As a result of the tapered annual allowance, more and more people are subject to an annual allowance charge, which can prove a significant sum of money.
For those who don’t meet the mandatory scheme pays rules, they may well have to find these funds themselves or use, if available, the voluntary scheme pays option.
Care needs to be taken to understand how these systems work, and the implications they will have on retirement benefits. Below is an outline of the complexities involved.
Mandatory scheme pays
An individual can elect to notify their scheme administrator that they require the scheme to pay some, or all, of their annual allowance charge liability in return for an appropriate reduction in their pension benefits in the scheme, if the following two conditions are met:
- Their annual allowance charge liability for the tax year has exceeded £2,000; and
- Their pension input amount for the pension scheme for the same tax year has exceeded the annual allowance amount in section 228 Finance Act 2004 – currently £40,000.
If these conditions are met, then a member is able to notify their scheme administrator that they want the scheme to pay all or part of their annual allowance charge. At that point, the administrator will become jointly and severally liable to the annual allowance charge together with the member.
The maximum amount a member can ask their scheme administrator to pay under mandatory scheme pays is based on the pension input amount under the scheme that exceeds the annual allowance. There is no minimum amount that the member can ask their administrator to pay. But if the amount is less than £2,000, they will need to confirm to their scheme that their annual allowance liability for the year is more than £2,000.
The member does not have to ask their scheme administrator to pay the maximum amount. They can ask the scheme to pay part of the amount they are allowed to ask it to pay, and then the member would pay the difference direct to HM Revenue & Customs.
It is still possible to request that mandatory scheme pays is applied, even if the scheme has transferred in the interim. The ceding scheme won’t be able to pay the charge because it won’t hold any of the client’s assets, but the requirement to pay can be passed on to the new scheme administrator.
Voluntary scheme pays
Voluntary scheme pays is just as it says. If mandatory scheme pays doesn’t apply, or doesn’t cover the whole payment due to the money purchase annual allowance or tapered annual allowance, the scheme can pay the charge on a voluntary basis. This type of scheme pays doesn’t make the scheme jointly liable for the payment: it is still the responsibility of the member to ensure it is paid.
This method was originally most common in money purchase schemes where the deduction of the charge is usually the simplest and has the least impact on the administrator. However, it has become more widely available in recent years from defined benefit pension schemes, too.
For those that are using voluntary scheme pays, it is worth noting the deadline for HMRC to receive the funds is the same that applies for self-assessment: January 31 following the tax year in which the charge arose.
For mandatory scheme pays the deadlines are more lenient. The scheme needs to be notified of the client’s intent to use scheme pays before July 31 following the end of the tax year in which the charge arose. That said, it will still need to be declared on the self-assessment form, so the figures will still need to be worked out by the January date.
A word of warning: I have known of schemes, in cases where they don’t appear to agree with the client’s request for mandatory scheme pays, trying to use carry forward as an excuse. The scheme has no right to calculate the available carry forward in order to decide if mandatory scheme pays applies – it is irrelevant.
Amount of deduction
The scheme must make sure that the adjustment made to the member’s entitlement to benefits is just and reasonable, having regard to normal actuarial practice. HMRC would expect a scheme to be able to demonstrate that the adjustment made was such.
Where the adjustment is not just and reasonable – or no adjustment is made at all – the payment of the annual allowance charge on behalf of the member by the pension scheme would be an unauthorised member payment.
I am unaware of any challenges to the adjustments made to pension benefits following the application of scheme pays, but that it not to say this could never happen.
Deductions in practice
Other than the requirement for there to be a just and reasonable adjustment to the member’s entitlement to benefits, the tax rules in relation to annual allowance charge payments – in cases where the member has elected to require the scheme to pay – do not place a requirement on when the adjustment must be made relative to when the tax has been paid.
The scheme administrator may decide to make the adjustment before the tax is paid over HMRC by the administrator, at the same time as the tax is paid, or after the tax is paid.
Even with money purchase schemes there can be various ways in which the deductions are made. However, this is usually as simple as a deduction made from the fund at the time that the scheme administrator pays the charge on the member’s behalf.
For a DB pension scheme there is a greater variation in the way in which the charge is funded. The result will be the same – a reduction in the benefits of the member in order to pay the tax charge.
One option that DB pension administrators use is a separate negative account – essentially a loan to the member to pay the tax charge. A notional record of the amount and any interest accrued is recorded against the member, and when they come to take benefits it is clawed back. This could be through a reduction in the pension payable by commuting the notional value into a pension, or by reducing the pension commencement lump sum or any additional voluntary contributions the client had built up.
It is important to understand how this works on a scheme-by-scheme basis in order to determine whether it will prove good value for the client to proceed down this path. It may be better value to pay the tax charge from external funds.
In the case of the negative account, scheme rules may require that amount is paid back if the member leaves the scheme. At that point in time, the notional value will be commuted to a pension value, and that value would then be deducted before the scheme is deemed deferred.
Alternatively, the scheme may apply a reduction to benefits immediately by way of commutation. This is likely to take into account the client’s age and term to retirement so as not to disadvantage other members. Tables from the pension scheme may be available to ascertain the reduction, otherwise the commutation rates may only be determined by the actuary when requested.
More options for members
Scheme pays has come closer to the forefront of administrators and advisers’ minds in recent years, mainly due to the tapered annual allowance. As a result, more schemes seem to be offering voluntary scheme pays to their members, most notably the NHS Pension Scheme.
It should be noted that scheme pays isn’t always the most efficient way to pay the tax charge; this will depend on the scheme rules and how they deal with recouping the funds used to pay the charge. But it does generally mean there are options available to scheme members to avoid having to find thousands of pounds of their own money to pay the charge.
Hopefully we will see more administrators and schemes offering good-value scheme pays to their members, otherwise we will see increased numbers opting out of very good and valuable pension schemes. In many cases, it is still better to remain a member of the scheme and pay the tax charge than to opt out and not receive the benefit of the employer contributions and guaranteed income in retirement.
If I were a member of a DB pension scheme and subject to annual allowance charges, it is safe to say I would be ensuring I considered all options and their implications before opting to leave a scheme that would provide me with some certainty in retirement.
That said, taking advice to determine the best course of action is key to getting these things right. Of course, when opting out of a DB pension scheme, there is often no option to rejoin at a later date.
Claire Trott is head of pensions strategy at St James’s Place Group
