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Lifetime allowance and annual allowance planning for the high net worth client

14 min read 6 Apr 22

By The Technical Team

In this article

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Overview


Here’s what you need to consider in relation to the Lifetime Allowance and Annual Allowance to see if pension saving is still right for high net worth clients.

Key points

  • Calculations may need to be carried out every year if Lifetime Allowance and Annual Allowance could be an issue.

  • In 2016 there was another reduction in the Lifetime Allowance, new protections and a change to annual allowance with the introduction of the Tapered Annual Allowance.

  • When undertaking a planning process there are considerations particular to whether Lifetime Allowance, Annual Allowance or both apply for a client.

  • Even if lifetime allowance or annual allowance tax charges apply, pension saving could still be advantageous for your client.

  • Alternative tax efficient strategies could involve vesting to drawdown and recycling income efficiently or using Enterprise Investment Schemes, Venture Capital Trusts, Open Ended Investment Companies, Bonds or an ISA.

Why you need to carry out calculations

Tax charges may not always be a bad thing if the overall outcome is better for the client. What is crucial is that the relevant calculations are done so that the client knows what to expect. 

This article deals with planning for the high net worth client. 

In 2016 there was another reduction in the Lifetime Allowance, new protections and a change to annual allowance with the introduction of the Tapered Annual Allowance. These changes may have had an impact on high net worth clients. Calculations need to be carried out on an annual basis to decide if pension saving is still appropriate.

As there is no timescale for applying for Individual Protection 2016 (IP16) and Fixed Protection 2016 (FP16) then clients can apply at any point using the online system although it would be wise to do this before the next benefit crystallisation event (BCE).

It is also important to note that although there is no application deadline for IP16, the statutory obligation on scheme administrators to provide values at 5 April 2016 only applies for 4 years so, if you need pension values from your scheme, be sure to request these before 6 April 2020.

If clients have not yet applied for FP16 or IP16 then the key points to note are: 

  •  With FP16 clients will receive a £1.25 million Lifetime Allowance but they must have opted out/ceased paying into a pension as at 5 April 2016.

  •  With IP16, clients must have had £1 million or over in pensions savings as at 5 April 2016 and they will receive a personal lifetime allowance between £1m and £1.25 million but pension savings may continue.
"Opting out to save a tax charge, even if the net benefit is better, would be a bit like a client asking their employer to stop paying their salary because there is a tax charge."

Lifetime and annual allowance planning

There are lots of different types of clients who all have different circumstances, are members of different types of schemes and have a range of different benefits. Planning will be different for each of these clients but the process for all may be the same.

  1. Calculate benefits based on existing arrangements projected to retirement

  2. Calculate overall cost of maintaining existing arrangements

  3. Calculate benefits payable net of any tax charge

  4. Calculate the value of “paid up/deferred” benefits at retirement date with no further accrual or contributions

  5. Identify the value of alternate arrangements

  6. Add the value of “paid up/deferred” benefits to the value of any alternative arrangements at retirement date.

The process is logical, but there are considerations particular to whether Lifetime Allowance, Annual Allowance or both apply to a particular client.

Considerations for each step

1. Calculate benefits based on existing arrangements projected to retirement

Considerations for Annual Allowance:

  • Defined contributions - levels of employee, employer and third party contributions

  • Defined benefit – benefit structure, accrual rates. Assumptions on salary increases and CPI for CARE schemes.

  • There will still be at least £10,000 tapered annual allowance available (or £4,000 for DC savings if the MPAA is triggered) so no need to fully stop pension saving

Considerations for Lifetime Allowance:

  • Considerations for defined contributions - contribution levels, term and anticipated investment return

  • defined benefit – assumptions on salary increases

  • Maximising PCLS when commutation less than 20:1 will reduce LTA usage.

  • CPI – for CARE scheme accrual and LTA increases (from April 2018 until April 2021  the LTA increased by CPI each year, this has now been frozen until the 2025/26 tax year)

  • Value of existing arrangements

2. Calculate overall cost of maintaining existing arrangements

Considerations for both Annual Allowance and Lifetime Allowance:

  • To allow fair comparisons the net of tax relief costs should be considered

  • There may be no/little cost to the individual if benefits are solely/mainly employer funded

3. Calculate benefits payable net of any tax charge

Considerations for Annual Allowance:

  • Scheme Pays – mandatory only or voluntary available?

  • Schemes arrangements for actuarial reduction of benefits including commutation factors.

Considerations for Lifetime Allowance:

  • Schemes’ rules may determine the basis on which any LTA excess can be taken

  • Where a choice is available consider the value of a lump sum after 55% tax, or a 25% charge and income thereafter at marginal rate tax.

Factor in any protections held

4. Calculate the value of “paid up/deferred” benefits at retirement date with no further accrual or contributions

Considerations for Annual Allowance:

  • Where pension contributions cease or member opts out of active membership there will be no more annual allowance usage

  • Carry Forward (for standard or tapered AA clients) will build up potentially allowing savings restarting in future (although re-joining is unlikely to be an option with DB schemes)

Considerations for Lifetime Allowance:

  • Deferred pensions revaluation rates will be needed for DB schemes

  • Money purchase pots will require the anticipated investment return

  • There could still be an LTA charge.

  • Factor in any protections held

5. Identify the value of alternate arrangements

Considerations for both Annual Allowance: and Lifetime Allowance:

  • What benefits would be provided by investing the net cost elsewhere?

  • There may be other losses through stopping e.g. employer matching contribution, employer sponsored life cover

  • Will the employer remodel pension / remuneration package and what are the tax implications?

6. Add the value of “paid up/deferred” benefits to the value of any alternative arrangements at retirement date.

Considerations for Annual Allowance:

  • Will clients want an increased salary now instead of a pension contribution?

  • Alternate benefits could be accrued in another tax wrapper

  • There will still be at least £4,000 tapered annual allowance available (or £4,000 tapered annual allowance for DC savings if the MPAA is triggered) so no need to fully stop pension saving

Considerations for Lifetime Allowance:

  • Will clients want an increased salary now instead of a pension contribution?

  • Alternate benefits could be accrued in another tax wrapper

Most clients will be unlikely to work through this process themselves and even where they could there’s still the need for advice to help them make the right decision.

If the client believes that the benefits payable (Step 3 of the process) represent value for money then the tax charge (Step 2) may be worth it.

Lifetime Allowance

Case study 1 – Defined Contribution

The client is a 40% tax payer and has a level salary of £100,000. They are currently a member of their employer’s defined contribution pension scheme where the employer pays 6% of salary as standard and employee contributions are matched 1 for 1 up to 6%. They plan to retire in 5 years. The fund was valued at £900,000 on 6 April 2021. They are considering whether they should stay a member (and if so should they contribute or not) or opt out of the scheme.

  Opting Out

In Scheme

Employer Contributions Only

In Scheme

Employer & Employee Contribution (6%)

Scenario*

A

B

C

Protection

None

None

None

LTA in 5 years

£1,116,453

£1,116,453

£1,116,453

Starting Fund at 6 April 2021

£900,000

£900,000

£900,000

Member cost

£0

£0

£18,000**

Fund at vesting

£1,148,652

£1,183,464

£1,253,086

LTA excess

£32,199

£67,011

£136,633

LTA charge

£17,709

£36,856

£75,148

LTA excess lump sum

£14,490

£30,155

£61,485

Pension fund remaining after LTA excess paid out

£1,116,453

£1,116,453

£1,116,453

*Assumptions: payments annually in advances, investment growth 5% net, the LTA has remained static at £1,073,100 until 6 April 2026 and 2% CPI applied any LTA excess taken as lump sum at 55% tax.

** 6% of £100,000 less 40% tax relief for 5 years

B is higher than A at “no cost” to the individual, whilst the funds after LTA tax are the same, the member has £15,665 more after LTA excess lump sum charges. But this is only half the process. Step 5 is key. If the employer is willing to provide an alternate benefit e.g. a higher salary now, the client may value that more than the difference between A and B e.g. a higher salary, so the decision may change.

In this example the values for A, B&C work out the same if taking a lump sum, but as an example if benefits were designated to income there would be a £52,217 greater pot after LTA charges if comparing B to C to provide income.

Essentially you have to assess if higher benefits are worth the cost? Could an alternative strategy return something more valuable with the same outlay?

Case study 2 – Defined Contribution

The logic behind case study 2 is exactly the same as the first, but the important fund value is the value as at 5 April 2016. Why is this date important? This individual could still apply for IP16. They can’t apply for FP16 as there have been contributions since 5 April 2016. Does the starting value of the fund make a difference?

  Opting Out

In Scheme

Employer Contributions Only

In Scheme

Employer & Employee Contribution (6%)

Scenario*

A

B

C

Protection

IP16

IP16

IP16

LTA in 6 years***

£1,200,000

£1,200,000

£1,200,000

Starting Fund at 5 April 2016

£1,200,000

£1,200,000

£1,200,000

Member cost

£0

£0

£21,600***

Fund at vesting

£1,608,113

£1,650,965

£1,736,669

LTA excess

£408,113

£450,965

£536,669

LTA charge

£224,462

£248,030

£295,167

LTA excess lump sum

£183,651

£202,935

£241,502

Pension fund remaining after LTA tax

£1,200,000

£1,200,000

£1,200,000

*Assumptions:  future standard LTA has not increased 

** Based on a 2.0% increase in the standard LTA from 2026/27  Individual Protected LTA will still apply.

*** 6% of £100,000 less 40% tax relief for 6 years

The same principle applies at higher starting points. But has pension freedom changed the dynamic?

If A, B and C are compared then in A the lump sum could be 25% of £1.2 million (£300,000) plus £183,651 LTA excess lump sum which is £483,651 with a remaining fund of £900,000 (total £1,383,651). Using the same theory, in B the total lump sum could be £502,935, with a remaining fund of £900,000 (total £1,402,935). In C the total lump sum could be £541,502 with a remaining fund of £900,000 (total £1,441,502).

Would the client value a higher lump sum and lower fund over a higher overall wealth? Could alternative remuneration arrangements create a higher return?  But would a client prefer pension, perhaps due to IHT issues?

C “beats” A, is equivalent to B in fund size but the lump sum after tax is higher – could the client do something better with an alternative non pension approach?

Prior to pension freedom, based on the options then available, a member may have preferred a higher LTA excess lump sum and a lower pension fund rather than  annuitising or entering drawdown with the relatively poor death benefits.

Pension freedoms have changed this dynamic. The ability to withdraw up to 100% of the pension pot could mean that the higher pension pot may be turned into a higher overall amount outside the pension.

Case study 3 - Benefits already crystallised

LTA planning may not be over at the time of taking benefits if Drawdown is used, as the growth in a drawdown pot is tested at the next BCE. In this case study we will assume that a member who is now 66 took their DB pension and PCLS 6 years ago, using 50% of the LTA (£18,750 income and PCLS of £125,000). They also took £100k PCLS from their money purchase pot and placed £300k into drawdown. No income was needed from the drawdown pot (using 40% of the LTA). This drawdown pot has grown to £402,028 since the original designation. 

The members state pension of £6,500 is about to come into payment and the DB income has increased to £25,126. This level of income (£31,626) will be sufficient for the client, and as further information they do have an IHT issue. 

Now the member is concerned about the drawdown growth and wants to mitigate any LTA charge to preserve the benefits in the pension being passed onto his loved ones. 

There are a number of strategies that could be implemented here, but we will show what happens if no income is taken, and if income is taken to mitigate any LTA excess at age 75. A drawdown pot is tested again at age 75 and if there is any growth in that arrangement, this is further tested against the LTA. 

 

Option A

Take no income

Option B

Take £17,519 per annum

Pension at age 75

£623,671

£420,838

Growth Tested at 75

£323,671

£0

LTA at age 75 (2% indexation)

£1,208,484

£1,208,484

LTA Left for member

£120,848

£120,838

LTA excess

£202,823

£0

LTA excess Charge

£50,705

£0

Gross Income Taken

£0

£157,671

Tax Paid on income (20%)

£0

£31,534

Net Income (20%)

 

£126,137

Remaining in pension

£572,966

£420,838

Whilst option B meets the objective to remove LTA charges (there is £10 of LTA left), does this meet the clients other objective of leaving as much as possible to loved ones? 

There is a net income taken of £126,137, but this may not all be at 20%, as the total gross income for the client in year one would be £49,145. Could the indexation of the DB and State income push some of this into higher rate? And does taking income at 40% make sense to avoid a LTA charge of 25%?

Option A will leave the greatest pot of money, despite the LTA charge being applied. As it’s 25% of the growth in excess of the remaining LTA that is lost, by definition 75% of that growth remains in the pension. 

This situation for the client is even more complex as there is a IHT issue. So if that income remains in the estate then the net benefit for the beneficiaries after IHT reduces to £75,682 (60% of the net income taken at 20%). The client could make use of allowances and exemptions to remove this from the estate. But this would all need to be considered in the round. 

Case study 4 – Defined Benefit

In this case study the client is a member of a 1/60th Defined Benefit scheme. They have a pensionable salary of £168,924, has 32 years service at 6 April 2022, retires in 5 years at Normal Retirement Age of 65. Pay rises of 2% per annum are assumed, deferred pension revalues at 2.5% per annum and commutation factor for LTA excess is 20:1. As at 5 April 2016 his salary was £150,000 and he had 26 years’ service. He applied for IP16 and was capped at the maximum of £1.25m. 

Scenario* A B

 

Opting out and deferring

Stays in scheme to NRD

Pension at 6 April 2022

£90,093

£90,093

Protection held

IP16

IP16

LTA in 5 years**

£1,250,000

£1,250,000

Pension in 5 years

£101,932

£115,013

Member cost

£0

£31,647***

LTA used in 5 years

£2,038,640

£2,300,260

LTA excess

£788,640

£1,050,260

LTA charge

£197,160

£262,565

Reduction in pension

£9,858

£13,128

Gross pension after LTA tax

£92,074

£101,885

*Assumptions:  future standard LTA has not increased , LTA excess taken from income using a factor of 20:1

** Based on a 2.0% increase to the standard LTA from 2026/27 Individual Protected LTA will still apply. 

*** 6% of increasing salary less 40% tax relief for 6 years. Personal allowance tax trap ignored (this would lower the net cost).

In essence, the same thought process applies where defined benefits are involved. Clearly, in the DB world pension freedom isn’t a factor.

There’s a “twist” though – the added consideration of the inherent value in a defined benefit pension arrangement and the likelihood of being able to replace any reduction in benefit.

B is higher than A even though it’s post tax – can £31,647 be invested, with or without a remodelled employment package to produce something more valued than the increase in pension of £9,811 per annum guaranteed for life?

Annual Allowance Case study

For annual allowance it is the same thought process but different calculations.

In this case study the client is 45% taxpayer with a salary of £315,000 (as such AA has been tapered to £4,000) and has no carry forward available.

The comparison made below is: 

  • a member of a DB 1/60th scheme, with employee contribution of 6% where the scheme pays the AA charge (based on commutation factor of 20:1).

  • a member of a DC scheme where employer pays 6% of salary as standard, employee contributions are matched 1 for 1 up to 6%. Scheme pays AA charge
  Defined Benefit Defined Contribution

Pension accrued

£5,250 p.a.

£56,700

AA used

£84,000

£56,700

AA excess

£80,000

£52,700

AA charge

£36,000

£23,715

Benefit reduction

£1,800 p.a.

£23,715

Post AA charge benefit

£3,450 p.a.

£32,985

Net cost

£10,395

£10,395

*Assumptions:  inflation ignored 

Therefore, the client of the DB scheme pays £10,395 net to generate an additional pension of £3,450 per annum and the member of the DC scheme generates an additional fund of £32,985 at the same net cost.

The calculations and value judgement to be made is perhaps easier where Annual Allowance is an “issue” – would a client pay £x to get £y.

If annual allowance and lifetime allowance are both an issue then the process is the same but the calculations are trickier.

Summary

Whether it’s DC, DB, Annual Allowance or Lifetime Allowance or a mixture the thought process should be broadly the same. Maths ability may be just as important as pension knowledge.

Alternative tax efficient strategies that may be suitable could involve vesting to drawdown and recycling income efficiently (but bearing in mind any potential reduction in the MPAA) or paying into others pensions, EIS, VCT, OEICs, Bonds or ISA?

The key point that clients need to remember is that tax is only bad if the net benefit is not deemed “worth it”. Opting out to save a tax charge, even if the net benefit is better, would be a bit like a client asking their employer to stop paying their salary because there is a tax charge.

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