What you need to know about fixed protection

As the lifetime allowance reduces to £1.5m advisers can apply for fixed protection for clients with pension pots likely to breach this amount. Matthew Stephens goes through the process

The Lifetime Allowance (LTA) reduces to £1.5m from April 2012 and a new form of protection - ‘Fixed Protection' (FP) - is available.

Individuals with FP get an LTA of £1.8m, not £1.5m. If the standard LTA ever increases above £1.8m the higher LTA will apply.

Someone with a £1.7m fund at retirement, and with FP, won't suffer an LTA charge. Without FP the charge would be £110,000 on the lump sum excess - £200,000 x 55%.

Important criteria apply to benefit from FP:

•No more ‘accrual' from 6 April 2012
•FP applications must be with HMRC by 5 April 2012 - there are no exceptions
•Those with Enhanced and/or Primary Protection cannot have FP

‘Accrual' means:

•Defined contribution schemes - contributions except contracted-out rebates and contributions to life assurance policies that started before A-Day
•Defined benefit schemes - benefit increases above CPI inflation OR the rate of increase for deferred members under the scheme rules at 9 December 2010. This means in practice active members won't be able to get FP

When advising clients FP is a bit like a mini A-Day, with a number of things to consider.

1. Is the value of all pensions, including ‘accrual', likely to exceed £1.5m at retirement?

The usual rules apply in valuing pensions: 20:1 factor for defined benefit; fund value for defined contribution.

If the answer is "no", there seems no need for FP. If the answer is "yes" we move on..........

2. Is the expected value with no further ‘accrual' likely to exceed £1.5m?

If it is, FP is beneficial. Any further pension saving must stop but that's OK - it can be made to an alternative home.

If the expected value is below £1.8m there's a chance to top up by 5 April 2012, so the expected value is close to £1.8m, and apply for FP.

If the expected value without accrual is over £1.8m, FP will be of benefit but the excess over £1.8m will suffer the LTA tax charge.

That said those who will have funds over £1.8m ignoring ‘accrual' may already have Primary/Enhanced Protection. There are no changes to the way they operate.

In particular, the extra factor used in calculating the higher LTA for Primary Protection will be applied to £1.8m, not £1.5m - e.g. a £1.65m pre A-Day fund has a factor of 0.1; the higher LTA is £1.98m (£1.8m x 1.1).

If the standard LTA ever increases above £1.8m, that higher LTA is used to calculate the primary protection LTA.

3. The expected value assuming no ‘accrual' is likely to be below £1.5m

Stopping pension savings is an issue here. Further judgements are needed -

•How much lower than £1.5m is it expected to be?
•Can the client make extra contributions now?

The key here is maximising contributions and applying for FP by 5 April 2012 - i.e. making pension contributions so the expected value is between £1.5m-£1.8m. FP will mean no LTA charge.

There's also an opportunity here for those with Enhanced Protection - a chance to contribute they thought they'd never get. If the value is expected to be below £1.8m a top-up contribution can be made by 5 April 2012, losing enhanced protection but then applying for FP.

It's key to remember that someone with both enhanced and primary protection will revert to primary on losing enhanced. Here, making further contributions won't work as they can't have FP.

The annual allowance has to be considered in all planning.

Contributions over £50k effectively get no tax relief but the three-year carry forward may give scope for more than £50k with tax relief on the whole amount.

A tax-free cash sting in the tail?

Maximum tax-free cash is normally 25% of the value, subject to 25% of the standard LTA.

Without any tax-free cash protection the maximum from a £2m fund will be £375k from April 2012 - 25% of £1.5m.

FP follows the same basic rule but uses £1.8m as the LTA, so maximum cash on a £2m fund is £450k.

The various pre A-Day tax-free cash protections work thus:

•Scheme specific = £1.8m LTA applies
•Enhanced Protection = ‘% of fund' at A-Day still used
•Primary Protection = £1.8m LTA applies in uplifting pre A-Day cash

Those with enhanced/primary protection but no tax-free cash protection, i.e. tax-free cash at A-Day was £375k or less, get the normal tax-free cash rules - 25% of the standard LTA.

For a fund of £1.8m with enhanced protection but no tax-free cash protection maximum cash is currently £450k (£1.8m x 25%). From April 2012 the maximum will be £375k - a £75k reduction.

Those affected and thinking of taking benefits fairly soon might want to consider acting before 6 April 2012 if cash is important.

FP raises both opportunities and some potential pitfalls. Clients will need advice more than ever to help make the right decisions.

Matthew Stephens is head of product and sales technical at Prudential