Compensation payment complications

A compensation payment may be due to a pension scheme member because of poor advice, bad administration or a failed or poorly performing investment. The aim of compensation is to put the client back in the position they should have been in, but because of how Her Majesty’s Revenue and Customs (HMRC) view compensation payments, this isn’t always straightforward.

The current guidance from HMRC states that where compensation is awarded to the member and paid into a pension, this payment is deemed to be a third-party contribution, which would attract tax relief. This is because HMRC deem the complainant to be the member and the resulting compensation to be due to the member personally.

Whilst receiving tax relief on top of compensation payments seems advantageous on the surface, this can cause problems for successful complainants, as the payment counts towards their annual allowance (or the tapered or money purchase allowances, where applicable). It could also have Lifetime Allowance implications as a contribution will cause the loss of any enhanced or fixed lifetime allowance protection that might be held.

For pension schemes which apply tax relief at source automatically, the scheme rules will generally state any personal member contributions they receive must be eligible for tax relief. This relies on the member having sufficient UK earnings to allow for the gross contribution amount – not always possible for those with only investment or pension income, or those on lower salaries.

Because of the potential complications providers may request that any compensation payment is paid directly to the member. In other circumstances the rules on which payments can be made from a pension scheme are typically very strict. Yet a compensation payment due to the member in respect of a pension can be paid to the member directly, and it is not an unauthorised payment. Paying the member directly means the funds would then be outside the tax-advantaged pension wrapper, so the member isn’t truly back in the position they should have been in.

It’s clear that clients who have already suffered a loss risk additional poor outcomes because of the treatment of pension compensation payments. It’s also bad for taxpayers in general, as compensation amounts can be subject to a reduction to reflect the fact taxpayer-funded basic rate relief will automatically be reclaimed by a pension provider to uplift the amount that ends up in the scheme.

Not only is there the potential for poor outcomes, but the treatment of compensation payments in relation to pensions is inconsistent with other tax wrappers. For example, the ISA regulations allow for compensation relating to investments held within a stocks and shares ISA to be paid into the ISA as a defaulted investment subscription. This payment will not use any of the investor's annual ISA allowance.

The issues could be solved by simplifying the treatment of pension compensation payments by mirroring the ISA rules. Allowing redress monies to be paid into schemes outside of the standard contribution rules would allow for clients who have lost out in some way to truly be put back into the position they should have been, and without any complications.

This article was previously published by Professional Adviser