I must be a masochist. Not content with the torture of bringing clarity to the labyrinthine annual allowance, I’ve now undertaken similar self-harm by tackling the lifetime allowance for pensions.
I’ve given it my best shot in the post that follows. If I failed then please feel free to use it as a sleeping aid.
What is the lifetime allowance and why does it exist?
The lifetime allowance is the total value of money you can build up in a pension before you’re hit with a lifetime allowance charge.
The lifetime allowance as of 2019/2020 is £1,055,000.
The lifetime allowance charge
Any amount above the lifetime allowance is called the excess. When that excess is taken back out of your pension, then a charge of:
- 55% is levied if it is taken as a lump sum.
- 25% is levied if it is taken as an income.
A quick recap.
When you put money into a pension the government provides tax relief.
For example, if you earn £80,000 a year then you are a 40% tax rate payer. If you put £600 into your pension out of taxed income, the government will also put £200 into your pension and you can claim £200 relief from HMRC. This gives you a total of £400 tax relief.
The underlying principle behind this pension tax relief system is that you defer taxes. You get back the tax you paid today in your pension, but you will later pay tax when you take the money out.1
It’s this principle which motivates the lifetime allowance.
In effect, the Government has decided it isn’t in the business of giving rich people unlimited tax deferral benefits. It therefore created the lifetime allowance, which limits the total amount of tax deferral the Government is willing to give you.
That sounds reasonable, but unfortunately – as with the annual allowance – the words ‘piss up’ and ‘brewery’ are never far away.
More on that later.
History of the lifetime allowance
The lifetime allowance came into existence on 6 April 2006 – a date known to those in the pensions industry as A Day.
A Day is the pension expert’s equivalent to the birth of Christ.
On A Day a huge raft of disparate measures and rules were scrapped with new ‘simplified’ rules coming into force.
More than eight different regimes were boiled down into two: the lifetime allowance and the annual allowance.
The lifetime allowance was initially set at £1.5 million. It crept up to £1.8m in 2010/11 before being drastically cut back down. But it’s not all bad news – from the 2018/19 tax year the lifetime allowance has increased in line with the CPI measure of inflation.
Just to complicate matters, each time the lifetime allowance was cut, the government provided protection mechanisms: in 2006, 2012, 2014, and 2016.
These ensured that some of the excess above the lifetime allowance in a person’s pension was protected from the tax charge.
When is the lifetime allowance assessed?
The most important thing to remember about the lifetime allowance is that it is not assessed just because you have a pension pot above £1,055,000.
Rather, the lifetime allowance is assessed at specific points when you interact with your pension.
These are called benefit crystallisation events (which I’m going to call BCEs for short, even though my editor The Investor hates acronyms!)
There are 12 BCEs in total. I’m going to focus on the six main ones (and also the pre-A Day interaction).
The benefit crystallisation events (BCEs)
Let’s run through what these mean:
BCE1 – When defined contribution benefits become available to pay a drawdown pension. The value is calculated as the market value of the assets made available for drawdown.
BCE2 – When you become entitled to a defined benefit pension. The value is tested as broadly 20 times the annual pension.
BCE4 – When you convert a defined contribution pot into a lifetime annuity. The value is calculated at the cost of purchasing the annuity.
BCE5a – When, for a pot in drawdown, the member reaches 75. This is calculated as the value of the drawdown less any amounts previously crystallised under BCE1.
BCE6 – When you receive a lump sum before age 75 (i.e. the tax-free lump sum). This is calculated as the value of the lump sum.
BCE8 – When you transfer out to an overseas pension scheme (called a QROPS). This is calculated as the amount transferred, less any amounts crystallised under BCE1.2
Pre-A Day test – The pots are measured at 25 times pension or max capped drawdown. This is to account for tax-free cash taken. Pre-A Day pots are measured when the 1st post-A Day BCE occurs (such as, reaching 75 (BCE 5a) with a drawdown pot post-A Day).
A word on defined benefit vs defined contribution treatment
What is perhaps noticeable is the disconnect between how defined benefit and defined contribution pots are measured.
Broadly, defined benefit pots (BCE2) are valued at 20 x annual pension whilst defined contribution pots are valued at the annuity purchase price (BCE4) or the drawdown market value (BCE1).
A £100,000 defined contribution pot could buy a £2,801 joint-life 50%, 3% escalation annuity at age 65.3
This would be valued at £100,000 under BCE4.
However if such an income was provided through a defined benefit pension it would be valued at only £56,020 under BCE2.4
With annuity rates at all-time lows, it is possible that were somebody to transfer from a defined benefit to a defined contribution scheme, they could end up the wrong side of the lifetime allowance and incur a tax charge that they may have avoided if they’d stayed in their defined benefit scheme.
How the charge is assessed
The charge is assessed by adding up all your pensions and ‘filling up’ the lifetime allowance like a bucket. You only get hit with a charge if the bucket starts overflowing.
Another thing to note is that drawdown pensions (except pre-A Day pots) are tested against the lifetime allowance twice.
The first test is BCE1 when the funds are first designated. The pension is then tested again on either:
- annuity purchase (BCE 4), or
- reaching age 75 (BCE 5A), or
- on transfer to a QROPS (BCE 8)
To ensure there no double counting, only the increase in funds crystallised under BCE 1 are tested at the second designation.5
How the charge is applied
As I mentioned above there are two tax-rates: 55% and 25%.
These are commonly called the ‘lump-sum’ and ‘income’ rates.
It may be easier though to think about these instead as whether the money ‘leaves’ or ‘stays’ inside the pension tax regime.
For example, if you take a tax-free lump-sum on drawdown, it ‘leaves’ the tax regime – because you won’t be subject to any further income tax on it. In this case, any excess above the lifetime allowance that you take as a lump sum is charged at 55%.
If you instead take an annuity income, then you take a 25% tax charge on the excess income above the lifetime allowance plus any income tax due.6
Aha! You might now be cunningly thinking that 25% is lower than 55%, and so taking income is always better?
In reality it all depends on what income tax rate you’ll be at, as an example shows.
You take a £100 lump sum over the lifetime allowance:
£100 x (100% – 55%) = £45 after tax
Take £100 income over the lifetime allowance:
45% tax-rate: £100 x (100% – 25%) x (100% – 45%) = £41.25 after tax
40% tax-rate: £100 x (100% – 25%) x (100% – 40%) = £45 after tax
20% tax-rate: £100 x (100% – 25%) x (100% – 20%) = £60 after tax
As those being hit by the lifetime allowance are likely to be high earners (40% or even 45% tax rate), there’s probably little difference in overall tax rate between lump sum and income.
In terms of how the charge is actually paid, usually, the pension scheme will pay it if they offer the facility. This is called ‘scheme pays’. Schemes are joint and severally liable for the tax, so they like to make sure the tax is paid to avoid having HMRC on their back.
However, pensions schemes do not have to offer scheme pays in all circumstances. It is best to check in advance.
Always use protection?
As I mentioned earlier, HRMC provided protections against the reductions in the lifetime allowance. These protections each work a little differently.
What protection is right for you – or whether you should employ protection at all – will depend on your circumstances.
I’ll only cover the two protections now available to savers: fixed protection 2016 and individual protection 2016.7
Fixed protection 2016 and individual protection 2016 were introduced on 6 April 2016 when the lifetime allowance was cut to £1 million.
Those intending to apply for fixed protection 2016 had to ensure that active membership of pension schemes ceased from 6 April 2016.
There is no deadline for applying for fixed or individual protection 2016.
Fixed protection 2016
Under fixed protection 2016 your lifetime allowance is fixed at £1.25 million. You can’t already have an earlier fixed or A-day protection. Once you opt for fixed protection, you can’t make any further contributions to a pension.8
Individual protection 2016
You can opt for individual protection 2016 if your pension pot was worth more than £1m on 5 April 2016. It fixes the lifetime allowance at the lower of £1.25 million or the value of the benefits on 5 April 2016.
Unlike fixed protection, you can keep saving into a pension or accruing.
Valuing the pension depends on its type:
1. Uncrystallised benefits (i.e. not yet paying):
a. Defined contribution – at the market value of funds
b. Defined benefit – at 20 x pension plus any cash by addition
c. Cash Balance – amount available for provision
2. Crystallised benefits (i.e. already in payment):
a. Pre-A Day pensions – 25 x pension / Max GAD (Government Actuary’s Department rate) for capped drawdown at the first post-A Day BCE9
b. Flexi-drawdown – 25 x Max GAD when flexi-drawdown entered10
c. Post-A Day vestings – Value at BCE
Unfortunately, it’s possible to lose protections after you’ve successfully applied for them. In some cases this can be completely unintentional.
The good news is that individual protections (and primary protection) are almost impossible to lose. The only situation where an individual can lose the protection is if they divorced and their pension shared (this is where a pension is split between spouses to allow for a clean break). This reduces the level of protection on the pension. Under individual protection 2016 there is an offset mechanism, which reduces the level of lost protection.
The bad news is that the rules are much more strict for fixed protection11. An individual loses fixed protection if they:
- increased their benefits in defined benefit scheme above a certain level;
- contributed to a defined contribution scheme;
- started a new arrangement under a registered pension scheme other than to accept a transfer of existing pension rights; or
- transferred to an unregistered pension scheme (i.e. not a QROPS), from a defined contribution to defined benefit scheme (depending on circumstances) or from one defined benefit scheme to another (again depending on circumstances)
Unlike with individual protection, an individual doesn’t lose fixed protection if they are subject to a pension debit (divorce). However, they will not be able to rebuild any pension fund without revoking their fixed protection.
Flaws with the lifetime allowance
Still awake? Amazing!
It’s time we stopped explaining the lifetime allowance and started complaining about it.
First of all, what was intended to hit only the very wealthiest earners has already started to swallow up hundreds of thousands of savers. This can be seen in the data – HMRC’s take from the lifetime allowance has increased by over 1,000% in 12 years.
Likewise, annuity rates have plunged since A-day meaning that a defined contribution pot buys a significantly lower guaranteed income for life.
At the same time the lifetime allowance has drastically reduced. At the time of writing, £1m would buy only a c. £28,000 3% rising, 50% joint-life annuity12. That is less than the median household income of c.£29,000.
A third problem is that planning for the lifetime allowance is incredibly difficult. It is a moving target. It is also hard to know whether it will still be around – or in what form – in 10-30 years’ time.
Another issue is that the combination of the lifetime allowance and annual allowance could result in not only the clawback of tax relief, but also see further tax paid on pension pots. The combination of the two also results in strong incentives to be wary of saving into a pension when you’re at peak earning capacity. (i.e. when the sun is shining, ahead of a future rainy day).
But the biggest issue is the lifetime allowance is flawed in construction. Even leaving aside that the £1m allowance figure is itself completely arbitrary, the allowance is only set to increase by CPI.
Most pension schemes target returns far in excess of inflation – as do most of us Monevator readers!
The FCA advises that the projected return for equities should be 3% to 5%.13 A common benchmark for master trust pensions is CPI plus 3%. And looking back over the past 10 years, passive investors would indeed have realised returns far in excess of inflation.
This means that even a very distant lifetime allowance charge can become a real issue for those prudent enough to save into a pension for retirement.
Without labouring the point, beating inflation is the whole reason we invest. This means that the lifetime allowance punishes most those that save and invest successfully!
Looks like we’ve made it to the end
Like the annual allowance, the lifetime allowance is a complicated moving puzzle and it is worth seeking professional advice if you need it.
Assuming you haven’t fallen into a coma, please let us know of anything we’ve missed in the comments below.
- It’s a bit more complicated than that – what with tax-free cash and the annual allowance – but we have to at least try to simplify things! [↩]
- Keep in mind that since 9 March 2017 QROPS transfers can incur a 25% tax charge if certain conditions are not met, plus a five-year look-back applies. [↩]
- https://www.hl.co.uk/retirement/annuities/best-buy-rates as accessed 11/11/2019. [↩]
- £56,020 = £2,801 x 20. [↩]
- For a worked example, see the HMRC tax manual. [↩]
- QROPS transfers count as a 25% charge. [↩]
- The other protections are 2006 primary and enhanced, introduced on A-day; fixed protection at 2012 and 2014; and individual protection 2014. [↩]
- Or accrue within a defined benefit pot at, roughly speaking, higher than 5% of RPI per year. [↩]
- The calculation for these is quite complicated, refer to HMRC guidance. [↩]
- The calculation for these is quite complicated, refer to HMRC guidance. [↩]
- The rules are also more strict for enhanced protection – but I only cover fixed protection here [↩]
- See: https://www.hl.co.uk/retirement/annuities/best-buy-rates as accessed 11/11/2019 [↩]
- These are the FCA prescribed projections. [↩]