Is your client’s pension safe on bankruptcy?

With the current backdrop of challenging economic conditions, here’s a reminder of how pensions are dealt with if the worst comes to the worst and a client finds themselves potentially entering bankruptcy.

General position

Under current insolvency legislation, workplace and personal pensions are excluded from a bankrupt’s estate and cannot be claimed by a Trustee in Bankruptcy (TIB). This is on the proviso that the pension scheme is registered with HMRC, which the vast majority of pension schemes are. The state pension is also exempt.

Therefore, the starting position is that a TIB cannot simply dip into a client’s pension in order to repay their creditors.

Exceptions to the rule

However, that’s not to say that a TIB is without avenues for recourse. If a client has made ‘excessive’ contributions into their pension in the period before they go bankrupt, the TIB may be able to reclaim some of these funds.

There is no definition of ‘excessive’ in the legislation, and it would be down to a court to decide, but if the TIB were able to demonstrate that the client had put money into their pension to the detriment of creditors a court might be favourable to the application.

Given that the annual allowance has been £40,000 since 2014, there’s been much less scope for individuals to squirrel away funds in a pension, but when you consider the possibility of a single contribution of £160,000 using carry forward, it’s possible to see how there could be sufficient basis to make a claim. The proportion of the client’s income being paid in, or changes to the pattern of contributions being made, may also be relevant factors.

The second option for a TIB is an Income Payments Order (IPO), which aims to claim surplus income above the individual’s “reasonable domestic needs”. A court can apply an IPO to pension income, and if a client has a lifetime annuity or a defined benefit pension in payment there will be a regular income to which the IPO could be attached. If a client has funds in income drawdown – the nature of which means income can be varied or even stopped – it’s likely to be more challenging for the TIB to claim any of it. Again, an IPO requires a court order, and it can last for up to three years.

A twist in the tail

One thing a TIB cannot do is force a client to take lump sums or income from their pension: this was settled in the 2016 Court of Appeal case of Horton v Henry. Furthermore, a TIB can only take pension income using an IPO if the pension was already in payment at the time of the bankruptcy.

The year before that, however, the Insolvency Service updated its guidance for Official Receivers to say that where an individual is aged 55 or over and has pension funds they haven’t yet accessed, they may not meet the threshold for insolvency given they’ve got funds they could in theory access.

The issue here of course is that, beyond the 25% tax-free lump sum, pension income is subject to Income Tax. A client with a significant pension pot, therefore, could face the unenviable prospect of having to choose between not entering bankruptcy and paying a large amount of Income Tax on withdrawals.

This article was previously published by Professional Adviser