Enhancing your protection

Most of the pension industry would agree that pension simplification was a good thing. The idea of removing all the various regimes that had gone before in one fell swoop and replacing them with one easier-to-understand set of rules was a great concept.

The downside for some was the introduction of the lifetime allowance, but with a starting rate of £1.5 million, legislated increases to £1.8 million, and protection for those already over the limit at introduction, it wasn’t too much of a trade-off for simplicity.

Over time, the landscape has changed, with the allowance being cut and other complications arising (money purchase and tapered annual allowance, to name two). It does feel like we have been regressing at each step since the first tinkering with annual allowances in 2009 (remember the special annual allowance?).

The various protections that were put in place when the lifetime allowance was introduced, and at every cut since, are well documented. What are less often discussed are the circumstances in which an individual’s lifetime allowance can be enhanced outside of changes to the standard allowance. These enhancements can arise at any time post A-Day (6 April 2006).

Generally, these relate to pension rights benefits that have not had the advantage of receiving tax relief in the UK or that have already been tested against the lifetime allowance. The circumstances when these enhancements can be granted are detailed below.

Pension credit enhancement factor

Where an individual receives a pension credit following a pension-sharing order on divorce, and that credit relates to crystallised pension rights that came into payment on or after 6 April 2006, the recipient will be entitled to a pension credit enhancement factor. This is because these pension rights will have already been tested against the lifetime allowance in the hands of their ex-spouse, but are treated as uncrystallised in the hands of the recipient so will be tested again.

Recognised overseas scheme transfer factor

Where a transfer is made from a recognised overseas pension scheme into a UK registered pension scheme, an enhancement factor can be claimed as the rights will not generally have benefitted from tax relief in the UK. If any funds in the overseas scheme have received UK tax relief at any point, these are deducted from the transfer amount for the purposes of calculating the enhancement factor.

Non-residence factor

If an individual accrues rights in a UK-registered pension scheme during a period when they are a relevant overseas individual, and therefore do not receive tax relief in relation to these rights, then they will qualify for the non-residence factor in relation to rights built up in the relevant tax years.

To calculate the lifetime allowance factor, the relevant amount is divided by the lifetime allowance at the time the rights were acquired. For pension credit enhancement factors, this will be the tax year the pension-sharing order was implemented and funds transferred into the member’s name. For the recognised overseas scheme transfer factor, it will be the year the transfer comes into the UK scheme, and for the non-residence factor, it will be the earliest of:

• immediately before their first benefit crystallisation event;
• the date they ceased to be a relevant overseas individual; or
• the date when benefits ceased to accrue.

When someone qualifies for an enhancement factor, they have five years following 31 January in the tax year following the relevant tax year to apply. So if someone received a QROPS transfer or relevant pension credit during the 2020/21 tax year, they would have until 31 January 2027 to apply. For the non-residence factor, in particular, care is needed as the clock might start ticking earlier than expected as outlined above. Ideally, the enhancement factor is claimed before benefits are crystallised but it can come later, in which case the lifetime allowance usage at any preceding benefit crystallisation events would have to be recalculated.

It is also possible for someone to have multiple enhancement factors, and/or to hold other forms of protection in conjunction with an enhancement factor.

If multiple enhancement factors are held, or one or more are held in addition to primary protection, then the factors are simply added together and applied to the relevant lifetime allowance (in most circumstances this will be the lifetime allowance when benefits are crystallised). When primary protection is held, the factor is applied to the underpinned lifetime allowance of £1.8 million.

Where any of the fixed or individual protections are held, the enhancement factor is applied to the individual’s personal lifetime allowance. It is not possible to have an enhancement factor with enhanced protection as benefits are already fully covered and no lifetime allowance charge can arise – you can’t enhance enhanced!

The circumstances that lead to lifetime allowance enhancements do not occur every day, but they can be very important to those who qualify – another complication of the current pensions system of which advisers should be aware.

This article was previously published by Retirement Planner