Impact of divorce on pension protection

Impact of divorce on pension protection

With the removal of the lifetime allowance the impact of holding pension protection has changed.

On one hand, having a protected amount is less important – after all you can now take unlimited sums out of a pension with only income tax applying. On the other hand, protection is still valuable to increase the amount that can be paid tax-free.

Having a pension sharing order (PSO) applied to a pension on divorce can impact the protection the member holds. This has always been the case, and just because the lifetime allowance has gone, it doesn’t mean it’s no longer something that should be considered.

In this article I look at each of the protections in turn, and how a pension sharing order could impact them under the new regime.

Enhanced protection

Starting with the oldest protections first, enhanced protection was the platinum form of protection when the lifetime allowance was introduced back in 2006. Provided it wasn’t broken, the member could never have received a lifetime allowance charge, regardless of the size of fund held. It also could come with or without a protected lump sum.

In the new world enhanced protection translates to a higher lump sum and death benefit allowance (LSDBA). However, it is no longer unlimited, rather restricted to the value of the uncrystallised funds on 5 April 2024 (with the intention that funds that were crystallised by this date are not tested).

If a pension sharing order is applied after 5 April 2024, then this will not change the available LSDBA, as there is no retrospective calculation to go back and re-adjust the figure.

In practical terms LSDBA won’t be an issue for most – provided no serious ill-health is taken before age 75, and death benefits are paid as a pension rather than a lump sum, then the level of LSDBA is likely to be irrelevant.

The impact on pension commencement lump sum (PCLS) is a more important factor for those holding enhanced protection.

If no protected lump sum is noted on the protection certificate, then the lump sum allowance (LSA) will be £375,000.

When calculating PCLS, the maximum payable is the lower of:

• the applicable amount
• the available LSA
• the available LSDBA

The applicable amount is one third of the sums used to provide a pension income.

Having a pension debit applied to uncrystallised funds will not change the LSA, but it will reduce funds available to provide a pension income. This will result in less PCLS being available unless the applicable amount is still equal to or above the £375,000 LSA.

For those with a protected lump sum, this will be noted on the certificate as a percentage, which can be more or less than 25%. When this percentage is stated on the protection certificate the member is entitled to that percentage of their fund as PCLS up to the maximum calculated on 5 April 2023.

This does mean that if protected PCLS is less than 25% and the fund value drops significantly following the pension debit then PCLS could be lower than if no protection was held.

Example – enhanced protection with protected lump sum

Enhanced protection with protected PCLS of 20%

Pension rights of £2 million on 5 April 2023 (max PCLS therefore £400,000)

Pension debit June 2024. Fund value when come to access pension is £1.2 million

Maximum PCLS is 20% of fund (up to 5 April 2023 maximum) = £240,000

It is worth noting that those with enhanced protection now have the option to make contributions without breaking the protection. This means that clients with UK relevant earnings and / or an employer can make contributions to rebuild their funds following the pension debit and may benefit from extra PCLS up to their pre-divorce limit (be that the protected LSA of £375,000 where no lump sum protection held, or their 5 April 2023 maximum).

Primary protection

Primary protection gave an enhancement to the lifetime allowance. The certificate states the enhancement factor. Under the new rules the enhancement factor is applied to £1.8 million and this translates to the individual’s enhanced LSDBA.

Like enhanced protection, primary protection can come with or without lump sum protection. If no protected lump sum is stated on the certificate, then the protected LSA will be £375,000.

If lump sum protection is held, this is stated as a monetary amount on the certificate. This amount is revalued at x1.2 less reductions for any amounts previously taken (with different rules depending on when taken), to give the maximum PCLS that can be paid in relation to the pre-6 April 2006 funds. Funds built up after this date have the standard 25% PCLS.

Primary protection will be reduced or lost if a pension debit is applied to a member’s pension.

When a pension debit is applied primary protection is reduced from the effective date, but the calculation is carried out as though the reduction happened on 5 April 2006.

Example – reduction in primary protection

Pension rights of £3 million on 5 April 2006, protected lump sum of £600,000

Primary protection factor = (£3m - £1.5m)/£1.5m = 1

Value of primary protection prior to PSO = £1.8m + (1 x £1.8m) = £3.6m

PSO pension debit of £1 million in 2024

Primary protection factor now based on holding £2m (£3m - £1m) on 5 April 2006 (£2m - £1.5m)/ £1.5m = 0.3333 Rounded up = 0.34

Value of primary protection after PSO = £1.8m + (0.34 x £1.8m) = £2.412m

Protected lump sum reduced from £600,000 to £400,000.

When the member has a pension debit that reduces their protection, regulations state they must inform HMRC ‘without delay’. HMRC will issue a new certificate showing the reduced level of protection.

It is also possible for the protection to be lost altogether if the deemed pension rights on 5 April 2006 are below £1.5 million.

Example – primary protection is lost

Pension rights of £3 million on 5 April 2006, protected lump sum of £600,000.

Primary protection factor = (£3m - £1.5m)/£1.5m = 1

Value of primary protection prior to PSO = £1.8m + (1 x £1.8m) = £3.6m

PSO pension debit of £1.6 million in 2024

Protection application now based on holding £1.4m (£3m - £1.6m) on 5 April 2006 – does not qualify for primary protection

The example above shows that a pension debit of £1.6 million has caused a loss of protection, this means the maximum PCLS will be up to the standard LSA of £268,275.

Fixed protections

Under the new rules the protected amount under fixed protection becomes the member’s protected LSDBA – so £1.8 million / £1.5 million / £1.25 million depending on the version held. The member’s protected LSA is 25% of the protected LSDBA.

Like enhanced protection, there is no direct impact of having a pension debit on the level of protection held. Similarly, it is more the impact of having a smaller fund to crystallise that will restrict the ability to take PCLS. The LSA will be unaffected by the pension sharing order, and there is now the ability to rebuild funds without losing the protection.

Individual protections

Where individual protection is held the level of protection is now the member’s protected LSDBA, and the protected LSA is 25% of this amount. Like primary protection, it can be lost or reduced when a pension debit is applied to the pension.

When calculating the new level of protection, the amount of the pension debit is reduced by 5% for each full tax year after the date of protection (i.e. 6 April 2014 for IP14 or 6 April 2016 for IP16). The date used in calculating whether a full year has passed will be the effective date. This amount is then deducted from the fund value at the date the protection was given, and the new level of protection is calculated.

Example – reduction in individual protection

Pension rights of £1.6 million on 5 April 2014

Individual protection 2014 (IP14) held of £1.5 million (maximum permitted). PSO pension debit of £600,000, effective date 15 June 2024

Pension debit effective ten full years after protection – 50% reduction. IP14 recalculated as £1.6m – (£600,000 x 50%) = £1.3m

LSDBA is now £1.3 million and protected LSA £325,000

Example – individual protection is lost

Pension rights of £1.6 million on 5 April 2014

Individual protection 2014 (IP14) held of £1.5 million (maximum permitted). PSO pension debit of £800,000, effective date 15 June 2024

Pension debit effective ten full years after protection – 50% reduction IP14 recalculated as £1.6m – (£800,000 x 50%) = £1.2m

Protection is lost (minimum value for IP14 was £1.25 million).

The member has 60 days to inform HMRC of the debit or they could be liable for penalties. HMRC will issue a new certificate or reference number with the reduced level of protection if it has not been lost altogether.

Pension credits

The flip side of a pension sharing order is the party who receives the pension credit. If they also held enhanced or fixed protection care was needed under the old regime to ensure the protection wasn’t broken. Under the new rules this no longer an issue and the protection will not be impacted.

Enhancement factors

It is still possible to apply for enhancement factors in relation to disqualifying pension credits received prior to 5 April 2024. However, these enhancements only increase LSDBA, they do not increase LSA or PCLS. The deadline for applying is 5 April 2025.

Planning point

For clients with primary or individual protection, a few pounds difference in a pension sharing order could make the difference between them having a reduced protection, or none. This could make a significant difference to the amount of PCLS available so should be properly considered when deciding the split of assets.