Fixed protection: the life cover problem!

Introduction

A threat to fixed protection has emerged from an unexpected source – continued life cover in respect of an individual’s dependants.

In this Alert:

• Key points 
• Background
• Restrictions on fixed protection
• Why is life cover potentially a problem?
• What can employers / trustees do?
• Is HMRC’s interpretation the only one? 

Key points

• Fixed protection allows individuals to retain an overall LTA of £1.8 million for pension savings when the LTA reduces to £1.5 million on 6 April 2012.1
• Certain types of lump sum death benefit may cause fixed protection to be lost.

Background

The LTA is the total amount of tax relieved pension savings that an individual can build up over their lifetime without incurring an additional tax charge. For this purpose, DC benefits are assessed by reference to the individual’s pot. For DB savings, it is the capital value of the pension, using a factor of 20.

From 6 April 2012, the LTA will reduce from £1.8 million to £1.5 million. However, fixed protection was introduced to allow individuals to maintain an LTA of £1.8 million but, in return, further pension saving is strictly limited.

Restrictions on fixed protection

Fixed protection will be lost:

• in a DC arrangement, if contributions are paid to the scheme by or in respect of the member;
• in a DB arrangement, if the pension and lump sum rights of a member increase by more than the “relevant percentage”2 at any time during a tax year. (The test for benefit accrual can occur at any time up to the point when benefits are actually taken);
• if a new arrangement is established in any registered scheme in respect of the individual; and
• on a transfer, subject to certain limited exceptions.

Why is life cover potentially a problem?

DB arrangements

A simple DB lump sum death benefit of, say, 4 x pensionable salary, will not jeopardise an individual’s fixed protection. This is because the DB test as to whether there is benefit accrual post 5 April 2012 applies.

However, the DB lump death benefit arrangement must have been in place before 6 April 2012.

DC arrangements

In contrast, the payment of a premium to a DC (or “money purchase”) death benefit after 5 April 2012 will prejudice fixed protection because it falls foul of the DC contribution test.

Hybrid arrangements

Unfortunately, HMRC appears to treat lump sum death benefits which are or could be restricted as “hybrid” arrangements (namely, a mixture of a DB and DC arrangement). As such, the payment of any premium post 5 April 2012 towards such arrangements could trigger the loss of fixed protection.

Some (non-exhaustive) examples of the type of death benefits which seem to fall into the hybrid trap are as follows:

• Type A – lump sum death benefits where the amount payable is the better of a multiple of salary or the proceeds of an insurance policy;
• Type B – lump sum death benefits where the amount payable is a multiple of salary but the benefit may be capped by the insurer where, for example, there is a “catastrophic event”. Death benefits of this type are far from uncommon and may be used by an insurer to restrict death benefits where multiple claims are triggered under a single policy relating to the same event.

What can employers / trustees do?

Employers with fixed protection members need to check their death benefits and seek legal advice on how to proceed. Trustees will also want to understand the position.

The appropriate solution to the death benefit problem will vary from scheme to scheme but it is important to bear in mind that any solution needs to be implemented by 5 April 2012 at the latest. Available options include:

• Cease providing affected death benefits – this may require the individual’s consent if the promise to provide life cover is, for example, written into employment contracts;
• Continue to provide life cover through the pension scheme – consider whether the scheme can be amended to provide a DB lump sum death benefit only (the employer may need to be willing to top up any available insurance proceeds to make this possible);
• Provide death benefits outside of the registered pension scheme – for example, by setting up an “excepted life policy”, although the tax consequences of doing so should be fully explored first.

Is HMRC’s interpretation the only one?

In our view, certain types of death benefit which HMRC seems to regard as hybrid DB/DC could just as easily be classified as “cash balance” death benefits, with the test for benefit accrual being similar to that for a DB arrangement.

The death benefit described under Type B above would certainly seem to fit within this definition under the relevant legislation.3 We have therefore asked HMRC to reconsider their approach to death benefits and are hoping to receive further guidance. However, as this may not be available before 6 April 2012, trustees and employers whose death benefits fall into the hybrid trap should press ahead with action now.

1 For more information, please see our Alert: “Fixed Protection: the deadline approaches” (dated 27 February 2012)
2 The relevant percentage is the rate specified in the scheme rules on 9 December 2010 by which a member’s rights are increased annually or, where there is no such rate, the annual rate of increase in CPI for the year ending with the previous September’s CPI figure
3 Under a cash balance arrangement “the rate or amount of [benefits] is calculated by reference to an amount available for the provision of benefits to or in respect of the member calculated otherwise than wholly by reference to payments made under the arrangement by the member or by any other person in respect of the member” (section 152(5), Finance Act 2004)