The latest figures from HMRC reveal that the tax collected from the LTA (Lifetime Allowance) have almost trebled within two years—from £40m in 2014-15 to £110m in 2016-17. Due to a combination of (i) increase in volumes of instructions (ii) increasing pension pots and (iii) previous reductions in the LTA limits, LTA tax is featuring more regularly in the work we do.
I would also argue that it is a highly insidious tax, which does nothing to heal the rift between defined benefit and defined salary schemes, leaving those who do not have the benefit of defined benefit pensions somewhat hard done by. Let me explain why.
The problem with how a pension is valued for LTA
In a defined benefit/final salary scheme, say for an NHS employee, the pension is valued for LTA purposes by multiplying the pension by a factor of 20 and adding on the lump sum. So, if an NHS employee retired on a pension of say £40,000 per annum, and a lump sum of £120,000, this will be valued for LTA purposes at £920,000—comfortably within the current LTA limit of £1.03m.
In a defined contribution/money purchase scheme, the pension is valued for LTA purposes simply by taking the value of the fund. If, say, a 60-year-old in a defined contribution fund wanted to buy an index-linked pension, with no investment risk, of £40,000 per annum and take a lump sum of £120,000, they would need a fund of c. £1.5m—well exceeding the current LTA limit of £1.03m.
The long and short of the issue is that current rules permit a member of a defined benefit final salary scheme to have a far larger pension in retirement, without being taxed, than someone with a defined contribution scheme.
But why is this especially an issue in divorce cases?
LTA tax and divorce
Let’s take a case where Husband (H) is a high earner, in a large private sector company, which still runs a defined benefit scheme. He is approaching retirement, and unfortunately, getting divorced from Wife (W). He has a preserved pension of £80,000 pa which will come into payment at age 60, and the CEV is £2.5m.
Even if the intention is a simple 50:50 split of the pension on divorce by reference to the CEV, it can be seen that after pension sharing, H will have a pension of £40,000 pa, which is valued at £800,000 for LTA purposes (and well within LTA limits) but W will have a defined contribution fund of £1.25m, well in excess of the LTA limit, and thus she will suffer a tax bill.
If equality of income is sought, the situation becomes slightly worse for W; a PSO of c. 52% may be required, generating pension credit of £1.3m. This will leave both parties with an in-theory gross income of £38,800 pa each, but H has no tax to worry about, other than income tax. W has to consider LTA as well as income tax. If we take LTA into account and seek to equalise incomes after LTA tax is deducted, then an even greater PSO is required to compensate W for the tax she will suffer (not suffered by H) creating an even larger tax bill for W—a vicious circle, where the only winner is HMRC, and both H and W lose as the pension pot to be divided, is reduced by this insidious tax.
What can be done?
We are increasingly seeing cases of inequality caused by LTA tax. The option which seems to find most favour (at the moment) is to use a combination of pension sharing and offsetting. The Pension Sharing Orders are restricted to a percentage which keeps W within LTA limits. There is often a “window” or range of PSOs within which (i) H is brought within LTA limits, and (ii) W is kept short of breaching LTA limits.
The problem is that in a case like the example above, if the PSO were to be only 40%, designed to restrict W’s pension credit to £1m and thus within limits, and H is also brought within limits (a 40% PSO reducing his pension to £48k pa, and thus valued at £960k for LTA purposes). Clearly, equality of income will not be achieved—that requires a PSO of 52%. To correct this, we have to then work out (in addition to a PSO of 40%) what W will require by way of offset, to achieve overall equality.
If this is making your head spin a little, that’s perfectly understandable. LTA is a complex issue that requires the touch of an expert to ensure equality between both parties. If you need help in dealing with LTA tax and other issues in Pensions and Divorce, my team at Mathieson Consulting is ready to lend a hand.