When pensions simplification came into force in 2006, it was thought life would be relatively easy: savers would have a single lifetime allowance (LTA) that was due to increase over the years, and they could simply take 25 per cent of their benefits as a tax-free lump sum.
This pension commencement lump sum (PCLS) could be taken each time benefits were crystallised until the LTA was exhausted. Yes, there were some protections, but a rising LTA would make these easily navigable.
In the event, we are now in a situation where individuals have either an unlimited LTA (enhanced protection), a multiple of £1.8m (primary protection), £1.8m, £1.5m, £1.25m, £1m, or somewhere between £1m and £1.5m (individual protection 14 and 16). All of this has an impact on what PCLS can be taken by individuals.
For those with a simple defined contribution pension scheme who take the PCLS as a single payment, the calculation is just as imagined in 2006: 25 per cent of the fund, up to the maximum allowed by their LTA.
For those in a defined benefit or final salary scheme, it is a little more complicated. There is no identifiable fund in these cases, but it effectively equates to 25 per cent of the capital value of the pension and lump sum. This usually means a chicken-and-egg calculation; a process that establishes how much lump sum an individual can have based on the amount they are taking.
Enhanced or primary protection
Those that applied for enhanced protection in relation to their benefits accrued before 6 April 2006 (A-day), would also have gained a measure of protection on their tax-free cash entitlements, as long as they had a claim of more than £375,000.
The enhanced protection certificate issued by HMRC would have included a percentage figure. This figure gives the individual the right to a PCLS corresponding to that figure: if the amount quoted is 20 per cent, the individual will be entitled to a lump sum of 20 per cent of their fund, with no test against the LTA.
If the member has been granted primary protection and the tax-free cash at A-day exceeded £375,000, the general rule is that the tax-free lump sum calculated at 5 April 2006 is protected and escalates in line with increases in the standard LTA (or 20 per cent if higher).
For the purposes of primary protection, the standard LTA is assumed to be £1.8m. When primary protection is granted, HMRC’s certificate confirms the amount of protected cash. Unlike enhanced protection, the cash sum may be taken from any scheme and in any proportion. This theoretically means it may be possible to take the whole of one pension fund as tax-free cash.
It may have been the case that the individual could not have protected their tax-free cash because it was below £375,000 at A-day. In these scenarios, the certificate will not show a percentage or figure for protection. However, in both cases the client’s LTA is assumed to be £1.5m for the purposes of the tax calculation at the point when the tax-free cash is taken.