Finance Bill would cap pension lump sum protection

Members holding enhanced protection with a protected pension commencement lump sum should consider whether to access their benefits, as the maximum tax-free entitlement may not grow after 5 April 2023.

The Chancellor of the Exchequer made much in the March 2023 Budget of the “abolition” of the Lifetime Allowance – the limit on how much tax efficient pension money an individual may build up during a working lifetime. There was also plenty of focus on a substantial increase to the scope to contribute in any given tax year – the Annual Allowance. These are covered in our Spring Budget Q&A blog.

However, when the Spring Finance Bill 2023 was published, a less well publicised change was the introduction of a mechanism to cap the tax-free pension commencement lump sum entitlements of members holding enhanced protection with protected lump sum rights in excess of £375,000. Those rights would be expressed as a percentage on the enhanced protection certificate issued by HM Revenue & Customs. 

Members holding this form of protection were promised in 2006 that as long as they did not accrue new benefits (broadly for SSAS members this effectively meant if no further contributions were made on their behalf), their lump sum entitlements would be protected as a percentage of their funds. So, however big the fund grew, the lump sum limit grew with it. The Finance Bill provisions would, if enacted, change that. It is important to note that this is still draft legislation and could change before it is eventually enacted. We know the Opposition has said they will reverse the changes to the Lifetime Allowance. This new cap on lump sum protection seems to me a little less likely to be rescinded, for some reason.

The change is that after 5 April 2023, a new overriding limit is introduced of the figure that would be arrived at under the same calculation, but as measured at 5 April 2023 using the market value of the assets and liabilities at that date. So, the percentage of fund calculation continues to apply - but subject to being no more than the monetary amount on 5 April 2023. Effectively, growth after 5 April 2023 will not carry with it any tax-free lump sum entitlement for this subset of members – yet a reduction in fund value would reduce that lump sum entitlement.

Example 1 – Growing fund

Claire has valid enhanced protection, with lump sum protection of 30% of her fund. At 5 April 2006 her fund was worth £2,000,000. When she takes benefits in July 2026 her pension fund has increased to £5,000,000.

The scheme administrator first values Claire’s fund at 5 April 2023, at £4,200,000. With lump sum protection of 30%, this means she is entitled to a pension commencement lump sum of up to £1,260,000 as at that date.

When Claire comes to take her benefits, even though she has accrued an additional £800,000 and the pension fund is now £5,000,000, and she still has valid lump sum protection of 30%, the maximum pension commencement lump sum will be capped at the 5 April 2023 figure of £1,260,000. Under the pre-Budget rules the lump sum could have been £1,500,000.

Example 2 – Shrinking fund

Ben has valid enhanced protection, with lump sum protection of 50%. At 5 April 2006 his fund was worth £1,600,000. When taking benefits in August 2024 his pension pot has decreased in value since 5 April 2023. 

The scheme administrator first values Ben’s pension pot, as at 5 April 2023, at £2,200,000. With lump sum protection of 50%, this means he is entitled to a maximum pension commencement lump sum of up to £1,100,000 at that time.

When Ben comes to take his benefits, the value of his fund has decreased to £1,800,000. He will be entitled to a maximum pension commencement lump sum of 50% of this lower value, so £900,000. 

Example 3 – What about this one? 

Alf has valid enhanced protection, with lump sum protection of 20%. At 5 April 2006 his fund was worth £2,000,000. When taking benefits in June 2024 his pension pot has decreased in value in the last two years. 

The scheme administrator first values Alf’s pension pot, as at 5 April 2023, at £1,000,000. With lump sum protection of 20%, this calculation means he is entitled to a maximum pension commencement lump sum of up to £200,000 at that time. 

Alf’s fund remains at £1,000,000 when he draws benefits, so his maximum lump sum appears to still be limited to £200,000 which is lower than the standard available amount. 

Under the pre-Budget rules, in those circumstances Alf might have given up his enhanced protection before drawing benefits, so as to use the higher 25% lump sum entitlement under the standard Lifetime Allowance, being £250,000. (Note for pension geeks that he is ineligible for Fixed Protection 2016). However it is at best unclear how Alf might be able to give up protection under the Finance Bill provisions if he wanted to pursue the higher lump allowance. 

With that in mind, since the maximum tax-free entitlement is not going to grow beyond 5 April 2023 if the change comes into force, it may be worth members who have not yet accessed all the benefits from the scheme considering whether to do so. 

In order to undertake the comparison against 5 April 2023 asset values, all the assets and liabilities would need to be valued at a true market value. This would mean a formal professional valuation of any property, and valuation statements being obtained for the various other investments. This could represent a significant expense in some cases. 

The rule change might not necessarily push all members with this protection towards accessing their funds. Members should of course take advice from suitably qualified professionals as to the most suitable approach for them. For example, one consideration would be that once the benefits were drawn from the scheme, they would form part of the member’s personal estate, and if not spent would potentially be exposed to inheritance tax on death. Pension scheme funds usually retain an exemption from inheritance tax on death benefits and can pass down the generations in a tax privileged environment. This might or might not outweigh the lump sum considerations.