Ten things to know about tax free cash

Andy Zanelli goes through the issues surrounding pension commencement lump sums

Having worked in the world of pension planning for 21 years the one subject that many clients have a keen interest in, for many different reasons, is tax free cash. Before I am corrected I know the proper name is pension commencement lump sum (PCLS), but the intention was to make a clear point; I often wonder why the words ‘tax free' were removed? In my opinion it is only a matter of time before the real reason for using PCLS moving forward becomes apparent. That said, this is an emotive area and one where there are some critical points to think about for many clients who have historical pre A-Day pension benefits:

1. Most clients whose PCLS entitlement is different from the standard 25% of fund value will have scheme-specific cash protection.Their cash entitlement will have been calculated at A-Day (hopefully), recorded by the provider and will grow in line with the raising of the standard lifetime allowance (SLA). With the SLA due to reduce to £1.5million in April 2012, it is important that clients are aware that the SLA used in their calculations is now the greater of £1.8million or the actual SLA.

2. As the financial planning world and the personal circumstances of clients change many will consider the transfer, and possible consolidation, of their pension benefits. Great care must be taken here; if an individual transfers these benefits individually to a new registered pension scheme they will lose their entitlement to a scheme-specific cash sum. In the new scheme their PCLS entitlement will revert to the standard 25% of the fund when vested (subject to the SLA).

3. However all is not necessarily lost, as HMRC recognised that some schemes could cease to exist through no fault of the members, and introduced the concept of the block transfer, often referred to as a buddy transfer. There are some clear rules that need to be taken into account if using this option, but effectively the receiving scheme is treated as if it was the original protected pension scheme. For many clients there is an option of finding a like-minded buddy and then effecting the transfer of their benefits.

4. Everything is simple and straightforward up to this point. However, it can get very complicated for those clients who do effect a transfer and can take advantage of the block transfer provisions. A very important point is the fact that effectively the receiving scheme is treated as if it was the original protected pension scheme. If a client has more than one older pension scheme with scheme-specific cash protection they should not be transferred to the same receiving scheme,as only one amount of cash could be protected the other benefits would revert to the standard 25% of the fund when vested (subject to the SLA).

5. It doesn't get any simpler for clients with just one older scheme, where they have scheme-specific cash protection. If we assume that they have transferred these benefits to a new registered pension scheme and kept the higher level of cash, they may then look to consolidate and bring in other pension benefits with the standard 25% of the fund (subject to the SLA). Whether this is a good idea or not really comes down to how well the funds have performed, as there is a complex formula used to determine the level of PCLS. In a nutshell;if the fund performance is more than the increase in SLA then the PCLS is the same as it would be if the schemes were kept separate. If the fund performance is less than the increase in SLA then the PCLS is lower than if the schemes were kept separate.

6. A very short point for this one, but the same as above could be said if clients are thinking of making additional contributions to a scheme that has scheme-specific cash protection. It all comes down to fund performance and the SLA. The future contributions could, in effect, not increase the amount of PCLS that will be paid at vesting.

7. Now for one of my all-time favourite pieces of pensions legislation - standalone lump sums. Whenever dealing with historical pre A-Day entitlements keep a keen eye out for these, as they are out there! The basic legislation in the Finance Act 2004, allowed individuals to take part of their benefits as a tax free lump sum on retirement, so long as the individual also became entitled to an authorised pension at the same time. In fact, the lump sum payable is referred to in legislation as a pension commencement lump sum for this very reason. In theory these protected lump sum amounts could be equal to 100% of the fund value, which meant you had two different sections of legislation that effectively worked against each other. However in practice, as the original legislation stood you would not have been able to pay the protected lump sum figure of 100% of fund value. HMRC recognised this and responded with the concept of a standalone lump sum. As the name suggests, in some cases, the legislation allows for 100% of a fund to be paid out as a lump sum without the need for an accompanying pension. Certain conditions were introduced to meet the standalone lump sum requirements and so care needs to be taken.

8. Another point in relation to standalone lump sums. They can be extremely beneficial to clients, as the entitlement to 100% of the fund as cash is maintained irrespective of the fund growth. This is the case as long as some strict rules around transfers of these benefits are followed. For example; no additional contributions can be made to these schemes and some other more in-depth considerations around schemes for the same employment. This is an area for extreme caution.

9. Another common area where people have pre A-Day pension benefits is in relation to S32 policies, effectively individual transfer plans for certain occupational pension benefits. Many of these older S32 contracts did not adopt some of the flexibility of the new post A-Day world, quite often the provision of drawdown from the scheme. In these circumstances the client may have looked to transfer, could not do a buddy transfer and would therefore revert to 25% of the SLA in the new scheme. This was an anomaly created by the A-Day legislation applying to scheme wind-ups, but has now been amended with the publication of Statutory Instrument 2010/529 in March 2010. This effectively means that protection is available on any scheme wind-up and a client can make several moves from one S32 to another S32 and retain their entitlement.

10. My final point is one that will not apply to many clients, but is worth knowing, and relates to the area of divorce. There could be a situation where one of the couple has a scheme with scheme-specific cash protection that becomes subject to a pension sharing order on divorce. The question is then how does this affect the PCLS entitlement?The answer can be not at all. An example may help: if the client had an executive pension plan (EPP) with a fund value of £200,000, protected PCLS of £90,000 and a subsequent pension sharing order gave £100,000 of the fund to the spouse. What is the PCLS entitlement that remains? The answer is still £90,000 as the fund subject to the sharing order does not affect it. This means the original owner of the EPP gets £90,000 and the ex-spouse gets 25% of the fund.

Some long and complicated points here, but very important.I haven't even touched on those lucky enough to have primary or enhanced protection at A-Day!

Andy Zanelli is head of technical sales at AXA Wealth