As the baby boomer generation moves into retirement, one of the questions that is starting to emerge more frequently is how to balance the lifetime allowance (LTA), maximising death benefits and drawing benefits.
Some lucky boomers will be in the situation where they have both defined benefit (DB) scheme membership from their early/mid working lives that can provide for their retirement needs, and defined contribution (DC) arrangements from their later working years from which they currently have no requirement to draw. They may also have some transitional protection, such as fixed protection (FP) 2014.
From an estate planning viewpoint, in such circumstances it would appear preferable to leave the DC arrangements untouched and, if DB income needs supplementing, draw on other investments – even to the extent of eroding capital.
But in practice, matters are not quite so simple. There are a variety of interrelated factors that come into play when considering what net amount will be available at death to beneficiaries.
Lifetime allowance
The LTA is the most obvious obstacle to simply allowing a DC fund to roll up until death. The standard LTA will now be CPI-linked following April’s increase to £1.03m. Assuming inflation of around 2.5 per cent, 10 years from now the LTA should be around £1.32m. That is no help to those with FP 2012 or 2014, nor probably for most of those with the individual protection (IP) counterparts.
In theory, over the longer term the fix of IP and FP will fall away. But in practice there is no ‘longer term’ beyond age 75, at which point a range of benefit crystallisation events (BCEs) could be triggered.
For those with no LTA issues yet, what matters is real returns. Taking the 10-year time frame again, a 2 per cent real return will see a fund of £850,000 today exceeding the LTA in 2028. This may suggest that the ‘do nothing’ option is not the best, but what are the other possibilities?
The first of four
It is sometimes suggested that immediate crystallisation into drawdown with no benefits taken is one way of mitigating the impact of the LTA charge. This can be true until age 75 because the payment of death benefits from a fund designated for drawdown is not a BCE, meaning any growth in the fund after crystallisation passes straight to the beneficiaries. However, BCE 5A kicks in at age 75. This illustrates the drawback of early designation to drawdown: in effect the LTA used for the crystallisation is frozen. See Box One.
Gifting
What happens if, instead of placing the entire fund in drawdown, the maximum pension commencement lump sum (PCLS) is taken and immediately gifted, with the balance going to nil drawdown? See Box Two.
First, the calculation becomes more complex: if we are trying to compare total benefits on death, some assumptions must be made about what value to place on the extracted PCLS at death. One simple method is to accumulate the PCLS at the assumed rate of return on the pension fund, subject to tax at the beneficiary’s marginal rate. This is a worst-case assumption, as any capital gains and dividends will be taxed, if at all, at less than the full income tax rate.
The next consideration is inheritance tax (IHT). The lifetime gift can be assumed to be a potentially exempt transfer, or possibly a chargeable transfer within the available nil-rate band, but it will still fall back into the estate for the next seven years.
Taper relief is not relevant as it applies only to tax payable on the gift, which will generally be zero. Instead, what needs to be considered is the pre-emption of the nil-rate band by the lifetime gift – 40 per cent of the gift (ignoring annual exemptions) for seven years.
Finally, there is the post-75 situation. Any benefits paid from the pension on or after age 75 are taxable as income in the hands of the beneficiaries. The PCLS is outside, so does not suffer this fate. The result of these factors is to produce an overall death benefits scenario with a distinct kink at seven years, and a gradually reducing advantage emerging after age 75.
Other options
One option is immediate crystallisation into drawdown, with income drawn and gifted at a level to avoid a BCE 5A. See Box Three.
The BCE calculation will deliver no charge if the residual fund at age 75 does not exceed the remaining LTA. This can be achieved by taking an appropriate level of income, which would be free of IHT if gifted under the normal expenditure rules. Because of the income tax paid on the withdrawals, this process produces a marginally inferior death benefit to crystallising and taking no income up to age 74. However, from age 75 the outcome is very similar.
Another route to consider is immediate crystallisation, then drawing and gifting the PCLS with income drawn and gifted at a level to avoid a BCE 5A. See Box Four.
This combination of the previous two options produces inferior results to either until age 75, at which point it beats both. But in the long run the advantage erodes, because this option yields the smallest amount rolling up within the pension fund tax shelter.
Chart 1 shows the outcome for all the above options, including the ‘do nothing’ choice of no crystallisation. The results are specific to the circumstances outlined and must not be read as providing any rule of thumb. They also need to be balanced against three important factors:
- Age 75: most people are going to reach the BCE fest that is age 75;
- Politics: the current generosity of the treatment of pension death benefits may not last. The rules have already changed several times, there is an ongoing Office for Tax Simplification review of IHT, and that is before the result of the next election is considered;
- Access to cash: the focus in this article is on death, but many potential beneficiaries would find more immediate access to cash far more attractive, even it is not the most tax-efficient option.
John Housden is an associate at Technical Connection, specialising in actuarial and development programming
