be paid to a member of any registered pension scheme whose total pension rights under the relevant arrangement do not exceed £10,000 (increased from £2,000 in 2014). In common with a TCLS, this lump sum is usually available from normal minimum pension age and payment must extinguish the member’s entitlement to benefits under the scheme. As the authority to pay a SLS is contained in a different piece of legislation to that applying to a TCLS, trustees should check if these payments are permitted by their scheme rules before offering the option to members.
As no information is required from the member to determine whether he is eligible to have his scheme benefits paid as a SLS, member cooperation or involvement may not be required. However, this will depend on the powers available under the scheme rules.
The fact that member consent may not be needed may be beneficial, particularly for trustees and employers of DB schemes, as the administrative burden and costs associated with providing the member’s benefits are likely to be disproportionate to the benefits payable. However, trustees will need to determine whether it is in a member’s interest if they decide to make the payment of their own initiative, rather than at the request of the member, as changing the form of the benefit being provided could have different tax implications for the member.
Uncrystallised funds pension lump sum (UFPLS)
The UFPLS was created on 6 April 2015 and is only available, at the member’s option, in relation to DC benefits. There is no legislative minimum or maximum threshold governing payment of an UFPLS, and members may take their DC scheme benefits as an UFPLS from normal minimum pension age on multiple occasions, provided that they do so in accordance with the scheme rules and/or legislation (see below) and comply with restrictions relating to the lifetime allowance.
The terms under which UFPLSs can be paid may depend on what is permitted by the scheme’s rules, unless the ‘permissive override’ (set out in legislation) is exercised, which gives trustees the power to pay an UFPLS even if the scheme rules do not provide for such a payment.
Although the override means that schemes need not formally amend their rules to pay an UFPLS, a formal rule amendment may still be beneficial to make it clear that such authorised payments are permitted by the scheme and to reflect any restrictions that the trustees and/or employer(s) may wish to apply to these payments. Also, the amendment could include a provision discharging the trustees from having to provide any further benefits to the member in respect of the UFPLS payment.
Regulations allow a scheme amendment to permit payment of an UFPLS to be made by trustee resolution, provided that the employer consents to the scheme modification.
If the scheme employer or the trustees wish to undertake a commutation exercise to reduce the number of individuals in the scheme with small pension values, it is important to be aware of the Pensions Regulator’s guidance on Incentive Exercises. This is relevant in a wide range of situations and can apply where an employer or the trustees write to more than one scheme member to inform them of their ability to take benefits as a lump sum, if this can be viewed as a time-limited exercise.
The main drawback of having to comply with the guidance is the possible need to provide relevant members with free access to an independent financial adviser, which could be costly and negate administrative savings created by the exercise.
Even where the proposed commutation exercise does not fall strictly within its scope, trustees may wish to consider whether they should nonetheless follow the spirit of the Pensions Regulator’s guidance.
Additionally, the Incentive Exercises Monitoring Board has published a voluntary code of good practice for employers and trustees dealing with incentive exercises, which was revised in January 2016. This code applies to incentive offers made to members and so should also be considered if an incentive exercise is undertaken.
A member’s contracted-out benefits under a DB scheme may be commuted as part of a TCLS or a SLS. A member’s contracted-out rights may only be commuted before the date the GMP comes into payment (GMP age) if the GMP is revalued by fixed rate revaluation.
Prior to the abolition of contracting out, where the pension being commuted included GMP, notional fixed rate revaluation was applied up to a member’s GMP age to determine whether the amount being commuted was within the relevant commutation limit. However, the lump sum actually paid only included revaluation up to the date of commutation.
The legislation in force following the abolition of contracting out, although intended to replicate the previous legislation, has omitted some wording, which raises questions around whether the lump sum actually paid does have to include an amount representing fixed rate revaluation between the date of commutation and GMP age. The position has yet to be clarified by the Government.
Commuting pension benefits can be advantageous for scheme employers and for the relevant members, although caution should be exercised and advice sought to ensure that payments are made in accordance with relevant legislation and guidance, as well as the scheme’s rules.
In light of the growing trend to encourage individuals to access their pension benefits flexibly, the number of individuals wishing to access their benefits through an authorised lump sum is likely to increase, and employers and trustees should be prepared to deal with such requests.