Wealthy pension savers who have used “fixed protection” arrangements to shelter their pension pots run the risk of being hit with six-figure tax bills due to a “ludicrous” quirk in rules designed to make the pensions system fairer.
Following a landmark High Court ruling last year, millions of people with final-salary pensions were set to be compensated when rules that allowed men and women’s defined benefit pensions to rise at different rates were branded discriminatory.
However, efforts to pay compensation are now at a standstill over fears the payouts could land some pension holders with six-figure tax bills.
The problem centres on payouts for people with larger pensions who took action to protect their retirement funds from successive cuts to the lifetime allowance, which governs how big a pension can grow before tax charges apply.
The compensation payouts risk invalidating “fixed protection” arrangements on those with retirement funds worth more than £1m, which could land savers with hefty tax charges of up to 55 per cent of savings in breach of limits.
Pensions experts have told the Financial Times that some individuals who receive a boost to their annual pension of only a few pounds a year could be landed with tax bills of tens or hundreds of thousands of pounds for breaching fixed protection rules.
“This is clearly a ludicrous situation,” said Bob Scott, partner with Lane Clark & Peacock, the actuarial consultants.
“The very real prospect is that someone getting a very small uplift in benefits, even a couple of pounds a year, could get slugged with tax charges.”
Pensions professionals have been urging the UK tax authorities to clarify exactly how the payouts — known as GMP equalisation — will be treated in the context of fixed protection rules.
Fixed protection arrangements were first offered in 2012, enabling individuals to crystallise their pension fund at a certain level so long as they stopped saving or building any further benefits in a defined benefit plan. Following successive cuts to the lifetime allowance, this has enabled many wealthy savers to amass pension pots worth several million pounds.
However, if the compensation payments are in breach of the rules, individuals risk losing their protection and seeing their lifetime allowance crash down to the current level of £1.05m.
“If this were to be the case, the member could be taxed not just on the small amount of extra pension from GMP equalisation but on the full value of their pension above the current lifetime allowance,” said Matt Davis, head of GMP Equalisation with Hymans, the actuarial consultants.
Based on an example provided by Hymans, an individual who had fixed protection of £1.8m could, in the worst-case scenario, be landed with a £400,000 tax bill for a payout that boosted their pension by only a few pounds a year.
“The industry hopes that HMRC will provide a pragmatic solution to this issue soon,” Mr Davis added. “It would be unreasonable for changes to pensions built up in the 1990s, based on the legislation and tax position at the time, to lead to severe tax charges now.”
In response, HMRC said it was “carefully considering” the pension tax issues in respect of equalisation of GMP benefits.
Industry experts say thousands of high earners across the public and private sectors could hold fixed protection and potentially be in line for an equalisation payout.
HMRC does not publish data on the number of individuals who have been granted fixed protection since it first became available in 2012, when the lifetime allowance fell from £1.8m to £1.5m. Fixed protection was made available again in 2014, when the LTA fell from £1.5m to £1.25m and again in 2016, when it reduced from £1.25m to £1m.
Tom Yorath, partner with Aon, an actuarial firm, said he was aware of around 100 pension schemes that had frozen compensation payouts until the issue was settled by HMRC.
“This is potentially a serious problem,” said Mr Yorath.
“Nobody wants to write to a member to say they have lost their tax protection. It is critical that HMRC issue guidance on how the extra benefits [from compensation] will be treated for fixed protection purposes.
“We want our customers to have the information they need, so will give more guidance on this through the pension schemes newsletter as soon as we can.”