David Downie: Tackling the DB transfer ‘appropriate limit’ hurdle

DB transfers that breach the 'appropriate limit' can have serious tax implications if a client has enhanced protection, writes David Downie. Here, he looks at how advisers can avoid this outcome and use partial transfers to their advantage …

Scrutiny from the FCA and rule changes now mean there is a lot to consider when advising on defined benefit (DB) transfers. In this climate, it is easy to overlook the extra hurdle of the ‘appropriate limit’ rule when your client has enhanced protection.

In 2006, ‘pensions simplification’ came into force, replacing long-standing occupational pension rules relating to DB schemes. Some higher-paid employees had built up pension benefits with a value that exceeded the lifetime allowance (LTA) in advance of the rules changing.

‘Enhanced protection’ was one of the options made available to individuals within that bracket who wanted to safeguard their pensions from the LTA tax charge. There was, however, a trade-off. In order to retain enhanced protection, there can be no further ‘benefit accrual’ after 5 April 2006.

For defined contribution (DC) schemes, such as personal pensions, or self-invested personal pensions, this means no more contributions (by individuals or their employers) could be made. For DB schemes, on the other hand, it meant benefits could increase, but must always stay below the ‘appropriate limit’.

If protection is lost, clients must inform HM Revenue & Customs within 90 days. The transfer from DB to DC is one occasion when there will be a test against the ‘appropriate limit’ and, if DB benefits exceed it, enhanced protection will be lost.

Although losing enhanced protection does not trigger an immediate LTA tax charge, it does potentially expose clients to significant tax bills when benefits are crystallised under the new pension. It makes checking the limit before recommending a transfer to a client essential.

Calculating the appropriate limit

The ‘appropriate limit’ was designed so that nobody who gave up DB accrual before the pensions simplification rules came into force lost enhanced protection.

However, deferred pensions that only increase by statutory revaluation, or in line with the scheme rules, do not break the limit. The ‘appropriate limit’ is broadly calculated as the higher of:

  • The DB LTA value at 5 April 2006 (i.e., 20 x the accrued pension) increased by the greater of 5% or RPI (the ‘relevant indexation percentage’ – RIP), or
  • A recalculation based on benefits built-up by 5 April 2006, but reflecting subsequent pay increase, the ‘post-commencement earnings limit’.

The calculation is complex and requires detailed knowledge of both the DB scheme rules and the old HMRC benefit limit regimes. Getting it wrong could be very costly, therefore the safest option is to ask the DB scheme to confirm the limit rather than trying to work it out yourself.

How partial transfers could help

Where a client’s DB transfer value is above their ‘appropriate limit’, they can still make a partial transfer up to the limit without affecting their enhanced protection.

Only the amount transferred is tested against the limit and so, if the partial transfer is within the limit, the client’s enhanced protection is maintained. The transferred funds can then grow without limit under the new DC pension, with no impact on the protection.

This gives the client access to pension flexibility with at least some of the value of their DB wealth. The client’s retained DB rights must still be tested against their remaining appropriate limit – but only when they come into payment or are transferred.

In these circumstances, it might be prudent to ensure the DC pension is fully crystallised before the remaining DB rights are taken or transferred to protect the DC rights against LTA tax. Loss of enhanced protection does not retrospectively affect earlier crystallisation events. This could be a long time in the future and a quirk in the legislation means the retained DB rights might be back within the limit by the time they are taken or transferred.

This is because, when the retained DB rights are tested, the available limit is the total ‘appropriate limit’ revalued to the test date (on the RIP basis) less the amount of the original partial transfer. So, you deduct a frozen amount (the original partial transfer figure) from a growing limit.

Over time, this can bring the remaining DB rights back within the limit – or allow another partial transfer later. This can happen very quickly, but the longer the gap between the original partial transfer and the limit test on the retained DB, the more likely it is that they will be within the revalued limit.

Pulling it all together

Transfer values have increased since 2006. Multiples are often more than 20 times the deferred pension, which means more and more transfers are exceeding the ‘appropriate limit’.

Among all the other regulatory complexities of advising on DB transfers it is easy to overlook the ‘appropriate limit’ issue for clients with enhanced protection. This could be a very expensive mistake, so it is worth adding to your DB advice checklist.

When a transfer to DC meets your client’s needs, but their transfer value is above the limit, always ask the DB trustees if they offer partial transfers because this might just provide a route to the desired destination without jeopardising their valuable enhanced protection.

David Downie is technical manager at Standard Life