RPSM09104250 - Technical Pages: Member benefits: Lump sums: Pension commencement lump sum: Maximum amount: General: Unsecured pension – why lump sum payment is linked to an arising entitlement to income withdrawal

Why the entitlement to a pension commencement lump sum where an unsecured pension is being drawn is linked to an arising entitlement to income withdrawal

When designating uncrystallised funds to provide an unsecured pension, the legislation links the pension commencement lump sum to the arising entitlement to income withdrawal, rather than an entitlement to an unsecured pension (para 3(1), Sch 29).

A lump sum can be treated for tax purposes as a pension commencement lump sum only when pension benefit entitlement first arises from uncrystallised rights or funds. This occurs at the point uncrystallised funds are designated to provide an unsecured pension. The lump sum is not paid from the arising unsecured pension fund, but from a proportion of the uncrystallised funds alongside those being designated to generate the unsecured pension fund.

Where funds are designated to provide an unsecured pension, the initial pension entitlement arising at that time will always be an entitlement to income withdrawal, and not to a short-term annuity income. This is because the legislation states that entitlement to income withdrawal arises at the point uncrystallised funds are designated to provide an unsecured pension (s165(3)(a)). So this is the point at which a lump sum can be treated for tax purposes as a pension commencement lump sum. It may of course have been paid earlier (within the 6 month period before the entitlement to the income withdrawal arose), or it may be paid up to 12 months later.

Entitlement arises at that point, whether or not income withdrawals are actually paid. (Income withdrawal is defined in the legislation by reference to an amount that “the member is entitled to be paid from the member’s unsecured pension fund “para 7(a), Sch 28).

Entitlement to a short-term annuity arises only when that contract is purchased. This will always occur after the initial designation to provide unsecured pension, and be purchased from the unsecured pension fund rather than from uncrystallised funds. So as far as the legislation is concerned, entitlement to a short-term annuity will always arise after an entitlement to income withdrawal.

The legislation therefore links the pension commencement lump sum to the pension entitlement that arises at the actual point uncrystallised funds are designated to provide unsecured pension, which is the entitlement to income withdrawal. When calculating the applicable amount, the entitlement being measured is the amount designated for income withdrawal, and not any particular measure of unsecured pension, as the latter can vary.

A lump sum payment cannot be treated as a pension commencement lump sum where an existing unsecured pension fund is used to purchase a lifetime annuity contract, applied to provide a scheme pension, or used to purchase a short-term annuity. To allow a further pension commencement lump sum to be paid from such funds would mean that the 25% limit on such tax-free payments could effectively be breached. This means that a further tax-free lump sum payment will only be possible where further uncrystallised funds are brought into that unsecured pension fund through an additional fund designation.