Techzone

The 'pensions simplification' rules were introduced on 6 April 2006 (A-Day). Prior to this, the occupational pension rules relating to defined benefit (DB) schemes meant that some higher paid employees had built up pension benefits with a value in excess of the lifetime allowance (LTA) at A-Day.

'Enhanced protection' was one of the options available to individuals who wanted to fully protect their pensions from the lifetime allowance tax charge.

The trade-off is that to retain enhanced protection, there can be no further 'benefit accrual' after 5 April 2006. This means:

• For defined contribution (DC) schemes such as personal pensions, SIPPs or group money purchase schemes, no more contributions (by individuals or their employers) can be made
• For DB schemes, benefits can increase, but must always stay below the 'appropriate limit'

If protection is lost, clients must tell HMRC within 90 days. The transfer from DB to DC is one occasion when there will be a test against the appropriate limit, and if DB benefits exceed the appropriate limit, enhanced protection will be lost.

However, there will not be a LTA tax charge at this point. This will only happen when benefits are crystallised above the standard lifetime allowance. To prevent potentially large tax bills in the future, it is therefore important to check the limit before recommending a transfer.

Calculating the appropriate limit

The appropriate limit was designed so that no-one who gave-up DB accrual before A-Day (6 April 2006) should lose enhanced protection.

Deferred pensions that only increase by statutory revaluation, or in line with the scheme rules, don't break the limit. The limit calculation reflects this.

The limit at A-Day

Firstly, calculate the individual's DB benefits at A-Day.

• Do the calculation as if they had retired and taken their pension on 5 April 2006 - with no early retirement factor.
• Use pensionable service, and pensionable salary, prior to A-Day (as set out in the scheme rules).
• Enhanced protection could only be granted if benefits were within the pre A-Day HMRC limits. Any excess scheme rights had to be surrendered before protection could be applied for. If this had happened, the pension for the appropriate limit will be the amount after any surrender.

The A-Day appropriate limit is 20 times this pension. If the DB scheme promises a pension plus separate tax-free cash sum (for example 80th pension + 3/80th cash schemes), add the amount of separate lump sum promised.

Increasing the limit to the transfer date

The A-Day limit is then increased up to the date DB benefits are taken or transferred (the 'relevant event date') by the higher of:

• RIP: The 'relevant indexation percentage'- 5% a year compound (or RPI if higher) – which effectively reflects statutory revaluation on the deferred pension, or
• PCEL: A benefit recalculation using the 'post-commencement earnings limit' rules (see below).

Benefits subject to statutory revaluation, like GMPs, can be increased in line with the statutory revaluation if this is higher.

Using the PCEL rules

The PCEL rules allow the limit to be recalculated using the lower of:

• the client's pensionable salary at the relevant event date (calculated as set out in the scheme rules as they stood as at 5 April 2006), and
• salary calculated using the PCEL rules set out below.

This allows pay increases after A-Day to come into the limit calculation - but benefits built-up, or benefit changes made, after 5 April 2006 must still be excluded.

Under the PCEL rules, salary can generally be recalculated using the member's best consecutive 12 months' earnings in the three years ending on the relevant event date (or, if earlier, the date the member left the pensionable employment or died). But this is capped at the higher of:

• 7.5% of the standard LTA (or £1.8M if higher) in force on the relevant event date, or
• the average yearly earnings for the 3 years ending on the relevant event date (or, if earlier, the date the member left the pensionable employment or died).

Earnings cap: If the client was subject to the old 'post-89' benefits regime under the DB scheme, the 7.5% PCEL cap applies (with no alternative averaging option).

Early/late retirement or transfer: If the PCEL rules are being used on early or late retirement, any early or late retirement factor that would have applied under the DB scheme rules as they stood on 5 April 2006 must be applied to the appropriate limit calculation. The same factor must be applied on transfer before or after the DB scheme normal pension age.

The scheme should be able to do this for you but let's look at an example calculation to bring this to life.

How partial transfers can help

DB rights are only tested against the client's appropriate limit when they're transferred or come into payment. So, where a client's DB transfer value is above their appropriate limit, they can still make a partial transfer up to the limit without affecting their enhanced protection.

• Only the amount transferred is tested against the limit. If the partial transfer is within the limit, the client's enhanced protection is maintained.
• The transferred funds can grow without limit under the new DC pension, with no impact on the protection.

This gives the client access to pension flexibility with at least some, possibly most, of the value of their DB wealth.

The client's retained DB rights must still be tested against their remaining appropriate limit – but only when they come into payment or are transferred (the 'second relevant event date').

• This means enhanced protection could be lost at that point.
• So it might be prudent to ensure the DC pension is fully crystallised before the remaining DB rights are taken (or transferred) – to protect the DC rights against LTA tax.

But this could be a long time in the future. And a quirk in the legislation means the retained DB rights might be back within the limit by the time they're taken.

Partial transfers – how the limit test on the retained DB rights works

When the retained DB rights are taken (or transferred), they are tested against:

• the total appropriate limit revalued to the second relevant event date (on the RIP basis – the PCEL rules can't be used after the first relevant event);

less

• the amount of the original partial transfer (with no indexation).

So effectively a frozen amount (the original partial transfer figure) is deducted from a growing limit.

Over time, this can bring the remaining DB rights back within the limit – or allow another partial transfer later. The longer the gap between the original partial transfer and the limit test on the retained DB, the more likely it is that they'll be within the revalued limit.

Let's revisit our example of Peter: