Spotlight: Focus on cash

Entitlement to a pension commencement lump sum - tax free cash - is one of the more endearing features of the UK’s pension regime and tends to be the one piece of detail clients believe they understand.

But getting the maths right, particularly in light of regulatory changes made in April 2011 for older clients, is not always clear cut.

The standard scenario, at least, should not prove overly complex. Tax free cash becomes available when a benefit crystallisation event (BCE) occurs, which is broadly when a client converts a money purchase pension pot into a drawdown arrangement or buys a lifetime annuity, or when benefits fall due in a defined benefit pension (see for the full list of BCEs.) At that point, the client may choose to take up to 25% of the value of the pension at that time as tax free cash, which can be paid up to six months before or 12 months after the entitlement to their pension begins.

The only restriction on the lump sum is that it cannot be paid back into the pension scheme (see HMRC’s ‘recycling’ rules) and that the lifetime allowance must not be exceeded. Defined benefit schemes will use their own rules to determine the 25% level, providing illustrations that explain how benefits are reduced if the client chooses to take the cash. In this instance, taking the lump sum often does not make sense mathematically, as the value of the benefits given up (including spouse’s pension, inflation proofing etc) is typically more than the cash offered when compared with the price of an equivalent annuity.

Money purchase scheme members have a more straightforward decision as the lump sum can in theory be used to buy another annuity with no loss of benefit, although that is a rare use. Either way, the main decision is whether the remaining pension is sufficient for the individual’s lifestyle.

For clients with money purchase pensions, their pot or pots can be broken up and converted to an annuity or drawdown in slices. Each time a portion of a pension pot is ‘crystallised’ in this way by converting part of the fund to an annuity contract or designated to become an unsecured pension – which is how HMRC still frequently refers to drawdown in its notes – again 25% of the market value of that slice can be released as tax free cash with the same 18 month window for when the payment must be made.

For technical reasons, HMRC only considers the purchase of a lifetime annuity or designation of uncrystallised benefits as drawdown to be linked to the pension commencement lump sum; not the purchase of a short term annuity, for instance, which would be considered a subsequent use or type of drawdown pension.

Another confusing HMRC quirk to be aware of when reading through its materials is that occasionally the notes refer to tax free cash as being ‘one third’ rather than 25%. This is because once one quarter of the pot is removed, that sum is equivalent to one third of the remaining three quarters. So the lump sum is one third of the remaining pension. It is not a different rule; rather, the same rule expressed from a different perspective.