Removing the Lifetime Allowance and more

The last two bars above show statutory deadlines.  Scheme administrators might typically issue retirement quotations 4 to 6 months in advance of a member’s chosen or assumed retirement date.  This means that schemes need to be in a position to issue appropriate detail to an April 2024 retiree by November 2023, which doesn’t leave much time for government to finalise its planned legislation, let alone for pension schemes to understand and implement the necessary changes.

Our viewpoint

It is key that HMRC continues to engage with the industry on an ongoing basis as its thinking develops, rather than waiting until the next release of draft material which may not be until November in the normal course of events.

LCP View overall

This will be a busy summer, to complete the job that has started with this release.  The Lifetime Allowance is so embedded into the A-day regime, that removing it (even if there is no intention for significant new policy change) is like pulling out a key brick in a Jenga tower – what is left may fall; or it may wobble and stay standing for a while with uncertain new vulnerabilities.  The speed at which this is all being done - involving some complicated law changes as well as high level policy decisions - does bring a real risk of glitches and unintended consequences.

Our timeline above includes deadlines for potential General Election dates.  The Labour Party’s immediate reaction to the Budget was that they will reverse the changes relating to the Lifetime Allowance and replace them with a “targeted scheme” for doctors.  We note that if the Government can implement these changes in the coming months, the policies will be harder to subsequently unwind.  With an election looming in 2024 this therefore creates material uncertainty for pension scheme members.

There is potential for real chaos and confusion in some situations.  For example, imagine if the General Election is called early enough to catch the Bill in progress.  Imagine a scheme that is paying out benefits on 7 April 2024 in accordance with the new regime, relying on draft legislation (as is inevitable with this sort of legislative process).  And then the election is called, purdah is entered, and the Bill is compromised or never actually becomes an Act because the new Government has a different policy to implement.

A final note of warning:  all the old rules and potential Lifetime Allowance charges will continue to apply in relation to retrospective exercises before 6 April 2023 – including GMP equalisation and some aspects of the public sector McCloud remedy.  And a retrospective change after April 2024 that has effect between April 2023 and April 2024 will still need all the Lifetime Allowance calculations carried out, even though there will be no charges arising.

At a glance 

HMRC has released draft legislation (with accompanying Explanatory Notes and a Policy Paper) for technical consultation to completely remove the Lifetime Allowance from legislation from 6 April 2024, and permanently freeze the cap on tax-free cash.  A subsequent Newsletter clarifies some HMRC intent and highlights specific areas for exploration.

This represents phase two of the changes announced by the Chancellor at the March 2023 Budget, with phase one being the significant increase to the Annual Allowance and removal of the Lifetime Allowance charge, which took effect from 6 April 2023.

Much in the drafts is as expected: they contain some simplification on pension, and key new rules for the allowed level and tax on lump sums at retirement or death.

The waters are muddied by two big surprises, which, if they were to go forward as presented, would represent unannounced changes of policy beyond anything the Chancellor suggested at the Budget.  The first is for defined benefit (DB) schemes - the possibility of paying taxed lump sums beyond the usual tax-free allowance, so effectively an extension of DC Freedom and Choice flexibilities direct to DB pensions.  HMRC has now apparently rowed back from that, but it leaves a confused position.  The second relates to DC funds - the possible removal of one tax break on death before age 75.  Both these changes would potentially affect pensions and pensions pots of all sizes.

Setting aside these two items, for many members outcomes could well be unchanged; and in some circumstances, those starting to draw large DB pensions or with large DC funds could have less income tax to pay than presently.

A key challenge will be for pensions administrators to implement the systems, processes and communications changes required to comply with the new tax rules.  This is because the drafts introduce technical changes at the detailed level even where the big picture mostly remains the same - for example on cashing out small benefits and on the range of protections.

The drafts also have important gaps.  For example, there is no indication of how benefits drawn before 6 April 2024 impact the scope for and tax position of lump sums paid after that date.  This is important for higher pensioned members making decisions now, and for overall system design.  This makes it difficult for pension scheme administrators to start to prepare for the changes at this time.  This is particularly concerning as the changes are intended to take effect from 6 April 2024, in less than 9 months’ time.  At present the timeline - see our section on this later - is ambitious.

Key actions to consider

There are some immediate steps that scheme administrators, trustees and employers should consider taking:

• Consider carefully what information to provide to pension scheme members in current benefit quotations, especially if these are for dates from 6 April 2024 (even if that is as limited as a warning that tax rules are on the move)
• Pensions administrators will need to start planning for changes, even if not all the Government intentions are yet clear. Scheme administrators might begin issuing retirement quotations in November for retirements in the new world – they will need to be as ready as possible; and even if no big policy change emerges, implementing the required changes will probably need specialist resourcing
• Consider whether the proposed changes could impact any current projects, for example a trivial commutation exercise. There may be merit in deferring some aspects of some projects until 6 April 2024 in case some areas become simpler / more tax efficient (but with some uncertainties on this, and the risk of delays as legislation work and guidance is completed/worked through).  Conversely schemes may wish to push on (or accelerate?) under the current known rules and processes

The Detail

No more Lifetime Allowance, but two new allowances – for tax-free retirement cash and for other cash

From 6 April 2024 no “limit” or “allowance” will apply to pension-style benefits (pension or DC drawdown) – pension will simply be subject to income tax.  With the Lifetime Allowance removed, two new limits will be introduced instead specifically to control tax relief on lump sums:

• The “lump sum allowance” is a cumulative limit of £268,275 on the tax-free part of lump sums at retirement (specifically the pension commencement lump sum (“PCLS”) and the 25% element of uncrystallised funds pension lump sum (“UFPLS”) from DC funds).  Within this, the formulae for how much tax free PCLS each scheme can provide (and when) continues largely as at present (broadly no more than 25% of benefit drawing per scheme up to the overall limit of £268,275)
• The “lump sum and death benefit allowance” is a cumulative limit of £1,073,100 on the total amount of tax-free lump sums payable to and in respect of a member. This covers lump sum benefits that are payable on death or on serious ill-health as well as the items in the above limit

Unlike the present, starting to draw a future pension will not eat into these allowances.

£1,073,100 is the current Lifetime Allowance; and £268,275 is 25% of that.  As per the stated policy intent, both limits are fixed with no provision for future indexation.

To the extent that payment of any lump sum death benefit or serious ill-health lump sum takes the total lump sums payable to and in respect of a member over the “lump sum and death benefit allowance”, the excess is subject to income tax at the marginal rate of the recipient(s).  As drafted, the legislation also appears to allow unlimited taxable PCLS; however, HMRC appears to have confirmed this was not the intention – see later.

Death before age 75 – rowing back on George Osborne’s give‑away?

Back in 2015, alongside the defined contribution (DC) Freedom and Choice reforms, George Osborne also brought in a tax break meaning that, broadly, if a DC saver dies before age 75 with uncrystallised funds, the funds can be paid out through the beneficiary drawdown vehicles or by purchasing an annuity for beneficiaries with no income tax applying at all.

The policy paper indicates an intention to row back on this – the proposal is that the recipients would pay income tax on payments drawn.  The only way to access these funds tax free would be by paying them out as a lump sum – so no longer with the benefit of sitting inside a pension pot with flexibility on drawing.

How do the existing protections fit in?

Some members have underpinned Lifetime Allowances because of holding a Lifetime Protection – such as one of the Individual Protections or Fixed Protections.  For these members, the level of the two new allowances will reflect their personal Lifetime Allowance.  Special provisions are included for the workings of Enhanced and Primary Protections; and some of the niche enhancements, eg for non UK residence, disappear.

Under the proposals, the window for new applications for Individual Protection 2016 and Fixed Protection 2016 will now close from 5 April 2025.

“Scheme specific lump sum rights” (historical rights to take more than 25% of scheme benefits as tax-free cash) appear to continue broadly as before.  They will not be capped by the new allowances and they eat into the allowances in a modified way.

Cash out of small benefits

The rules for cashing out small benefits broadly remain; but the draft legislation proposes that any tax-free element of these lump sums is tested against the new allowances (whereas presently they largely fall out of the Lifetime Allowance testing).

Key uncertainties and missing policy decisions

Taxed retirement lump sums for defined benefit schemes

At present, members of defined benefit schemes who have reached normal minimum pension age are routinely allowed to take a “tax free cash sum” at retirement of up to 25% of the value of their benefits being “crystallised”.  In general, lump sums in excess of this amount will count as “unauthorised payments”, and subject to special charges, and so generally do not occur.  Once a member reaches the Lifetime Allowance there is again scope for an authorised lump sum, albeit on a taxed basis.

The draft legislation as released would change this: quoting the Background Notes “there will be no limit on the size of authorised lump sums …. only a limit on the amounts not subject to income tax”.  Such tax law would put defined benefit pensions on a par with the 2015 “Freedom and Choice” reforms introduced for money purchase schemes.

However, the HMRC newsletter somewhat confusingly states that “it is not the government’s intention to significantly expand pension freedoms”.  It highlights that the drafting was designed to accommodate the removal of the lifetime allowance excess lump sum and specifically asks for feedback on “whether restrictions may be necessary to prevent any unforeseen impact”.

This does mean that, for now, we do not know HMRC’s likely approach for paying lump sums from defined benefit schemes, even for members who have benefits that are below the new allowances.  We might assume that the tax-free part will be as drafted (broadly, 25% of the benefit package being drawn) but what, if any, will be the scope for taxed cash above these limits?  Currently a member with only a DB pension of £20,000 pa might, broadly, exchange pension for a package of tax-free lump sum of £100,000 and pension of £15,000 pa.  Under the proposals this does not change – the key question is how much more could be exchanged on a taxed basis.

Benefits drawn before 6 April 2024 – how they impact the future

A missing element in the draft legislation at this stage is the policy on how benefits drawn before 6 April 2024 eat into the starting position for individuals on the new allowances applying thereafter.  The rules in this area need to be practical.  Often the information needed to identify past lump sums will not be available – scheme administrators will simply have recorded a total Lifetime Allowance usage, without splitting it between pension and tax-free lump sum.  For example: If before 2024 a member had drawn a pension (using up some of their lifetime allowance) but didn’t draw any tax-free cash alongside – will they have the full allowance to draw tax free cash in future?  Or will they have a notional 25% reduction, or some other variation?

Information Exchange

Also missing from the material is what information provisions will be required by law in the new world to enable allowances to be managed correctly?  To date, if a member has crystallised benefits, the scheme administrator is usually required to give the member an annual reminder of the Lifetime Allowance used up – that helps members to feed information into tests of subsequent crystallisations.  Going forwards, in testing against the new lump sum allowances, what information will scheme administrators be required to provide to the member and how often?  The answer to this - and to the other questions above - will feed into how schemes design systems to identify what benefits can be paid and what tax to deduct.

The biggest challenge - the timeline

There is no indication in the release of how matters will proceed from here.  The chart below shows how matters would usually proceed – allowing for the multiple strands still unknown.

The last two bars above show statutory deadlines.  Scheme administrators might typically issue retirement quotations 4 to 6 months in advance of a member’s chosen or assumed retirement date.  This means that schemes need to be in a position to issue appropriate detail to an April 2024 retiree by November 2023, which doesn’t leave much time for government to finalise its planned legislation, let alone for pension schemes to understand and implement the necessary changes.