The lifetime allowance and annual allowance are limits on the amounts which can be saved into UK private pension schemes without paying additional tax. These limits have either been frozen or cut over recent years, which potentially means more workers in the education system could be paying pensions tax.
The ability to ‘carry forward’ three years’ worth of unused allowances should mean that the vast majority of those in active service should still avoid a tax charge. However, the freezing of the annual allowance amount in particular means that more people could be drawn into tax in the years ahead.
The lifetime allowance is a limit on the amount of pension benefit that can be drawn from pension schemes – whether lump sums or retirement income – which can be paid without triggering an extra tax charge.
The lifetime allowance is £1,055,000 for 2019-20. Previously it was much higher, reaching £1.8 million in 2010-11. However, legislation now means the lifetime allowance is indexed annually to Consumer Prices Index (CPI) inflation. The level of the lifetime allowance is still high enough that it will not affect many teachers.
In order to work out whether you have exceeded the lifetime allowance, the value of your pension rights has to be tested against it.
For members of defined benefit pension schemes (like the Teachers’ Pension Scheme and Local Government Pension Scheme), the value of your pension rights is calculated as 20 times the pension that you have accrued under the scheme, plus any tax-free cash that you received (if you have been drawing income since before 6 April 2006, this income payment is valued by multiplying by 25). So, in 2019-20 people with defined benefit pension rights of less than £52,750 will not breach the lifetime allowance.
A ‘lifetime allowance charge’ is payable if the value of the benefits being crystallised exceeds the value of any lifetime allowance available. The rate is 25 per cent if the amount withdrawn is taken as income (such as through an annuity or income drawdown) or 55 per cent if it is taken as a cash lump sum.
When the lifetime allowance was introduced in 2006, and in subsequent years when it has been reduced following pension reforms, those with benefits valued in excess of the lifetime allowance have been able to apply for ‘protection’ to protect the value of benefits they have built up (and future benefits that may accrue) from tax charges.
The lifetime allowance is an extremely complex area and members must seek independent financial advice. The NEU will not give individual advice on the lifetime allowance. Members seeking financial advice should contact Lighthouse Financial Advice, an NEU-approved partner, for a complimentary, no obligation initial consultation on freephone 0800 085 8590 or visit: lighthousegroup.plc.uk
The annual allowance is a limit to the total amount of contributions that can be paid to defined contribution pension schemes and the total amount of benefits that you can build up in defined benefit pension schemes (including the Teachers’ Pension Scheme and Local Government Pension Scheme each year) for tax relief purposes.
The level of the annual allowance has been £40,000 a year since April 2014 and there are no signs that the government intends to increase it. This has meant over time that more teachers have potentially become subject to the annual allowance.
Calculating the increase in value of career average pension rights is complex. The Government use a ‘flat-factor’ method, with a factor of 16. This means that an increase in a person’s annual pension of £1,000 is deemed to be worth £16,000.
For a member in the Normal Pension Age (NPA) 65 scheme, an increase in annual pension of above £2,500 would exceed the £40,000 threshold. For members in the NPA 60 scheme, the automatic accrual of a lump sum again has to be accounted for, which means an increase in pension of £2,105 will exceed the threshold.
The £40,000 annual allowance level can easily catch teachers who get significant pay rises in mid or late career when they have sizeable final salary service. If a member gets a large pay rise in a final salary pension scheme, the pay rise increases the total value of their pension rights.
Fortunately, members who exceed the annual allowance figure can carry forward any unused annual allowance from the previous three tax years. This should mean that most affected members face no tax bill.
Career average and final salary
The way pensions are worked out will have an impact on whether the annual allowance limit is triggered. Most teachers have both ‘final salary’ and ‘career average’ service in the Teachers’ Pension Scheme.
A final salary scheme bases pensions on years of service and pensionable earnings at or near retirement. An increase in salary in late career will therefore increase the value of the whole of an individual’s pension rights.
Career average pensions generally treat each year of accrual as a separate unit – so what you get depends on earnings in that year. A subsequent pay rise should have no impact on previous years’ accrual. This means career average pensions are less likely to trigger annual allowance problems than final salary pensions.
But even if a teacher is currently a member of the career average scheme, any pay rise received will increase the value of their final salary pension rights – because final salary is based on when they leave teaching, not their salary when they switched into the career average scheme.
The more years of final salary service a teacher has, the more likely it is that a significant pay rise will trigger annual allowance issues, even if the teacher is not currently a member of a final salary scheme.
Money purchase annual allowance
If you start taking money from a defined contribution pension scheme, the amount you can pay into a pension and still get tax relief may reduce. The Money Purchase Annual Allowance (MPAA) is currently £4,000. The MPAA only applies to contributions to defined contribution pensions and not defined benefit pension schemes.
Scheme pays is a process that allows an individual to pay an annual allowance charge from their pension scheme. Broadly, where a member’s annual allowance charge is at least £2,000, schemes can be required to pay some or all of the charge, but must make a corresponding reduction in the member’s pension benefits. In other cases, schemes may agree to pay the annual allowance charge on a voluntary basis.
The annual allowance is an extremely complex area and members must seek independent financial advice. The NEU will not give individual advice on the annual allowance. Members seeking financial advice should contact Lighthouse Financial Advice (as advised on page 1 above).
In some cases the employer can grant ‘premature retirement’ in the Teachers’ Pension Scheme because of redundancy or for efficiency reasons. In this case the member’s pension is granted without any actuarial reduction for early payment. In the Local Government Pension Scheme, an unreduced pension must be granted if the member is made redundant or leaves for business efficiency reasons at age 55 or above.
There is no exemption from the annual allowance for redundancy. This has not proved to be a problem in practice. Use of the flat factor method means that a pension taken at an earlier age is not deemed to be of extra value. So, a premature retirement that grants existing pension rights without actuarial reduction for early payment does not count against the annual allowance. Giving extra years would count against the annual allowance.
Ill health retirement
There is no blanket exemption from the annual allowance rules in cases of ill health. However, HM Revenue & Customs (HMRC) allow an exemption if their definition of ‘severe ill health’ is met. The NEU’s understanding is that the total incapacity definition in the Teachers’ Pension Scheme meets the ‘severe ill health’ definition. Therefore, the additional service credited is exempt from the annual allowance calculation.
Members who receive a partial incapacity award will not be affected by the changes to the annual allowance. Partial incapacity benefit adds no additional service to the member’s pension and, as with premature retirement, the early payment of pension is not relevant for annual allowance purposes.