A recent WTW survey found that almost two-thirds of schemes had considered whether to make a discretionary increase for 2023. One fifth of respondents granted an increase, with almost two-thirds of those schemes having pre-funded for it and one-third using surplus to meet the cost.
Granting a discretionary uplift to a pension in payment that continues for life, assuming the scheme rules allow this, is relatively straightforward. Under the current HMRC rules (to 5 April 2024), provided that any pension increase (when measured over the preceding 12 months) is no greater than the increase in the retail prices index, Lifetime Allowance (LTA) testing would not be needed2. There are also other exemptions from LTA testing, although these can become complex.
Although this option is (relatively) straightforward, because the pension will be paid for life at the higher level, it is a considerably more costly option than a one-off lump sum. Reflecting this, over four in five schemes granting a discretionary increase did so as a continuation of past practice, with nearly two-thirds of survey respondents citing pre-funding as a reason they made an increase. Most who did not grant an increase attributed this to the employer not approving it.
A one-off discretionary lump sum, because it does not increase future liabilities (with uncertain eventual costs) might, therefore, be a more attractive option. However, this is not normally possible under current HMRC rules. If such payments were to be permitted, it seems reasonable to assume that more pension scheme sponsors would be prepared to agree to their payment. This is perhaps particularly the case as the funding position of many defined benefit (DB) schemes moves (further) into surplus – see WTW’s white paper3.
Any payment that is not an authorised payment attracts penal tax charges (minimum 40% for member and 15% for the scheme).
Broadly, in a DB scheme, the authorised benefits payable are a tax-free pension commencement lump sum (PCLS) and a DB scheme pension payable for life. The scheme pension must not reduce from one year to the next and hence it is not possible to increase a pension just for one year4.
The origin of HMRC’s “no reduction” in pension rule is to prevent members receiving an artificially high PCLS. The PCLS is restricted to 25%5 of the value of benefits being put into payment and, for HMRC purposes, the pension value within a defined benefit (DB) scheme is determined as 20 times the annual pension. In the absence of a “no reduction” rule, a scheme could offer an artificially high starting pension, pay the PCLS based on its HMRC value and then reduce the pension.
So how then might schemes support pensioners in straightened circumstances without breaching HMRC tax rules? There is an approach that trustees of money purchase schemes can use, with a possibility that the government might permit similar flexibility under defined benefit schemes.
Within a money purchase arrangement (defined contribution (DC) or cash balance), there is already a facility for delivering one off payments – an uncrystallised funds pension lump sum (UFPLS). This is a single payment, 25% of which is tax free, and the balance is taxable at the individual’s marginal rate.
It can also be possible for DB schemes to route a one-off discretionary payment through an UFPLS, but it is not straightforward (because that is not what it was designed for).
If there were a separate DC scheme or a DC section of a DB scheme, an employer could pay a lump sum of the desired amount to that DC scheme/section with pensioners taking that amount as an UFPLS. It could also do so through a cash balance arrangement. In either case, if the scheme rules do not already permit UFPLS payments, then legal advice would be required6.
It might be possible to use a DB surplus to provide the DC contribution or cash balance benefit. Legal advice would be required as this depends on the scheme rules.
Any member who receives an UFPLS becomes subject to the money purchase annual allowance (MPAA). This is only relevant if they are also making other retirement savings (or might do so in future) and, as the MPAA increased to £10,000 (from £4,000) for the 2023-24 and subsequent tax years, this further reduces the extent to which this might be a barrier7. However, it would seem sensible to offer pensioners an opt-out of the top-up and legal advice would be required on the process for this.
Where the DC route is chosen for provision of an UFPLS, schemes that don’t currently include DC benefits would need to take care not to trigger the DC governance requirements. They would also want to avoid being left with many small DC pots.
Care would need to be taken if the UFPLS payment were structured as occurring in an existing cash balance arrangement and that arrangement were currently benefitting from the annual allowance (AA) deferred member carve out.
There are other conditions attached to availability of an UFPLS, for example it can be paid only if a member has scope within the LTA. Members with benefits above the LTA would need to receive some or all of the lump sum as a lifetime allowance excess lump sum (LAELS). This is now taxed as pension income – there is no longer a flat LTA charge – although there is no tax-free element attached to a LAELS.
There would also be adviser and administration costs to consider.
From 6 April 2024, the government intends to remove the concept of the LTA from the legislative framework. A consultation on the 2024-25 pensions tax regime framework has been published8 and this does not include any provisions seeking to limit “excessive” pension increases (which might have been introduced to protect against avoidance of the AA as AA avoidance risk increases once the LTA is removed). If enacted as currently drafted, the process of granting discretionary increases would become simpler as there will no longer be checks needed on the level of increases to pensions in payment.
However, the legislation is being consulted on and, because it is a consultation, the existing provisions could change, and new provisions could be added.
The draft legislation effectively restricts the amount of UFPLS that can be paid tax-free to the same as currently permissible, but the mechanism is slightly different. The tax-free amount will generally be 25% of each payment. There is a caveat to this, relating to removal of the LTA. The government proposes to introduce a tax-free allowance (an individual’s lump sum allowance, ILSA) of £268,275 (25% of the current LTA) and the tax-free amount of an UFPLS will be capped at the unused ILSA9.
If the government wishes to encourage pension schemes to help mitigate cost of living pressures for pensioners, adding one-off discretionary lump sums as a new category of authorised payment would be very helpful, offering a far simpler mechanism for delivering a payment than currently exists. While there is a political risk that doing so might be portrayed as the government lacking confidence in its plans to drive down the rate of inflation, it would be facilitating delivery of additional income to pensioners, irrespective of inflation levels.
The abolition of the LTA from 6 April 2024 provides such an opportunity. HMRC could introduce a new option to permit additional one-off lump sums to pensioners from DB schemes, even if there was no increase to the underlying pension, subject to whatever qualifying conditions it considers necessary.
For example, if HMRC does have concerns about schemes manipulating their benefit structure to avoid the AA, it could restrict one-off lump sum benefits, perhaps in line with the current legislation for ‘small’ increases which do not need to be tested against the LTA ie up to the highest of £250, 5% of the pension or the increase in RPI applied to the pension.
There is an argument that 25% of such a lump sum should be paid tax-free ie treated consistently with an UFPLS from a DC/cash balance arrangement.
The draft legislation published does not include such a provision, but all the focus has been on addressing the direct consequences of the LTA abolition and the government has a regulation-making power10 to create new authorised payment types, it would not necessarily need to feature in a Finance Bill.
The UFPLS concept was introduced in 2015 as a part of the pensions’ freedom and choice reform11. That reform recognised that requiring DC members to purchase an annuity might not deliver good value as the income purchased would normally be conditional on short-term economic conditions. Hence, from 6 April 2015, the ways in which an individual can access their DC pension savings were relaxed. Since then, there has been no requirement that DC funds are used to provide an income for life. They can, instead, be designated for drawdown and a PCLS taken in relation to the designated funds. The designated funds can then be accessed as taxable income, as and when it suits the member (subject to scheme rules). At the same time, the option to take funds as an UFPLS was introduced.
The freedom and choice reforms were not deemed appropriate for DB because of perceived liquidity and investment risks to the wider economy; further, the member has a different set of choices to a DC member and the pension promise is not dependent on short term economic conditions.
Members in private sector occupational pension schemes did, however, retain the right to a statutory transfer value, but with the additional requirement for appropriate independent advice for all bar the smallest DB pensions. This enabled DB members to access DC flexibility.
In July 2023, HMRC has stated12 that “it is not the government’s intention to significantly expand pension freedoms”.
The issue here, however, is not about introducing greater flexibility for how uncrystallised DB benefits can be commuted for a lump sum at the point of payment, it is about enabling a lump sum augmentation to be delivered more simply and flexibly to pensioners. We would expect these payments to be met from surplus or additional contributions, so it seems unlikely therefore that there would be the same liquidity/advice concerns.
It is possible for trustees of pension schemes to help pensioners during these difficult times, albeit not straightforward. The government could make this simpler, without imposing significant additional complexity and at little or no cost to the exchequer.
1 Bank of England note: “When will inflation in the UK come down?” (as at 24 July 2023). The May update stated “We expect inflation to fall quite quickly, to around 5% by the end of this year and then meet our 2% target by late 2024”.
2 For the tax year 2023-24 there is no LTA charge, but all LTA calculations continue to be required as a person’s available LTA is still relevant for the determination of any pension commencement lump sum (PCLS). From 6 April 2024, the intention is that the LTA will be abolished.
3 WTW press release: WTW calls for six pension policy changes to fuel UK economic growth.
4 There are exceptions for benefits designed to integrate with the state pension and for total commutation of smaller benefits.
5 Where an individual had a right to a tax-free lump sum of more than 25% of the benefit value at 5 April 2006, that higher percentage can be protected.
6 A money purchase scheme can offer an UFPLS even if the scheme rules do not permit such a payment. Finance Act 2004 includes a permissive statutory override allowing payment, even if the rules explicitly prohibit such a payment. It would also be possible to modify the scheme rules by resolution to allow payment of an UFPLS. Trustees should check with their appointed legal advisor as to the appropriate approach for their scheme.
7 UK Budget 2023, pension-related announcements.
8 Draft Finance Bill measures, published 18 July 2023.
9 For members who have taken a serious ill-health lump sum, there is a second cap.
10 Finance Act 2004 Section 164 para 1(f).
