RPSM09104490 - Technical pages: member benefits: lump sums: pension commencement lump sum: maximum amount: maximising lump sums where a member has rights under both money purchase and defined benefit arrangements in the same scheme
RPSM09104150 explains that while the amount of pension commencement lump sum must be justified by reference to pension provided under the same scheme, that pension need not be provided either entirely, or even at all, from the same arrangement.
RPSM09104280 and the pages that follow, provide some examples of how such pension commencement lump sums can be paid ‘across arrangements’. The purpose of the examples is to demonstrate how to check that the lump sum that is being paid is authorised by the tax legislation. However the examples do not show how to arrive at what is the highest possible lump sum before tax charges apply.
The maximisation of tax-free pension commencement lump sums is not strictly a regulatory matter for HMRC, however, HMRC is aware that there is pension industry interest in this matter and in view of this, provides the guidance below.
It is important to bear in mind that maximising the pension commencement lump sum, will not always be the most favourable option for any given member. It is, of course, a matter of best financial advice as to whether a member should opt to take tax-free cash, and if so in what proportions. Tax reliefs are provided as an incentive to save in a registered pension scheme so as to be able to provide income in later years. While tax-free cash is often useful, its attraction should be balanced with the member’s anticipated longer term financial needs. This guidance does not address how that balance should be assessed or reached.
There may be a number of ways to calculate the maximum pension commencement lump sum. The method provided here is a simple formulaic one.
The method described looks purely at the ‘applicable amount’ (see RPSM09104310), without any consideration to matters such as deductions (see RPSM09104460) or lifetime allowance (see RPSM09104220 & RPSM09104510). It also presumes there is no relevant transfer or surrender of the kind described at RPSM09104406 and RPSM09104407. It only applies for the simple case where part of a member’s scheme pension is commuted to lump sum using no more than one commutation factor (though different factors can be used in different cases even in the same scheme). This method should not be used where the lump sum is not derived from the commutation of pension, e.g. public sector schemes that calculate lump sums and pensions separately.
The method only applies where there are benefits under both defined benefit and money purchase arrangements within the same scheme, providing benefit rights for the same member, with entitlements arising within the relevant time limits (see RPSM09104120).
If the case concerns a scheme which imposes requirements on whether the lump sum is taken from one arrangement in preference to the other, then the ability to maximise may be affected. In such a case, schemes should substitute the text in the first box in the flowchart below with the following:
“Does the scheme demand that none of the lump sum may be drawn from the defined benefit arrangement until the money purchase arrangement is exhausted”.
L = the highest possible tax free lump sum
g = the defined benefit pre-commutation pension for the member in terms of gross pension per year
c = the value of the member’s money purchase fund available for the provision of benefits for the member and their dependants
f = the commutation factor, i.e. the rate at which £x of future pension promised can be given up to have cash in hand now. E.g. 12:1, where you give up £1 future pension per year in order to generate £12 cash now. In such a case f=12.
v = the relevant valuation factor, usually this will be 20.
|L = 5g + 0.25c|
|L =||fg + c|
|0.15f + 1|
|L =||c + gf|
|L =||f (vg + c)|
The result of the above maximum lump sum calculation, is a theoretical figure. It only leads to an authorised maximum lump sum payment, if the actual lump sum is backed by pension that is taken in the form(s) that optimise(s) that lump sum. This means that any lump sum that is actually provided should be tested against the legislation using the statutory formulas that apply to those actual kinds of pension provision. The examples linked at the top of this page show how those tests are done.
In practice, difficulties can be avoided by ensuring that any lump sum based on the above calculations is drawn from the right arrangements, as follows
- if using formula A or B, then the maximum lump sum must first be drawn from the money purchase arrangement. Only if the funds under the money purchase arrangement are exhausted should any lump sum be drawn from the defined benefit arrangement.
- if using formula C or D, then the maximum lump sum must first be drawn from the defined benefit arrangement. Only if entitlement to benefits under the defined benefit arrangement is exhausted should any lump sum be drawn from the money purchase arrangement.
RPSM09104120 explains the time limits for making a payment of pension commencement lump sum. In a situation where the pension commencement lump sum is being paid across arrangements, the pensions justifying that lump sum might commence at different times. Likewise the pension commencement lump sum might be paid in more than one instalment within the time limit. It is important that any instalment of lump sum remains within the time limits for payment based on the date of entitlement to the particular slices of pension that justify that specific portion of lump sum. Conclusion:
Always ensure that any lump sum that is being paid is actually authorised by the tax legislation. Examples of such checks begin at page RPSM09104280.
In simple cases, where all the payments are to be made simultaneously and are imminent, the following simple cross checks can also be performed:
L <= (L + r + m) / 4
L = total pension commencement lump sums from scheme
r = (‘v’ as defined above) x (the initial annual starting level of post commutation defined benefit scheme pension)
m = the amount of the sums and assets applied to purchase the money purchase pensions including AVCs