Scheme-specific lump sums in the new world

The last of the changes relating to the removal of the lifetime allowance came into effect in November last year, and were backdated to the start of the 2024/25 tax year.

While most clients were unaffected, there were niche scenarios where some were in limbo waiting for the rules to be corrected. Amongst them were people with scheme-specific lump sums – commonly referred to as ‘protected tax-free cash’.

What is a ‘scheme-specific lump sum’?

Usually, the lump sum was valued below £375,000, as those with higher values would likely have applied for enhanced or primary protection with an associated protected lump sum instead.

Lump sums in excess of 25% of the pension rights would have been built up in some occupational schemes under the rules that were in place before pension simplification. It was also relatively common for these to have been transferred to section 32 buyout policies – so these policies may also have had higher levels of tax-free cash attached by the time A-day came round in 2006.

It was not necessary to apply for scheme-specific lump sum protection – rather the scheme administrator would keep a record of the monetary amount of lump sum entitlement on 5 April 2006.

Transfers with SSLSs

As the name suggests, this type of lump sum protection is specific to the scheme in which the entitlement built up. Usually, the entitlement to more than 25% pension commencement lump sum (PCLS) would be lost if the member transferred their pension benefits to a new scheme after 6 April 2006.

However, it was, and still is, possible to transfer these benefits and keep the protection if the transfer meets the conditions to be a block transfer.

To qualify, two or more members must have all their rights under the scheme transferred in a single transaction to the same receiving scheme. For the protection to be kept, the member cannot have been a member of the receiving scheme for more than 12 months.

The receiving scheme does not have to be an occupational scheme, so it is possible for block transfers to be made to personal pensions, such as SIPPs.

“A single transaction” just means that there must be a single agreement for all the assets for two or more members to be transferred in a reasonable time frame. HMRC accepts that the physical transfer of assets may not happen all in one day.

It is not necessary for all members involved to have a protected SSLS. It could be that one member has the protection, and another joined the scheme after A-day and so has the standard 25% PCLS. By transferring together, the member with the protection gets to keep it.

Where a client has a protected SSLS from more than one pension scheme, it’s not possible to merge them and keep multiple protected lump sums. The scheme that holds the SSLS (be that the original scheme or one that first received a block transfer) keeps that protection, but any further transfers in would be treated as having the standard 25% PCLS, regardless of whether it was a block transfer from a scheme with a protected SSLS.

Before A-day it was common for people leaving occupational schemes to transfer their benefits to personal schemes, such as deferred annuity contracts (section 32 policies), or to hold a retirement annuity contract. These often have SSLSs attached, but are single-member schemes, so can never meet the block transfer conditions to be transferred without the entitlement being lost.

To confuse matters, new versions of block transfers were introduced in Finance Act 2022. These relate to members keeping a protected pension age of 55 or 56 when the normal minimum pension age increases to age 57 from 6 April 2028. The rules for these types of block transfers are different.

Taking SSLS

When it comes to accessing a pension scheme that has an SSLS, a key difference is that the whole fund must be crystallised at the same time, and all the SSLS taken as a single lump sum. No partial crystallisation is allowed.

If the member joined the scheme to receive a block transfer, but subsequently had other transfers in or made contributions to accrue other pension rights, these must also be fully crystallised. It is possible to accrue further rights in the scheme once the SSLS has been taken, either through transfers in or contributions, and these would not have any special conditions attached – i.e. standard 25% PCLS would apply, and funds could be partially crystallised if appropriate.

Revaluing SSLS under the lifetime allowance

When a member with an SSLS came to access their benefits under the lifetime allowance, a calculation was used to work out how much tax-free cash they were entitled to.

From 6 April 2012 onwards, the legislation gave the rather horrible-looking calculation below:

(VULSR x ULA/FSLA) + ALSA

VULSR is the value of the individual’s uncrystallised lump sum rights under the scheme on 5 April 2006.

ULA is the greater of £1.8 million and the standard lifetime allowance when benefit entitlement arose.

FSLA is £1.5 million.

Given the fact that the standard lifetime allowance never rose above £1.8 million, we can simplify the calculation to:

VULSR x 1.2 + ALSA

ALSA is the additional lump sum amount, and is calculated using the formula (but cannot be below 0):

[LS + AC - (VUR x CSLA/FSLA)] / 4

LS is the amount calculated by VULSR x 1.2

AC is the amount crystallised by becoming entitled to a pension in connection with which the lump sum is paid, i.e. the amount being put into drawdown.

VUR is the value of the individual’s uncrystallised rights under the scheme on 5 April 2006.

CSLA is the (current) standard lifetime allowance when benefits were taken (or £1.8 million or £1.5 million where the individual had fixed protection 2012 or 2014 respectively).

As all benefits had to be taken in one go, in practice LS + AC was simply the total fund for defined contribution schemes.

So, at the time when the lifetime allowance was £1,073,100 for clients with no protection, the calculation could be given as:

VULSR x1.2 + [current fund value – (VUR x £1,073,100/£1,500,000)]/4

Example:

Tax-free cash available on 5 April 2006 = £150,000

Fund value on 5 April 2006 = £500,000

Current fund value = £1,000,000

£150,000 x 1.2 + [£1,000,000-(£500,000 x £1,073,100/£1,500,000)]/4

SSLS that can be paid = £340,575

Revaluing SSLS under the new regime

When Finance Act 2024 was introduced, the new calculation didn’t work as expected and could result in higher levels of SSLS than intended. This has now been rectified by the November regulations, and the current legislation gives the same amount of SSLS as under the old calculation above.

The calculation has been simplified to (A x1.2)+B, where A is uncrystallised lump sum rights on 5 April 2006 (i.e. VULSR under the old calculation).

B is the equivalent of ALSA which is now defined as [C+D – (E x F /£1.5 million)]/4

C and D are the old LS and AC, E is the old VUR, and F is now the member’s lump sum and death benefit allowance.

How SSLS was tested against the lifetime allowance

Up to 5 April 2023, if the amount of SSLS calculated under the formula was greater than the client’s available lifetime allowance, it could still be paid, but the excess above the lifetime allowance would be subject to the lifetime allowance charge.

Testing SSLSs against the new allowances

The new rules for SSLS state that the member only needs to have available LSDBA in order to be paid a tax-free SSLS. There is no requirement to have available LSA. This can make quite a difference when compared to the lifetime allowance regime.

When an SSLS is taken, it uses up LSA as if 25% PCLS was taken, even though the actual tax-free amount is higher. The amount of LSDBA used is the actual tax-free amount taken.

Let’s take the example of Matthew, who has already taken £250,000 PCLS from his SIPP and wanted to take his SSLS from his section 32 policy in January 2023. The SSLS has been calculated as £100,000.

Had we still been under the old rules, taking £250,000 PCLS and putting £750,000 into drawdown would have used 93.18% of the lifetime allowance at its outgoing level. This would leave 6.82% remaining, or £73,185.42. When Matthew came to take his SSLS, this is the maximum he could take that would be tax-free; anything above this would be subject to the lifetime allowance charge.

However, if Matthew had taken the £250,000 PCLS first, under current rules this would leave him with £18,275 LSA and £823,100 LSDBA remaining.

As the requirement is now only to have LSDBA remaining, he could take the full £100,000 SSLS and it would all be tax-free.

If Matthew’s section 32 policy was valued at £300,000 then taking the SSLS would use up £75,000 of LSA (25% of £300,000) so he would have no LSA remaining, but the total tax-free cash taken (£100,000) is counted against his LSDBA, so he now has £723,100 remaining.

Why the order of benefits could make a big difference

The example above shows Matthew maximising his tax-free cash. This is possible as he took his non-protected pension (the SIPP) first, then the SSLS later.

For clients with high levels of pension savings, the order benefits are taken can make a big difference.

Take Lynne as an example. Lynne has £1.2 million in her SIPP and a section 32 policy valued at £500,000 with an SSLS of £175,000.

If Lynne takes her SSLS first this uses up £125,000 of her LSA (25% x £500,000), leaving £143,275 LSA to take PCLS from her SIPP. Her total tax-free cash would be £318,275.

If, instead, she takes the full £268,275 PCLS from her SIPP first, this will use up all her LSA, but she can still take the full £175,000 SSLS from the section 32, as she has plenty of LSDBA remaining. By taking benefits this way round she can have £443,275 tax-free – a whopping £125,000 more than if she’d accessed the section 32 first.