A guide to enhanced protection and primary protection

Background

The lifetime allowance (LTA) is a general limit on the amount of benefits you can take from all your pension schemes before you incur tax charges.

It was introduced in 2006/07 as part of the ‘A-Day’ pension simplification process, which introduced new tax rules to apply to all types of pension.

The LTA was originally set at £1,500,000 (this is a key number, as we’ll see later) and there were scheduled annual increases, taking it to a high point of £1,800,000 in 2010/11.

It was then cut several times, taking the allowance down to £1,000,000 in 2016/17, from which point it started increasing again each year in line with the rise in the Consumer Prices Index.

The LTA currently sits at £1,055,000 (tax year 2019/20).

For some pension scheme members, the pre-2006 pension rules were more favourable than the new ‘simplified’ rules, and they might have built up pensions benefits that were higher in value than (or close to) the new LTA limit.

In order to soften the blow, the Government introduced two forms of LTA protection so people could take the full value of the benefits they had built up before A-Day: these were primary protection and enhanced protection.

Further forms of LTA protection were later introduced in the form of fixed protection and individual protection.

However, there are still thousands of members with enhanced protection and primary protection, and the changes in LTA have made this a complicated area for members and advisers.

We’ll be focusing on those protections in this article, looking at the application conditions for each and the calculations for tax-free lump sums and for LTA usage.

Jargon buster

A benefit crystallisation event (BCE) is a defined event or occurrence in a pension scheme, usually connected to the taking of benefits.

BCEs are important in this context as they are the points at which a member’s pension rights are calculated against the LTA.

There are around a dozen BCEs: they include the payment of a tax-free lump sum, the designation of funds to drawdown, the purchase of a lifetime annuity and the establishment of a defined benefit scheme pension.

Primary protection – application conditions

To qualify for primary protection, a member needed to have pensions valued at £1,500,000 or higher as at 5 April 2006.

In order to apply for this protection, the member had to notify HMRC using prescribed application forms on or before 5 April 2009, including details of all of their pension scheme benefits on the form. HMRC then issued a certificate confirming that the protection had been granted.

Except in some pension-sharing cases, primary protection cannot be lost once it has been granted, and it is not affected by the transfer of funds between pension schemes.

Importantly, members with primary protection can continue to make contributions to pension schemes after 5 April 2006, which is not the case with other forms of protection.

Primary protection – lifetime allowance calculations

For most pension scheme members, their pensions are (or will have been) subject to the LTA figure(s) mentioned in the opening section. This is often referred to as the ‘standard’ LTA.

Members with primary protection, however, have a ‘personal’ LTA that is greater than the standard LTA. Any LTA tax charge will only apply to benefits that exceed the member’s personal LTA.

The member’s personal LTA is calculated based on an ‘enhancement factor’. This factor was calculated with reference to the member’s fund value on 5 April 2006, so it is specific to them, and it’s confirmed on the protection certificate.

For BCEs from 2012/13 onwards, the personal LTA is calculated by applying the enhancement factor to what is known as the ‘underpinned’ LTA, which is set at £1,800,000.

personal LTA = underpinned LTA + (LTA factor x underpinned LTA)

The underpinned LTA will remain in the calculation unless the standard LTA exceeds £1,800,000, at which point the personal LTA calculation will again be based on the standard LTA.

For BCEs before 2012/13, the factor was applied to the standard LTA in place at the time.

Example

Mr Green has an enhancement factor of 1.00. He crystallised his entire fund in May 2012 when his fund was valued at £3,500,000. The standard LTA at the BCE date was £1,500,000.

£1,800,000 + (1.00 x £1,800,000) = £3,600,000

This means he has a personal LTA of £3,600,000. As the fund value was lower than his personal LTA, Mr Green didn’t suffer an LTA charge.

While it doesn’t seem overly rational or helpful to a lot of people, note that the LTA usage for primary protection is reported to the member as a percentage of the standard LTA, not as a percentage of the personal LTA.

Primary protection – tax-free lump sum calculations

Ordinarily, the value of a tax-free lump sum is limited to the lower of:

• 25% of the value being crystallised; or
• 25% of the member’s remaining standard LTA at the time of the BCE.

When calculating the maximum tax-free lump sum for a client with primary protection, however, the lump sum is limited to 25% of £1,500,000 (£375,000).

It’s not limited to 25% of the underpinned LTA (£1,800,000) or to 25% of the personal LTA.

This applies unless the standard LTA in the future increases above £1,500,000, at which point the tax-free lump sum would be limited to 25% of the standard LTA.

If the member was entitled to a tax-free lump sum on 5 April 2006 of more than £375,000, they could preserve that entitlement after 2006 by applying for lump sum protection as part of their primary protection application.

The protected lump sum is confirmed on the protection certificate and is expressed as a monetary amount.

When calculating the tax-free lump sum at a BCE, the monetary amount is revalued or indexed in line with the change in standard LTA. Therefore, the calculation looks like this.

Lump sum at A-Day x (standard LTA at current BCE / standard LTA at A-Day)

While the standard LTA is less than £1,800,000, as it is now, however, the underpinned LTA of £1,800,000 is used in the calculation.

Lump sum at A-Day x (underpinned LTA / standard LTA at A-Day)

Example

Mrs Brown had lump sum rights on 5 April 2006 of £1,000,000. Her enhancement factor is 3.00. She decided to take all of her benefits in September 2015 when the standard LTA was £1,250,000. Her fund value was £6,500,000 at the time.

Mrs Brown’s personal LTA was £7,200,000.

£1,800,000 + (3.00 x £1,800,000) = £7,200,000

Mrs Brown’s lump sum was revalued upwards in line with the underpinned LTA and was therefore £1,200,000.

£1,000,000 x (£1,800,000 / £1,500,000) = £1,200,000

Mrs Brown took her maximum lump sum of £1,200,000. The remaining £5,300,000 was designated to drawdown.

As the total value of benefits (£6,500,000) was less than the value of her personal LTA (£7,200,000), there was no lifetime allowance tax charge.

Enhanced protection – application conditions

Unlike with primary protection, there was no fund value requirement for enhanced protection, and members could apply for enhanced protection even if their benefits were worth less than £1,500,000. However, there were still prescribed forms to complete, and the deadline for application was again 5 April 2009.

The key application condition for enhanced protection was that the member could not have had any relevant benefit accrual from 6 April 2006 onwards.

This means they couldn’t have made a contribution to a defined contribution scheme and they couldn’t have accrued benefits under a defined benefit scheme (above a certain limit).

This is an ongoing condition, which means it’s still relevant today. Clients with enhanced protection need to be careful around automatic enrolment contributions. They will also need to be aware that some compensation payments are viewed by HMRC as contributions if they are directed into a pension scheme.

(Certain transfers can also mean enhanced protection is lost – as can the establishment of a new pension scheme outside of prescribed circumstances – but this is outside the scope of this article.)

If enhanced protection is lost, the member will have to rely on the standard LTA for all future BCEs (unless they also applied for primary protection – see final section). However, previous BCEs are not reassessed retrospectively.

The member will also have to notify HMRC that they have lost their protection within 90 days of losing it. If they don’t do this, they may face a fine.

Enhanced protection – lifetime allowance calculations

The main benefit of enhanced protection is that it fully protects the member’s pension rights from the LTA.

This means their pensions will never be subject to the LTA tax charge when they come to be crystallised, regardless of their value at the time. This is the main difference between primary protection and enhanced protection.

Therefore, LTA usage for members with enhanced protection is calculated as normal. There are no modifications to the calculation. LTA usage is reported to the member as a percentage of the standard LTA.

Enhanced protection – with no protected lump sum

For clients with enhanced protection, the tax-free lump sum (much like under primary protection) is normally limited to 25% of £1,500,000.

Again, if the standard LTA in the future increases above £1,500,000, it will be limited to 25% of the standard LTA.

For clients with pre-2006 lump sum rights of £375,000 or higher, it was possible for them to protect their lump sum entitlement under enhanced protection as well.

Unlike primary protection, however, the protected lump is expressed as a percentage of the total value of the pension benefits, rather than as a monetary amount.

The percentage is confirmed on the protection certificate. It may be more than 25% or less than 25% depending on the member’s pre-2006 rights to a tax-free lump sum. Either way, this will still work out more than what they would normally receive based on the current rules.

The lump sum will always be calculated based on the percentage on the certificate. It is not restricted by the member’s remaining available LTA.

Enhanced protection with dormant primary

On a final note, it was possible to apply for both primary protection and enhanced protection at the same time provided the client met the conditions for both.

This was often done for tactical reasons in case the enhanced protection was lost or revoked at a later date.

In this situation, the enhanced protection takes precedence, and the primary protection is considered ‘dormant’. The certificate will read “Enhanced Protection with Dormant Primary”.

This article was previously published by FT Adviser