Pensions World

Lorna Buckland, Linklaters, details some practical things for schemes to think about when it comes to dealing with scheme pays

With effect from April this year, the annual allowance reduced substantially from £255,000 to £50,000 a year, bringing many more members within its scope. In some circumstances, a member who incurs an annual allowance charge can take steps to make his or her pension scheme directly liable to pay all or part of it (with his or her benefits then being reduced accordingly).This is being referred to as “scheme pays”.

How does scheme pays work? 

Before looking at the practicalities, below is a brief reminder of the key features of scheme pays:

• The option to have the scheme pay all or part of the annual allowance charge will be available to the member only if he or she has an annual allowance charge – across all schemes – of at least £2,000 (having used any available “carry forward” relief from the preceding three years to the full).
• In some cases, this annual allowance charge may have been incurred across two or more schemes. If so, the member can only exercise this option against a scheme where there have been sufficient contributions or accrual in that scheme alone to give rise to an annual allowance charge. (The option will then only apply to the part of the member’s annual allowance charge which is attributable to that scheme.)
• To exercise the option, the member must serve a notice on the scheme containing certain information. This will make both the scheme and the member liable for the annual allowance charge, but in reality the scheme will pay it (and adjust the member’s benefits accordingly).
• Schemes which pay this annual allowance charge liability are required to make a consequential adjustment to the individual’s benefits on a basis that is just and reasonable having regard to normal actuarial practice. However, guaranteed minimum pensions may not be reduced and so scheme pays does not apply where meeting the annual allowance charge would make it necessary to reduce those benefits.
• Although the benefit adjustment in relation to a money purchase pension scheme should be a relatively straightforward matter of deducting the amount paid from the member’s money purchase account, the manner of adjustment for defined benefit schemes will be less clear cut.
• There is no provision enabling schemes to charge the member an administration fee.
• There are only limited exemptions to the scheme pays requirements, namely: schemes in the Pension Protection Fund assessment period; and at the discretion of HM Revenue & Customs, schemes that can demonstrate that paying the charge would substantially harm members’ interests.  

 The advantage of scheme pays for the member is that it saves them from having to meet the whole annual allowance charge upfront. However, scheme pays is likely to be yet another headache for pension scheme trustees and administrators. It will be of most immediate concern to those members who become entitled to benefits in the near future and who face a substantial annual allowance charge. This article considers some of the practical issues pension scheme trustees and administrators will need to think about to comply with the requirements.*

Giving notice

Schemes do need to think about scheme pays relatively quickly as, with effect from 6 April 2011, members can request it when benefits become due. It is therefore those schemes which have retirements coming up in the near future (where the members retire with a substantial annual allowance liability) that are likely to be the first to have to deal with scheme pay issues.

Broadly, a member must give the pension scheme his or her scheme pays notice by:

• 31 July of the calendar year after that in which the relevant tax year ends – so
• 31 July 2013 in respect of tax year 2011/12. It has been announced, however, that for this first tax year of the new regime only the deadline will be extended to 31 December 2013
• if sooner, the date when the member becomes entitled to receive all his or her benefits under the scheme.

Issues for schemes

Scheme pays raises a number of issues:

1. There is no obligation on schemes to advise members of the scheme pays facility, but some schemes may prefer to do so anyway.
2. An associated question for schemes to address (if they do decide to advise members of the scheme pays option) is how widely they should cast the net. For example, they may decide to advise every member whose benefits from the scheme are sufficient to trigger an annual allowance charge taken on their own, or only advise in those cases where the accrual reaches a set level that is high enough to suggest that the member is likely to reach the £2,000 annual allowance charge threshold.
3. Schemes will also need to liaise with their administrators to ensure that all necessary system requirements are in place. These would include the need to acknowledge a member’s “scheme pays notice” upon receiving it and the establishment of a clear process for advising members who ask how scheme pays would affect their benefits.
4. Defined benefit schemes are likely to need advice on the appropriate basis for adjusting the benefits. Practical issues include:

• a) If the member has paid money purchase additional voluntary contributions (AVCs), the scheme may prefer to recover its costs by reducing the member’s money purchase account (at the time the annual allowance charge is paid) rather than go through the more complex route of reducing defined benefits. This appears to be allowed, even if it is the member’s defined benefit accrual (rather than his or her AVCs) that has given rise to the annual allowance charge.
• b) The scheme will normally find it simpler to reduce the member’s retirement lump sum than his or her pension. This may not be the member’s preferred option (as it means his or her benefits will be reduced immediately rather than over his lifetime), but the method of adjustment is the scheme’s (not the member’s) decision. However, clear communication will be key.
• c) Failing this, the scheme will have to reduce the pension itself. A possible starting point might be to treat the tax liability like a “pension debt” on divorce (calculated using a cash equivalent basis).
• d) Some schemes may decide to go further than strictly required by providing a member with the scheme pays facility in cases where they are under no obligation to do so, for example, because a member has not met the £2,000 annual allowance charge threshold or they have not fully satisfied the notification requirements as specified above.
• e) No rule amendment is necessary in order to comply with the scheme pays requirements. This is because the scheme’s obligation to pay, and to adjust the member’s benefits, is overriding.

Imminent retirements

There is a separate issue in respect of retirements that are imminent over the next few weeks, ie before the regulatory regime is fully up and running, but members request (or expect) schemes to implement scheme pays.

Here, schemes might take the view that retiring members are likely to have a lump sum which can be used to meet the charge and so take no action.

Alternatively, the scheme may seek to agree with the member a temporary adjustment of his or her benefits (such as holding back part of the retirement lump sum or reducing the initial level of pension instalments), while the regulations are finalised and the scheme formulates a method of benefit adjustment which complies with the new requirements.

Some care will be needed as to how this is done. For example, the lump sum should not be temporarily held back for longer than a year (as it can no longer be paid tax free once a year from the date of entitlement has elapsed).
 

*This article is based on the Finance Act 2011 and on draft regulations relating to certain aspects of the scheme pays facility outlined here. The regulations are not yet in final form.