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HMRC internal manual

Pensions Tax Manual

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Annual allowance: tax charge: scheme pays: adjustment to member’s benefits

Glossary PTM000001
   

 

Just and reasonable adjustment
Effect on death benefits and dependants’ benefits
Timing of the adjustment
‘Negative DC Accounts’ 
Member dies between asking the scheme to pay and the scheme actually paying

Section 237E Finance Act 2004

The Registered Pension Schemes (Modification of Scheme Rules) Regulations 2011 - SI 2011/1791

Where a scheme pays the member’s annual allowance charge, then the member’s entitlement to benefits under the pension scheme must then be reduced by a corresponding amount.

The guidance on this page, except where specifically noted otherwise, applies whether the adjustment is made to benefits because the member has elected to require the scheme to pay an amount of annual allowance charge or where the scheme is paying an amount of annual allowance charge on a voluntary basis.

PTM056410 has more details about when a member can elect to require a scheme to pay an amount of annual allowance charge, or ‘scheme pays’, and when a scheme might decide to pay an amount of annual allowance charge on a voluntary basis.

The form of this adjustment will depend on the type of arrangement in which the adjustment is being made.

Where the adjustment is being made in an other money purchase arrangement, the adjustment will reduce the overall amount of the fund from which the member’s benefits will be provided. Where the adjustment is being made in a defined benefits (or cash balance) arrangement, the adjustment will be to the benefits that the member has accrued under the arrangement. For a hybrid arrangement the different natures of the arrangement types underlying the hybrid arrangement would have to be considered in order to come to an appropriate adjustment that applies however the benefit emerges from the hybrid arrangement.

Note that the annual allowance charge might arise from benefits in one arrangement under the pension scheme but the reduction is applied to benefits in a different arrangement (and possibly an arrangement of a different type) under the scheme.

Provided the adjustment to benefits complies with the tax law requirement (see next section Just and reasonable adjustment), the adjustment to the member’s benefits where a scheme pays the member’s annual allowance charge will be allowed under DWP regulations which provide an exemption from the inalienability and forfeiture provisions in the Pension Act 1995. In addition, where a pension scheme has a specific rule that means that the member’s benefits cannot be reduced in this way, HMRC regulations nevertheless allow a scheme to make the consequential reduction to benefits without having to modify their scheme rules.

Just and reasonable adjustment

The scheme must make sure that the adjustment made to the member’s entitlement to benefits is just and reasonable, having regard to normal actuarial practice. HMRC would expect a scheme to be able to demonstrate that the adjustment made was just and reasonable.

Where the adjustment is not just and reasonable (or no adjustment is made at all) the payment of the annual allowance charge on behalf of the member by the pension scheme would be an unauthorised member payment. PTM131000 has details about the taxation of unauthorised member payments.

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Effect on death benefits and dependants’ benefits

When a scheme pays the member’s annual allowance charge a ‘just and reasonable’ adjustment must be made to the entitlement of the member to benefits under that scheme.

For example, such an adjustment might be designed to be made solely to the member’s own pension that will become payable on retirement or the adjustment could apply both to the member’s own pension and to the amount of pension death benefits that would be paid under the member’s arrangement on the member’s future death. However, it is not possible to apply a reduction to such contingent dependants’ benefits or other death benefits alone to pay the member’s annual allowance charge.

Where the reduction is being made in an other money purchase arrangement, the reduction in the fund value could have an effect on the amount of benefits that could be paid from the scheme on the member’s death.

In the case of defined benefits arrangements when there is an attaching contingent dependant’s pension payable on the death of the member the value of that dependant’s pension might (during the time that it is still just a contingency) be considered as part of the overall value of the member’s entitlement to benefits. Typically the dependant’s pension might be a percentage of the amount of pension that the member was receiving (or would have received if the member had reached retirement) at the time of their death.

For example, suppose the member’s pension that will become payable on retirement before any reduction to take account of the tax paid on behalf of that member is £10,000 per annum and the surviving spouse, if any, on death of the member before or after retirement, would receive a pension of £5,000 per annum (50 per cent of the member’s pension).

An example of a ‘just and reasonable’ adjustment might be (depending on the actuarial assessment of the figures) where the reduction to take account of the tax paid is one of the following:

  • solely the member’s pension payable on retirement is reduced to £8,750 per annum with the contingent surviving spouse pension remaining £5,000 per annum, or
  • the member’s pension payable on retirement is reduced to £9,000 per annum and the contingent surviving spouse pension is reduced to £4,500 per annum.

In the first case, the value of the reduction in the member’s pension payable on retirement is taken into account when judging whether (using normal actuarial practice) the reduction is just and reasonable compared to the tax paid. In the second case, the value of the reductions in both the member’s pension payable on retirement and pension payable to the spouse (contingent on death of the member) are together taken into account when judging whether the reductions justly and reasonably match the tax paid.

It would not be possible to agree a reduction to a lump sum that might otherwise be payable on the member’s future death.

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Timing of the adjustment

Other than the requirement for there to be a just and reasonable adjustment to the member’s entitlement to benefits, the tax rules in relation to annual allowance charge payments where the member has elected to require the scheme to pay (‘scheme pays’) do not place a requirement on when the adjustment must be made relative to when the tax has been paid. It might be decided by the scheme administrator to make the adjustment before the tax is actually paid over to HMRC by the scheme administrator, at the same time as the tax is paid or after the tax is paid. (Note that there may be a timing requirement related to other issues which might limit the timing of the adjustment - for example it might only be possible to make the adjustment at the time the tax is paid.

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‘Negative DC Accounts’

An example of where an adjustment might be made at a future date, such as at retirement, is where the pension scheme operates a ‘negative DC account’.

Typically this will happen when an adjustment has to be made to a member’s defined benefits. The amount of annual allowance charge paid by the scheme administrator on behalf of the member is recorded in a ‘notional negative DC account’ (i.e. no actual money is placed in any actual account). The amount in the notional account is then increased at an agreed roll-up rate from the date the pension scheme pays the annual allowance charge to a pre-defined set of future events, such as when benefits under the scheme fall due to the member or the member requests a transfer-out or the member’s death. The roll-up rate might, for example, be a set interest rate (such as the Bank of England base rate plus a fixed margin) or based on investment returns (such as the investment return on pension scheme assets or the return on a particular index) and the scheme administrator may have the right to change the chosen benchmark at some time in the future if conditions change.

When, for example, the member’s defined benefits become due for payment the amount standing in the notional negative DC account at that time is converted into an equivalent amount of benefit and the member’s defined benefit is then reduced by that benefit equivalent. Conversion will have to be on appropriate terms to satisfy the requirement that (allowing for this and the roll-up) the adjustment is “just and reasonable having regard to normal actuarial practice” - for example if the conversion is to pension it may be that the terms are pre-agreed to match the terms of some other conversion under the scheme rules.

As the notional negative DC account might not impact the defined benefits until a future event occurs, when applying the valuation assumptions (see PTM053600), the calculation of the pension input amount for the pension input period in which the negative DC account is set up, and in subsequent pension input periods, ignores the fact that the negative DC account has been set up as a result of an amount of annual allowance charge being paid by the scheme administrator - i.e. it is the same number work for the pension input amount calculation as if scheme pays had not been used. This is the case even though one of the future events where the negative DC account may impact on the defined benefits is the member retiring and becoming entitled to benefits.

In the pension input period in which the member’s entitlement to benefits is eventually adjusted it is likely that the number work for the pension input amount will “ignore” the adjustment. Where a scheme pays benefit reduction is made, it is normally “added back” to the calculation (in effect the adjustment is disregarded - see PTM053300). There is an exception to this where a scheme pays adjustment is made in the same tax year as that in which the member crystallises all the benefits under a scheme (see PTM053740). However, this exception would not apply where (as is likely to be the case here) the annual allowance charge to which the reduction relates arises in a different tax year (or years) to that in which the benefits under the scheme are all crystallised.

Example

John is an active member of a defined benefits arrangement. Pension benefits under the arrangement accrue at a rate of 1/45 x pensionable salary x pensionable service with an option to commute some pension at retirement for a lump sum.

John uses scheme pays in relation to an annual allowance charge and the scheme administrator pays an amount of annual allowance tax charge for him in respect of the 2013/14 tax year of £4,500. The scheme administrator decides to pay the amount to HMRC on 31 July 2014.

A ‘notional negative DC account’ of £4,500 is established on 31 July 2014 for John, and is increased by a roll-up rate, such as a set interest rate.

John continues as an active member of the defined benefits arrangement, accruing further pension. His annual allowance pension input calculations for the defined benefits arrangement prior to drawing pension are based on his accrued pension ignoring the ‘notional negative DC account’.

When he comes to draw pension, in 2018 when he reaches age 60, John has accrued a pension of £30,000 per annum. John’s notional negative DC account (including the roll-up amount) has increased to £5,400.

John’s benefit rights under the defined benefits arrangement are reduced as follows:

  • Level of John’s notional negative DC account at age 60 is £5,400
  • His pension entitlement prior to the scheme pays reduction is £30,000 per annum
  • The factor in this case (set by the scheme administrator in an appropriate manner to satisfy the ‘just and reasonable’ requirement) for converting the amount in the notional negative DC account into a pension equivalent is £1 per annum of pension to the member per £18 of the account amount at that time
  • The pension equivalent of the amount in the notional negative DC account is £300 per annum (£5,400/18)
  • John’s benefit entitlement is reduced by the benefit equivalent of the notional negative DC account amount
  • John’s reduced benefit entitlement after taking into account the reduction for scheme pays is: £29,700 per annum (£30,000pa - £300pa). His scope for drawing pension commencement lump sum by way of commutation of pension is calculated taking into account reductions to his pension put in place before the pension entitlement commences (so here would be expected to be based on the reduced pension of £29,700)
  • John’s pension input calculation for the final pension input period is by reference to the pension entitlement adjusted to add back the scheme pays reduction, so by reference to a pension of £30,000 per annum.

It may be that the negative DC account is set up on the basis that, if the member leaves service before normal retirement date with entitlement to deferred pension due from normal retirement date, the leaving service is itself a trigger for the reduction in benefits. At that point the then balance of the notional negative DC account would be converted into a “determined” reduction in deferred pension rights, and the reduction made. The notional negative DC account would cease to exist. Thereafter the member’s benefit management would be the same as for any other deferred pensioner.

The analysis for pension input purposes would be the same as above - the calculation of pension input amount for the pension input period in which the negative DC account is set up, and in subsequent pension input periods, can ignore the fact that the negative DC account has been set up as a result of an amount of annual allowance charge being paid by the scheme administrator - i.e. it is the same number work for the pension input amount calculation as if scheme pays had not been used. In the pension input period where the member leaves service, the reduction to reflect the negative DC account balance will be “added back” to the calculation (in effect the adjustment is disregarded - see PTM053300). In subsequent pension input periods, any pension input amount calculations would reflect the deferred pension as reduced (but it may be that the deferred member carve-out applies, in which case the pension input amount would be nil for the pension input period(s) concerned).

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Member dies between asking the scheme to pay and the scheme actually paying

This depends on whether the pension scheme is able to make an adjustment to the member’s benefits.

If the pension scheme is able to make the adjustment to the member’s benefits before they died, even though the scheme had not yet paid over any tax to HMRC, the scheme can continue to pay as the member gave notice to their scheme before their death.

If the scheme is not able to make the adjustment to the member’s benefits it might not be possible for the scheme to continue with the member’s request. This is because the tax rules require that an adjustment must be made to the member’s benefit entitlement when the scheme pays an amount of annual allowance charge on their behalf. If it is impossible for the pension scheme to meet this requirement it can ask HMRC to be discharged from the requirement to pay the amount of tax the member asked it to pay before their death.

The member’s estate would then have to account for the full amount of the annual allowance charge liability that the member had before their death.