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HMRC internal manual

Pensions Tax Manual

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HM Revenue & Customs
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Member benefits: pensions: scheme pensions: paying a scheme pension

 

Glossary PTM000001
   

 

Securing a scheme pension liability with an insurance company under a defined benefits arrangement
Payment of a pension commencement lump sum in connection with a scheme pension
A scheme pension must be paid for life and cannot be reduced (except in specific, excepted circumstances)
What is a relevant 12-month period and how to establish whether there has been a reduction in the rate payable
Increasing the rate of scheme pension paid year-on-year
Guaranteeing a scheme pension
Taxation of a scheme pension
Benefits that may be paid where a member in receipt of a scheme pension dies
Transfer of a scheme pension

Securing a scheme pension liability with an insurance company under a defined benefits arrangement

Paragraph 2(2) Schedule 28 Finance Act 2004

Paragraph 11(2) and (3) Schedule 10 Finance Act 2005

Members with defined benefits arrangements must receive their pension in the form of a scheme pension. A scheme pension must be paid for the life of the member. For some schemes, particularly those with relatively few members, it might not be practical for them to guarantee to pay a certain level of pension for life direct from the scheme on an ongoing basis, so the tax rules allow for a scheme of any size to secure its liability to that pension with an insurance company of its choice. They can do this before, when or after that entitlement actually arises.

If the scheme does decide to hand over their liability to pay the member’s pension to an insurance company by purchasing a policy in the name of the member the insurance company must provide a pension in the form of a scheme pension to the member and not a lifetime annuity.

Alternatively a scheme can purchase an annuity in the name of the scheme trustees and use it as an investment to fund the scheme pension. In these circumstances the scheme administrator retains the liability to pay the scheme pension, even where such a policy requires the insurer to act as the scheme’s agent paying pensions directly to the member.

Conditions imposed on the annuity contract

Section 161(3) and (4) Finance Act 2004

Where a scheme pension is secured through an insurance company then any payments made under the terms of that contract with the insurance company are, for the purposes of the authorised payment rules, treated as if made by the registered pension scheme that purchased the annuity even if the scheme has subsequently been wound up. The pension scheme administrator cannot hand over their liability in this regard, irrespective of how any insurance policy is arranged. For this reason the policy contract must only provide benefits that are authorised under the tax rules, namely providing a pension to the member that comes within the scheme pension rule and only providing benefits on the death of the member that come within the death benefit rules - see Benefits that may be paid where a member in receipt of a scheme pension dies.

Any other payment made by the insurance company is an unauthorised payment, and taxed as such - see PTM132000.

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Payment of a pension commencement lump sum in connection with a scheme pension

Paragraph 1, 2 and 3(6) to (8) Schedule 29 Finance Act 2004

When a member becomes entitled to a scheme pension, the scheme rules may also give the member the right to receive a lump sum.

If the lump sum payment falls within certain parameters, it may be paid tax-free. This is referred to as a pension commencement lump sum.

More information on pension commencement lump sums can be found at PTM063200

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A scheme pension must be paid for life and cannot be reduced (except in specific, excepted circumstances)

Paragraphs 2(3)(b) and (4) Schedule 28 Finance Act 2004

Paragraphs 11(4) to (7) Schedule 10 Finance Act 2005

Scheme pensions are intended to provide a stable and predictable source of pension income for the life of the recipient. Once a member becomes entitled to a scheme pension under an arrangement, that pension must be paid for the lifetime of that individual and at least annually. And except in specifically defined circumstances, the annual rate of scheme pension payable to a member under the arrangement cannot be stopped or reduced year-on-year (in what the legislation refers to as a ‘relevant 12-month period’) once pension payments start and entitlement is actual rather than prospective.

The heading below explains what is meant by ‘relevant 12-month period’ and how to measure whether there has been a reduction in the rate payable.

The specific circumstances where the rate of scheme pension payable can be reduced are described at PTM062340. Note the guidance on that page relating to ‘abatement of a scheme pension in a public service pension’, as there are certain circumstances where pension instalments payable to the member may be re-directed or withheld without constituting a reduction in pension entitlement under the legislation. That page also explains the tax consequences where a scheme pension is reduced in other circumstances.

If a scheme pension entitlement could be reduced without restriction it would be possible for the pension commencement lump sum rules to be abused (as the limit on the amount paid is based on the crystallised value of the initial scheme pension level).

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What is a relevant 12-month period and how to establish whether there has been a reduction in the rate payable

Paragraph 2(3)(a), (3A) and (7) Schedule 28 Finance Act 2004

Paragraph 11(4) and (5) Schedule 10 Finance Act 2005

A relevant 12-month period is any 12-month period that begins on or after the first anniversary of the date the entitlement to the scheme pension actually arose.

The point of reference for considering whether the rate of pension paid in a relevant 12-month period has been reduced is:

  • the rate of pension the member was entitled to immediately before the beginning of relevant 12-month period, or
  • if it is the first such period in which that pension is being paid, the rate of pension that the member became entitled to at the point entitlement first arose.

This is referred to as the ‘relevant time’ in the legislation.

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Increasing the rate of scheme pension paid year-on-year

A scheme pension can be increased year-on-year as the scheme’s rules provide.

Where this increase rises above a defined cost-of-living margin, a further lifetime allowance test may be triggered, with the excess annual increase over that margin crystallising for lifetime allowance purposes through benefit crystallisation event 3 (see PTM088630).

A scheme can also allow a member to take their scheme pension entitlement in stages, over a period of time.

Guaranteeing a scheme pension

Section 165(1) ‘Pension rule 2’ and paragraphs 2(3)(a) and (6) Schedule 28 Finance Act 2004

A scheme pension may be guaranteed for a term certain of no more than ten years. So if the member dies before that term has ended the scheme pension will continue to be paid until the end of the guarantee period, but to another person. These guaranteed payments cannot be commuted and paid as a lump sum.

The ten-year maximum term-certain period runs from the date the member first becomes entitled to the scheme pension.

A scheme pension entitlement may be guaranteed for up to ten years even if earlier pension entitlements under the arrangement were similarly provided with a guarantee. For example, if a scheme pension is provided under a money purchase arrangement, there may have been earlier guarantees under a short-term annuity contract, or attached to a drawdown pension (up to 6 April 2011 called alternatively secured pension) entitlement.

The scheme rules may provide that any term-certain entitlement ends on the recipient of the continuing pension payments:

  • marrying
  • reaching the age of 18, or
  • ceasing to be in full-time education.

See below for the taxation of those continuing term-certain payments.

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Taxation of a scheme pension

Paragraph 6 Schedule 31 Finance Act 2004

Section 579A to 579D chapter 5A Income Tax (Earnings and Pensions) Act 2003

A scheme pension is taxable as pension income on the recipient through PAYE.

The taxable pension income for a tax year is the full amount of the scheme pension under the registered pension scheme that accrues in that year, irrespective of when any amount is actually paid.

Where the member dies in receipt of a scheme pension, and scheme pension payments continue because of a term-certain guarantee, the recipient of the continued payments is taxed in exactly the same way as above.

Where the member is entitled to a scheme pension benefit under a defined benefits arrangement then, where that individual fails to draw their entitlements by age 75, those entitlements are tested for lifetime allowance purposes at that point (see PTM088200). However, those benefits do not have to come into payment at that point. Other than any lifetime allowance charge due, income tax will only become due when that pension entitlement is actually taken and pension income begins to accrue.

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Benefits that may be paid where a member in receipt of a scheme pension dies

Sections 165 and 167 and paragraph 2 Schedule 28 Finance Act 2004

Paragraphs 13, 14 and 16 Schedule 29 Finance Act 2004

A registered pension scheme is authorised to provide a number of benefits on the death of a member in receipt of a scheme pension entitlement. For more detail see PTM070000.

Transfer of a scheme pension

Section 169(1), (1A) and (1B) Finance Act 2004

Paragraphs 11(8) and 36 Schedule 10 Finance Act 2005

The Registered Pension Schemes (Transfer of Sums and Assets) Regulations 2006 - SI 2006/499

The transfer of an entitlement to a scheme pension in payment from a registered pension scheme will be an authorised payment (as a recognised transfer) provided certain conditions are met - see PTM100000 for more detail.