HM Treasury has published draft legislation which will update the tax rules relating to how individuals can access money purchase pension savings. The new rules –which are complex – will:
- introduce new benefit payment options for DC savers, which will be available from 6 April 2015
- introduce new annual allowance rules where individuals access money purchase benefits in certain ways
- provide for a permissive override to allow (but not compel) trustees to offer the new payment options even if not permitted by their scheme rules, and
- restrict the payment of trivial commutation lump sums to defined benefit arrangements only.
Trustees, pension providers and employers need to understand these changes and consider whether to update their scheme’s design to enable their members to make use of the new benefit payment options.
The legislation is subject to change as it goes through Parliament. However, we do not expect the new benefit payment options summarised below to change substantially.
Benefit payment options
Under the proposed new rules individuals with pension savings in a ‘money purchase arrangement’ (as defined in the pensions tax legislation) will be permitted, provided their scheme allows, to:
- Take their savings as an ‘uncrystallised funds pension lump sum’ (UFPLS) – This allows a member to take their pension savings as cash in one go or in instalments. The first 25% of each payment will be tax free with the remainder being taxed at the individual’s marginal tax rate.
- Purchase a lifetime annuity and take tax free cash – Individuals will continue to be able to use some or all of their pension savings to purchase a lifetime annuity if they want to. However, the Government is planning to relax the rules around annuities so that, amongst other things, annuities will be permitted to go down as well as up. This is intended to facilitate innovation in the annuity market and to enable annuities to better reflect the income requirements of individuals in retirement. Where an individual accesses their savings in this way, they will be able to take 25% of the amount accessed as tax free cash where they use the remainder to purchase an annuity.
- Transfer funds into flexible drawdown account and take tax free cash – Individuals will be able to transfer some or all of their savings into a drawdown facility (referred to in the legislation as ‘flexi-access drawdown’ (FAD)) under which they will be able to keep their funds invested and draw them down as and when they want to. They could also use some of the funds in a drawdown facility to purchase a short-term annuity payable for a period of no more than 5 years. Where an individual accesses their savings in this way, they will be able to take 25% of the amount accessed as tax free cash where they transfer the remainder into a flexi-access drawdown facility.
- Receive a scheme pension and take tax free cash – Individuals will continue to be able to convert their money purchase savings into a pension from their scheme. Where an individual accesses their savings in this way, they will be able to take 25% of the amount accessed as tax free cash where they convert the remainder into a scheme pension.
- Turn a small pot into cash – As at present, where an individual has less than £10,000 worth of savings in a money purchase arrangement they will be able to take this as a single cash lump sum (subject to them only being able to exercise this right on up to 3 occasions under personal pension arrangements).
- Select a combination of the above – Individuals will be able to pick and choose between the options outlined above. So an individual could, for example, use some of their savings to buy an annuity, take a tax free lump sum, transfer some into a drawdown facility and leave the rest as ‘uncrystallised funds’ within their DC scheme until they decide what to do with them.
If an individual wants to select one of the options outlined above and their scheme does not offer it they will have the right to transfer their savings into an arrangement that does.
The draft legislation contains a permissive override which will enable trustees to choose whether or not to do any of the following (even if their scheme rules do not allow it):
- provide a drawdown pension to members and dependants
- purchase a short term annuity for members and dependants
- pay an uncrystallised funds pension lump sum.
The statutory override is not currently subject to employer consent. However, this may change before the legislation is finalised given that, in most cases, the employer(s) will bear some or all of the cost associated with providing any additional facilities, such as flexible drawdown, under a scheme.
Subject to their fiduciary duties and compliance with discrimination laws, trustees will be able to offer different benefit payment options to different members if they wish.
From 6 April 2015, trivial commutation lump sums, which are payable where an individual has less than £30,000 worth of pension savings under all of their registered pension schemes, will no longer be capable of being paid from a money purchase arrangement. The rationale for this is that individuals will be able to take all of their savings under a money purchase arrangement as cash using one of the options outlined above.
However, by taking away the ability for money purchase arrangements to pay trivial commutation lump sums, the legislation will restrict the scope for hybrid schemes to make such payments (including defined benefit schemes with a money purchase additional voluntary contributions (AVCs) facility). This is because a trivial commutation lump sum can only be paid where it extinguishes all of the individual’s rights under the relevant scheme and, if a member has any money purchase rights under the scheme these will not be capable of being extinguished as they will no longer be capable of being included in a trivial commutation lump sum.
Reduced annual allowance
In order to prevent individuals from abusing the new flexibilities to avoid tax on their earnings or to gain a windfall by recycling their pension savings, new annual allowance rules will apply to individuals where, on or after 6 April 2015, they:
- drawdown funds from a flexi-access drawdown facility or use them to purchase a short-term annuity
- receive an uncrystallised funds pension lump sum
- take more than the permitted maximum from a capped drawdown fund established before 6 April 2015, or
- receive a ‘stand-alone lump sum’ (which can only be paid in limited circumstances) when they are not entitled to enhanced protection.
Individuals who have made use of flexible drawdown prior to 6 April 2015 will also be subject to the new annual allowance rules from 6 April 2015. Where the new annual allowance rules apply to an individual they will have a £10,000 annual allowance for future money purchase savings. If an individual exceeds the £10,000 money purchase annual allowance in any tax year:
- they will be subject to the annual allowance charge on the excess over £10,000, and
- the annual allowance for the remainder of their pension savings will be reduced to £30,000 plus any unused annual allowance that they are entitled to carry forward from the three previous tax years.
If the individual does not exceed the £10,000 money purchase annual allowance in any tax year their total annual allowance, including for money purchase and defined benefit arrangements, will continue to be £40,000 plus any unused annual allowance carried forward from the three previous tax years.
Individuals will not be able to carry forward any unused money purchase annual allowance.
Trustees and pension providers that operate schemes which provide any kind of money purchase benefits (including money purchase AVCs) need to ensure that they understand the new tax rules and, in particular, the new benefit payment options that will be available to DC savers from 6 April 2015. They also need to decide which of the new payment options they will provide under their scheme from that date. Trustees ought to discuss this with their scheme’s employers.
Member communications will need to be updated so that individuals are aware of their new options, even if their particular scheme does not offer them all, so that they can make informed decisions about how to access their retirement savings and, if necessary, whether to transfer to an arrangement that offers greater flexibility. Trustees and providers will also be required to signpost DC members to the new guidance guarantee service, which will be available from 6 April 2015 to help them understand the options available to them.
Finally, the new tax flexibilities only apply to ‘money purchase arrangements’ as defined under the pensions tax legislation. This definition is different to the new statutory definition of money purchase benefits that has recently been introduced under general pensions legislation which many schemes are currently grappling with (read more). Therefore, trustees need to take care to ensure that any benefits to which they think the new flexibilities apply are, in fact, money purchase benefits for pensions tax purposes.
It is difficult to imagine many more complex ways of introducing the new flexibility for DC pension savings and a lot of work needs to be done between now and April next year to ensure that schemes are ready for their introduction. Still, on the upside, at least we have a couple of snappy new pensions acronyms to add to the lexicon – in the shape of FADs and UFPLS.