Coming to grips with the lifetime allowance

If your pension pot breaches the £1m mark, you could face a punitive tax bill when you retire. So how can you protect your funds?

Originally published in The Sunday Times, written by Marianne Curphey

With a significant proportion of the UK population facing a shortfall in retirement income, the government has used tax breaks to encourage long-term pension saving. But those who save too much could face a potential tax charge of up to 55% if the value of their fund exceeds an upper limit known as the lifetime allowance (LTA).

Under the current rules, a pension saver is allowed to make an annual contribution of 100% of their income, capped at £40,000. Those who have regularly made large contributions to their pensions over the years could fall foul of the LTA should they have accumulated more than £1m in their pension pot. Any funds above the threshold would be subject to 55% tax if withdrawn as a lump sum, or 25% if taken as income.

The LTA was introduced in 2006, when it was set at £1.5m. It peaked at £1.8m in 2010, but thereafter it was either frozen or reduced until 2017, after which it started rising again, in line with inflation. In this year’s spring budget, the government said that the current cap (£1,073,100) would be frozen for five years. But there have been discussions about reducing it again. One leaked proposal is to slash it to about £800,000. This would draw many more pension savers into the LTA net.

Broadly, there are two types of pension scheme. A final-salary or defined-benefit (DB) pension – common in the public sector – pays you a proportion of your former salary when you retire. A money-purchase or defined-contribution (DC) pension is found more often in the private sector. In this case, contributions from you and your employer are invested on your behalf. The value of those investments is the pot of money that you can then use to generate an income through retirement. A pension fund of £1m may sound like a lot, but, if you have a private pension, that will buy you an annual income of only just over the annual average salary in the UK, notes Romi Savova, CEO of PensionBee.

“Using certain estimates, a £1m pension pot would generate an income of roughly £35,000 a year, which is not an excessive amount for many retirees who find themselves free from work and looking forward to enjoying their retirement,” she says. One of the anomalies in the LTA rules is that the cap hits people who have a private-sector pension or personal pension harder than those who have a public-sector pension. Nevertheless, the LTA has been blamed for the decision of some senior doctors – members of the NHS pension scheme – to retire early.

Take the amount of pension income that you would expect from a DB scheme and multiply that by 20 to give you a notional pot value, according to Pete Glancy, head of policy, pensions and investments at Lloyds Banking Group. It’s a lot simpler for DC schemes, he says, where you simply look at the actual value of the pot.

“Of course, many people will have worked in both the private sector and the public sector during their working lives,” Glancy notes, adding that it’s actually very difficult for people to determine whether they’ll have to deal with the LTA.

“You would need to contact the administrator of each pension scheme for each employer with which you worked in the past, ask them to provide an illustrated value of the benefits and then apply some complex maths,” Glancy says. “This will include assumptions about investment growth and inflation.”

It’s best to work with a professional financial adviser who can do all of this for you. Financial advice comes at a cost, of course, but you could potentially avoid tax penalties running to tens or even hundreds of thousands of pounds.

The LTA applies to the value of all your pensions, except for the state pension. Only the funds that exceed the LTA are subject to the charge, not the whole fund. The LTA charge is applicable when certain conditions are met. First, if you die before the age of 75 and your funds have not been accessed at all. Second, if you reach 75 and you haven’t accessed your funds or they’re in pension drawdown.
Third, if you decide to take pension benefits, either in the form of a tax-free lump sum, a regular sum, or pensions drawdown. Or lastly, if you transfer your pension funds overseas.

According to HMRC statistics obtained by pensions consultancy LCP, more than 325,000 people have registered for protection against the LTA since 2006 (see “How can I protect myself?”, opposite page). But only about 4,000 have done so this year. As a result, some who can benefit could face unnecessary tax bills, LCP warns.

Matthew Arends, head of UK retirement policy at Aon, says that reducing the LTA would potentially make a new swathe of pension savers liable to a tax charge. This is particularly the case for private-sector employees saving into DC pensions.

“As the assessment of the LTA is more generous to DB pensions than it is to DC pensions, this creates a disparity between the public and private sectors,” Arends says. “The most likely mitigation action for those with DB pensions would be to consider retiring early, if a reduction would be applied to the pension to reflect the early payment. There are no mitigation actions
for DC pensions.”

Again, this is a complex area in which you should seek financial advice.

“Mitigating the size of the tax penalty could involve changes in the amount you save into a pension versus other savings products, such as ISAs,” Glancy observes.

“Alternatively, it could involve changes to the way in which your money is invested. Or it could involve changes to the timing and phasing of your retirement. These are complex considerations and unique to each individual’s circumstances.”

Savova says: “People who find themselves on or near the threshold should consider whether it makes sense to divert some of their savings to another tax-effective vehicle, such as an ISA, to void penalties of up to 55% for breaching this limit and making withdrawals.”

Claire van Rees is a partner at Sackers, a specialist law firm for pension providers, trustees, employers and corporate investors. She believes that taking drastic action to avoid exceeding the LTA may not be the right option.

“Stopping your pension contributions if you’re close to the LTA won’t necessarily be the best financial decision,” van Rees says, explaining that this could mean that you’d lose out on employer contributions to a DC pension arrangement, while those in DB schemes could be better off building up pension benefits and paying the LTA tax charges. But, again, everyone’s personal financial circumstances are different, so it’s important to seek expert guidance if you’re considering this course of action.

DB pensions are tested against the LTA by multiplying them by 20, so someone could have a DB pension of about £50,000 without exceeding the current LTA, she says. But it would cost someone with a DC pension a lot more than £1,073,100 to buy a guaranteed income of £50,000 from an insurance company, as annuity rates have fallen a lot over recent years.

The last word should go to Baroness Altmann, who was minister of state for pensions when the LTA was at its lowest level. Now an expert commentator for the industry network Pension Playpen, she says: “It is very difficult to protect against the LTA because one cannot predict investment performance. In a DB scheme, this might mean retiring early to ensure the calculation basis is fixed now. But then that prevents all ongoing pension accrual and has done damage to the NHS too. In the end, if there is a generous employer contribution and higher-rate tax relief, it may
still be worth incurring an LTA charge.”