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Pensions Tax Manual

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Member benefits: pensions: scheme pensions: stopping or reducing a scheme pension

 

Glossary PTM000001
   

 

Circumstances where a scheme pension may be reduced or stopped
Where the member recovers from ill-health
Where a scheme-wide reduction is applied
Where the scheme pension is a bridging pension (member reached state pension age before 6 April 2016)
Where the scheme pension is a bridging pension (reductions made on or after 6 April 2016 and member reached state pension age on or after 6 April 2016)
Reducing a scheme pension while the scheme is being wound-up
Reducing a scheme pension due to forfeiture of entitlement
Abatement of a scheme pension in a public service pension scheme
Scheme administrator paying an amount of annual allowance charge
Circumstances where a scheme pension is not deemed to have been reduced or stopped
Consequences of reducing or stopping a scheme pension, other than in the excepted circumstances
The imposition of an additional unauthorised payments charge on the member following a substantial reduction of a scheme pension
The imposition of an additional unauthorised payments charge on the member where there are avoidance arrangements
An additional unauthorised payments charge can only be imposed once on an appropriate amount in relation to a single scheme pension entitlement
Example showing how the additional unauthorised payments charge is applied where a substantial reduction in the rate of scheme pension occurs in non-excepted circumstances

Circumstances where a scheme pension may be reduced or stopped

Paragraph 2(4) and (4A) Schedule 28 Finance Act 2004

The Pension Schemes (Reduction in Pension Rates) Regulations 2006 - SI 2006/138

The Registered Pension Schemes (Bridging Pensions) and Appointed Day Regulations 2016 - SI 2016/1005

Normally, a scheme pension must be payable for life at a rate not less than the initial rate.

But in specific circumstances set out in the legislation the annual rate of a scheme pension payable to a member may be reduced or stopped, without prejudicing that pension’s classification as a scheme pension.

The specific circumstances are those where:

  • a scheme pension paid on the grounds of ill-health stops or reduces ,
  • the reduction in the rate of scheme pension payable is being applied to all scheme pensions being paid under the scheme to or in respect of its members,
  • the scheme pension is a bridging pension that is being reduced or stopped at an age between age 60 and state retirement age (for tax years before 2013-14 the upper age limit was age 65) by an amount that does not exceed a figure calculated by reference to the state retirement pension at that time,
  • the scheme pension is being reduced while the scheme is being wound-up because there are insufficient sums and assets in the pension scheme to continue to pay the pension at the existing rate,
  • the rate of scheme pension payable is being reduced in consequence of a pension sharing order (see PTM029000),
  • the rate of scheme pension payable is being reduced due to forfeiture of entitlement, in a manner consistent with circumstances prescribed by regulations laid by HMRC,
  • the rate of scheme pension payable is being reduced in consequence of a court order,
  • a scheme pension payable under a public service pension scheme is reduced due to abatement, and
  • the rate of scheme pension payable to a member is being reduced on or after 6 April 2013 in consequence of the scheme administrator paying an amount of annual allowance charge in relation to the member.

Each of these situations is explained in more detail below. References to reduction of a scheme pension include circumstances where the pension is reduced entirely so that it ceases to be payable, whether temporarily or permanently.

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Where the member recovers from ill-health

Paragraph 2(4)(a) Schedule 28 Finance Act 2004

A scheme pension may be paid on ill-health grounds only where:

  • the scheme administrator has evidence from a registered medical practitioner that:

    • the person is unable to carry out their current occupation due to physical or mental impairment, and
    • the person will not be capable of returning to that occupation at a future date, and
  • as a result of the ill-health, the member actually ceases to carry out that occupation.

A scheme pension paid on ill-health grounds may be paid at any age. Any ill-health pensions which were already in payment on 5 April 2006 are treated as if they met these criteria and do not need to meet any additional tests.

Where an entitlement to a scheme pension arises on the basis of the individual’s ill-health, including those already in payment on 5 April 2006 the tax rules allow such a pension to be reduced or even stopped at any time. This allows for scheme rules to provide for a level of pension appropriate to the member’s capacity to carry out their occupation where for example the member subsequently recovers or partially recovers from ill-health. After such a change the scheme pension may later recommence or increase back to the earlier rate or to some intermediate amount. Whether the scheme’s provisions do this, and to what extent, whether it is automatic or dependent upon the administrator’s discretion, depends on the rules of the particular scheme concerned.

If a scheme pension paid on ill-health grounds is reduced in accordance with this rule and the reduction is part of what the legislation calls ‘avoidance arrangements’, the member will become liable to an additional unauthorised payments charge on a defined ‘appropriate amount’.

What the legislation means by ‘avoidance arrangements’ and the ‘appropriate amount’ are explained below at The imposition of an additional unauthorised payments charge on the member where there are avoidance arrangements.

For the avoidance of doubt, where the scheme pension is to return to its former level or re-commence the scheme rules may allow this without the member needing to meet the ill-health condition again.

PTM088620 explains how this re-commenced scheme pension is treated for lifetime allowance purposes.

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Where a scheme-wide reduction is applied

Paragraph 2(4)(b) Schedule 28 Finance Act 2004

A scheme pension can be reduced provided the reduction was applied to all the scheme pensions (not including dependants’ scheme pensions) currently being paid from the scheme.

This exception is intended to cover situations where, for example, the scheme has to reduce pensions payable to below the previous year’s level on the basis of actuarial advice.

This reduction may be applied on a pro-rata basis or a flat-rate basis.

But if a scheme pension is reduced in accordance with this rule, and the reduction is part of what the legislation calls ‘avoidance arrangements’, the member will become liable to an additional unauthorised payments charge on a defined ‘appropriate amount’.

What the legislation means by ‘avoidance arrangements’ and the ‘appropriate amount’ are explained below at The imposition of an additional unauthorised payments charge on the member where there are avoidance arrangements.

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Where the scheme pension is a bridging pension (member reached state pension age before 6 April 2016)

Section 279(1) and paragraph 2(4) and (4A) Schedule 28 Finance Act 2004

The Registered Pension Schemes (Bridging Pensions) Regulations 2007 - SI 2007/826

The Registered Pension Schemes (Bridging Pensions) and Appointed Day Regulations 2016 - SI 2016/1005

This guidance applies for individuals who reached state pensionable age on or before 5 April 2016.  (That is, men born on or before 5 April 1951 and women born on or before 5 April 1953).

Some schemes pay a higher scheme pension before state pension age, and then reduce at that age by an amount to reflect the state pension that the member receives. This type of pension is known as a bridging pension.

The reduction in the rate of the scheme pension must take effect during the “permitted period”. The permitted period runs from the day the member reaches age 60 and ends on the day the member reaches either age 65 or, if later, their pensionable age for the purpose of paying state pension.

The reduction (or the aggregate of the reductions where there has been more than one such reduction) during the permitted period must not be greater than the ‘relevant state retirement pension rate’ at that time. If the ‘relevant state retirement pension rate’ is greater than the level of scheme pension being paid, then the scheme pension may stop entirely.

The ‘relevant state retirement pension rate’ at any time is:

  • where an employment of the member is or has always been contracted-out employment by reference to the pension scheme, 125% of the rate of the basic state pension at that time
  • where an employment of the member has never been contracted-out by reference to the pension scheme, 250% of the rate of the basic state pension at that time
  • where the member has both contracted-in and contracted-out periods of employment by reference to the pension scheme, the rate as calculated by using the ‘prescribed percentage formula’ (see below).

The ‘prescribed percentage formula’

The prescribed percentage is the rate of the basic state pension that is found by using the following formula:

125 + (125 multiplied by A divided by B) where

A is the total number of years of a member’s employment to which the pension scheme relates which is not or has not been contracted-out employment, and

B is the total number of years of a member’s employment to which the pension scheme relates.

Fractions of a year may be used in this formula provided A and B are treated consistently.

A basic state pension is the basic pension specified in section 44 of the Social Security Contributions and Benefits Act 1992 (or section 44 of the Social Security Contributions and Benefits (Northern Ireland) Act 1992.

Example

Carlton becomes entitled to a scheme pension at age 55.

The whole period of his employment in relation to the scheme providing the pension was contracted-out.

His scheme pension commences to be paid at the rate of £10,000 per annum (index-linked).

Carlton’s state pension age is 65.

At age 65 the pension is then worth £13,000 and reduces to reflect that he becomes entitled to a state retirement pension. At this time the basic state pension is worth £4,000 per annum. Carlton’s scheme could therefore reduce his scheme pension by up to £5,000 (£4,000 x 125%) when he reaches age 65, with the reduced pension continuing to be index-linked as before.

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Where the scheme pension is a bridging pension (reductions made on or after 6 April 2016 and member reached state pension age on or after 6 April 2016) {#}

Section 279(1) and paragraph 2(4) and (4A) Schedule 28 Finance Act 2004

The Registered Pension Schemes (Bridging Pensions) and Appointed Day Regulations 2016 - SI 2016/1005

This guidance applies for reductions made to scheme pensions on or after 6 April 2016 for individuals who reached state pensionable age on or after 6 April 2016.  (That is, men born on or after 6 April 1951 and women born on or after 6 April 1953).

Some schemes pay a higher scheme pension before state pension age, and then reduce at that age by an amount to reflect the state pension that the member receives. This type of pension is known as a bridging pension.

The reduction in the rate of the scheme pension must take effect during the “permitted period”. The permitted period runs from the day the member reaches age 60 and ends on the day the member reaches either age 65 or, if later, their pensionable age for the purpose of paying state pension.

The reduction (or the aggregate of the reductions where there has been more than one such reduction) during the permitted period must not be greater than the ‘relevant state retirement pension rate’ at that time. If the ‘relevant state retirement pension rate’ is greater than the level of scheme pension being paid, then the scheme pension may stop entirely.

The ‘relevant state retirement pension rate’ at any time is 200% of the full rate of the state pension at that time, as described in section 3(1) of the Pensions Act 2014.

Example

Anthea becomes entitled to a scheme pension at age 55.  Anthea’s state pension age is 65.

She receives a scheme pension at the rate of £20,000 a year.

At age 65, her annual scheme pension is £25,000.  Under the scheme rules, it will be reduced at that time to reflect that she becomes entitled to a state retirement pension.

At that time, the full rate of the state pension is £8,500 a year. But Anthea is entitled to more because under previous state pension rules she would have been entitled to ‘additional state pension’ because she had not been contracted out of the state second pension.  Anthea receives a state pension of £10,500 a year.

Anthea’s scheme reduces her scheme pension by £10,000 a year when she reaches age 65.  The reduction is less than 200% of the full rate of the state pension (2 x £8,500 = £17,000).

The reduction in Anthea’s scheme pension falls within the circumstances where a reduction in a scheme pension may be made without affecting its status as a scheme pension for tax purposes, as long as it is made on her 65th birthday at the latest.


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Reducing a scheme pension while the scheme is being wound-up

Regulation 5 The Pension Schemes (Reduction in Pension Rates) Regulations 2006 - SI 2006/138

Where an occupational pension scheme reduces a scheme pension while the scheme is being wound up and the reason for the reduction is that there are insufficient sums and assets in the pension scheme to continue to pay the pension at the existing rate, the pension is still considered to be a scheme pension.

If the reduction in scheme pension is part of what the legislation calls ‘avoidance arrangements’, the member will become liable to an additional unauthorised payments charge on a defined ‘appropriate amount’.

What the legislation means by ‘avoidance arrangements’ and the ‘appropriate amount’ are explained below at The imposition of an additional unauthorised payments charge on the member where there are avoidance arrangements.

Reducing a scheme pension due to forfeiture of entitlement

Paragraph 11(6) Schedule 10 Finance Act 2005

The Pension Schemes (Reduction in Pension Rates) Regulations 2006 -SI 2006/138

Some scheme rules provide that in exceptional circumstances a member will lose all entitlement to benefits, for example where the member attempts to assign those benefits, or defrauds their employer.

The above Regulations specify the narrow circumstances in which an entitlement to a scheme pension can be taken away under a forfeiture clause and still be an authorised payment.

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Abatement of a scheme pension in a public service pension scheme

Paragraphs 7 to 10 and 11(6) Schedule 10 Finance Act 2005

Temporary suspension or reduction of pensions (known as “abatement” of the pension) by public service pension schemes on the re-employment of members within the public sector is a long-standing feature of some public service pension arrangements.

Abatement and the lifetime allowance (BCE 2 and BCE 3)

If a scheme pension entitlement under a public sector pension scheme is abated at the point it first arises, the amount crystallising for lifetime allowance purposes at that point is not altered because of that abatement. The amount crystallising through BCE 2 is calculated using the full rate of the scheme pension, ignoring any abated amount.

Abatement is similarly disregarded where considering future increases of scheme pension in relation to BCE 3.

This explained in more detail under the definition of ‘P’ at PTM088620 and at PTM088630.

The member’s pension commencement lump sum is not affected by their linked scheme pension being abated - see PTM063230.

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Scheme administrator paying an amount of annual allowance charge

The Pension Schemes (Reduction in Pension Rates) Regulations 2006 - SI 2006/138

Registered Pension Schemes (Reduction in Pension Rates, Accounting and Assessment) (Amendment) Regulations 2013 - SI 2013/1111

An individual may have the right to elect to require the scheme administrator of their pension scheme to pay some or all of their annual allowance charge liability on their behalf. This is known as ‘Scheme Pays’.

If a member does not meet the conditions for ‘Scheme Pays’ to apply, their pension scheme may agree to pay their annual allowance charge liability on a voluntary basis.

In either case there must be an appropriate reduction in the member’s benefits under the registered pension scheme as a consequence of the scheme administrator paying the amount of annual allowance charge.

PTM056410 has more details about ‘Scheme Pays’ and voluntary ‘Scheme Pays’.

The above Regulations specify that a member’s entitlement to a scheme pension can be reduced as a consequence of the scheme administrator paying an amount of the member’s annual allowance charge liability, whether on a ‘Scheme Pays’ or voluntary basis, and still be an authorised payment.

Note - the regulations have effect only for reductions made on or after 6 April 2013.

Reducing a scheme pension before 6 April 2013 as a consequence of the scheme administrator paying an amount of the member’s annual allowance charge liability (whether on a ‘Scheme Pays’ or voluntary basis) could have resulted in the ongoing payments of the pension being unauthorised member payments unless at the time of the reduction that reduction could meet the conditions for any of the specific circumstances that allowed for a scheme pension to be reduced that applied at that time.

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Circumstances where a scheme pension is not deemed to have been reduced or stopped

Some registered pension schemes have a provision allowing for the recovery by an employer of any money due to it through any criminal, fraudulent or negligent act or omission by the employee. This is referred to as an employer’s lien rule. Where the employer deducts debts due from the member from scheme pension payments then the rate of pension has not been changed. So compliance with an employers’ lien would not prevent the payments made in respect of the member continuing to meet the requirements of the scheme pension rules.

By contrast, a forfeiture order would effect a permanent reduction in the rate of pension payable and compliance with such an order would contravene the scheme pension rules, unless specifically exempted through legislation.

Correction of pension levels

When considering whether or not a scheme pension is being reduced, the comparison is by reference to the member’s legal entitlement. So if an administrative error occurs, with the result that a member is paid too high a pension, for example, because of a transposition error paying £21,000 instead of £12,000, the subsequent correction of those payments is not a reduction in pension. That is because the individual was not legally entitled to the earlier higher rate.

The question of what benefits an individual is actually entitled to is an issue the scheme must deal with.

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Consequences of reducing or stopping a scheme pension, other than in the excepted circumstances

Paragraph 2 and 2A Schedule 28 Finance Act 2004

If the rate of scheme pension payable to an individual is reduced in any circumstances other than those allowed by the legislation, then all future payments will be unauthorised member payments, and will be taxed as such. The pension will fail to satisfy the scheme pension conditions as soon as the reduction occurs.

There are also three circumstances where an additional unauthorised payments charge will arise on what is called the ‘appropriate amount’ (see heading below). These circumstances are where:

  • other than in the excepted circumstances, the payment of a scheme pension is stopped entirely in the member’s lifetime, and so contravenes the requirement that the scheme pension must be paid for life,
  • other than in the excepted circumstances, the rate of scheme pension payable in a relevant 12-month period is reduced to a level that is a substantial reduction from the initial rate of pension payable when entitlement to that pension first arose (see explanations above), or
  • a scheme pension is reduced by a rate that has been applied to all other scheme pensions being paid under the scheme (so is an excepted circumstance - see Where a scheme-wide reduction is applied), but the reduction is deemed to be part of ‘avoidance arrangements’ (see later below). The ongoing pension payments still represent scheme pension payments (so they are not unauthorised member payments), but an unauthorised payments charge becomes payable on the appropriate amount.

In the circumstances set out in the first two bullets, this additional charge on the ‘appropriate amount’ applies as well as any charge due on any ongoing pension payments.

This additional charge can be imposed only once on a scheme pension entitlement (as explained under the heading below).

It can only be imposed on a member’s scheme pension. A dependants’ scheme pension may be reduced without triggering such a charge.

The appropriate amount

Paragraph 2A(3) Schedule 28 Finance Act 2004

The appropriate amount is the amount of any tax-free lump sum paid by the scheme in connection with the commencement of that scheme pension entitlement. So the charge negates the tax benefit originally afforded to the lump sum payment.

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The imposition of an additional unauthorised payments charge on the member following a substantial reduction of a scheme pension

Paragraph 2A(3) Schedule 28 Finance Act 2004

If in circumstances other than those listed under the heading Circumstances where a scheme pension may be reduced or stopped, the rate of scheme pension payable is reduced beyond a certain level (or payments stop entirely) then the member will become liable to an unauthorised payments charge on what the legislation calls the ‘appropriate amount’. This charge is at the rate of 40%. In addition, the 15% unauthorised payments surcharge and/or the scheme sanction charge (at a maximum rate of 15%) may be charged. See PTM131000 for more detail on these tax charges.

This charge is in addition to the unauthorised payments charge imposed on the actual continued payments of pension made in that and subsequent years, if any (as explained under the previous heading).

This additional charge arises where the rate of scheme pension payable is substantially reduced in any relevant 12-month period by reference to the annual rate of entitlement that was in force at the time the entitlement to that pension arose. The substantial reduction may occur at the same time the pension ceases to be a scheme pension, or it could be in any subsequent relevant 12-month period. What the legislation means by relevant 12-month periods is covered in PTM062310.

What is a substantial reduction?

Paragraph 2A(3) Schedule 28 Finance Act 2004

The legislation defines a substantial reduction as being the reduction of the rate payable to less than 80% of the annual rate of scheme pension payable when the member first became entitled to the pension.

So if a member becomes entitled to a scheme pension at the rate of £10,000 per annum, then if the rate paid in any future relevant 12-month period falls below £8,000 there has been a substantial reduction and an additional charge is triggered. That £8,000 payment would also be subject to an unauthorised payments charge, as that pension would no longer represent a scheme pension. Any future payments would be treated the same way.

What is the appropriate amount?

Paragraph 2A(5) Schedule 28 Finance Act 2004

The appropriate amount is defined as in the heading above and is the amount of tax-free lump sum that was paid to the member in connection with the entitlement to that scheme pension, i.e. the pension commencement lump sum.

There’s an example later below.

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The imposition of an additional unauthorised payments charge on the member where there are avoidance arrangements

Paragraphs 2A(2) and (4) Schedule 28 Finance Act 2004

A scheme may provide for a scheme pension to be reduced where the rate of reduction is being applied scheme-wide to all scheme pensions currently payable from the scheme (see Where a scheme-wide reduction is applied).

However, if a scheme uses this excepted circumstance as part of a wider arrangement with the member(s), where the intent is to manipulate the member’s entitlement to a tax-free pension commencement lump sum by artificially raising the member’s initial rate of pension with no intention of maintaining this rate for the lifetime of the member, an unauthorised payments charge will become due at the point of reduction. The tax is charged on the level of lump sum originally paid to the member (the appropriate amount). This is referred to in the legislation as ‘avoidance arrangements’.

The term avoidance arrangements covers any scheme, arrangement or understanding of any kind, whether or not it is legally enforceable.

There’s an example later below.

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An additional unauthorised payments charge can only be imposed once on an appropriate amount in relation to a single scheme pension entitlement

Paragraph 2A(6) Schedule 28 Finance Act 2004

Once an additional unauthorised payments charge has been imposed on the appropriate amount following the reduction of a scheme pension entitlement, whether in circumstances described under either of the previous two headings above, then because the charge will effectively recover the tax benefits that applied to the lump sum payment, any further reduction in the rate of that pension at a later date does not trigger this charge again.

Example

Barbara’s pension payments are reduced so that the rate of pension payable is 50% of the rate payable when she first became entitled to it. 12 months later her pension payments are reduced a second time later to 10% of the initial rate of the pension to which she was entitled.

The unauthorised payments charge is triggered only on the first occasion there was a substantial reduction in Barbara’s pension, i.e. the 50% reduction.

The ongoing pension payments actually made will still represent unauthorised member payments in their own right, and Barbara will be liable for a 40% unauthorised payments charge on each of those payments.

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Example showing how the additional unauthorised payments charge is applied where a substantial reduction in the rate of scheme pension occurs in non-excepted circumstances

John becomes entitled to a scheme pension of £20,000 per annum on his 65th birthday on 10 January 2007. This is increased by 5% per annum under the scheme rules.

This entitlement gives rise to a £50,000 pension commencement lump sum.

On 1 April 2008 the rate of scheme pension payable to John is reduced to £15,000 per annum.

The annual rate of pension payable in the relevant 12-month period of 1 April 2008 to 31 March 2009 is therefore £15,000 per annum.

The rate of pension payable immediately before this 12-month period (on 31 March 2008) was £21,000 per annum (the £20,000 starting pension, plus the first annual increment of 5%).

This reduction is not due to any of the specific circumstances set out above.

The pension ceases to be a scheme pension. All future payments from 1 April 2008 onwards therefore represent unauthorised member payments. John will be subject to a 40% unauthorised payments charge on each of those payments.

In addition the reduced rate payable in the relevant 12-month period of 1 April 2008 to 31 March 2009 (£15,000) is less than 80% of the rate payable on the arising of that pension entitlement on 10 January 2007. (80% of £20,000 = £16,000.)

So John also becomes liable to an additional unauthorised payments charge on 1 April 2008 on the level of tax-free lump sum paid back in early 2007 (the appropriate amount) as a substantial reduction has occurred. This is £20,000 (40% of his £50,000 pension commencement lump sum).

If the continuing pension payments were to be reduced again in the future, a further additional unauthorised payments charge would not be triggered on the appropriate amount, because one charge on the appropriate amount has already been levied.