Tim Kehoe explains the rules applying to occupational pension scheme members who choose to receive benefits ahead of schedule
Although all occupational pension schemes must set a normal retirement date (NRD), more and more individuals now want to take their benefits before or after that date.
Members of occupational pension schemes who wish to draw their benefits directly from the scheme before the NRD must leave the service and retire from the employment to which the pension benefits relate. Controlling directors must also resign their directorship. In such cases, the benefits may commence at any point from the age of 50, subject to the scheme's rules allowing this.
However, if an individual does not wish to leave their current employment, they can leave pensionable service and transfer benefits to either a personal pension/stakeholder scheme (PPS) or a Section 32 contract and draw benefits from age 50 onwards. Where a guaranteed minimum pension (GMP) is included in the Section 32, benefits can be taken before State pension age only if the revalued GMP will be covered at State pension age.
Within a PPS, protected rights cannot be taken before the age of 60. A regulated individual ' someone who is, or was, at any time in the 10 years prior to transfer, a controlling director, or someone aged 45 and over earning more than the earnings cap in the current year or in any of the preceding six tax years ' can only transfer if they pass the new test set out in Appendix XI of the occupational pension scheme practice notes IR12.
The Inland Revenue has stated that once benefits originating in an occupational pension scheme have commenced, even after a transfer from a PPS or Section 32 contract, the maximum permissible benefits are set as far as employment is concerned. It will not be possible for the member to subsequently join another occupational pension scheme in respect of that same employment.
However, it is possible to take out a PPS and contribute up to £3,600 a year without providing any evidence of earnings. Employees other than controlling directors could also pension future service with that employer through a PPS based on net relevant earnings.
The Inland Revenue is clamping down on those individuals who return to work for the same employer after they have started to draw their pension benefits from that employer's occupational pension scheme. The Revenue will want to know if the retirement is genuine or just an attempt to extract benefits early. The potential penalty is that the lump sum could be subject to tax and/or the pension payments suspended until the normal retirement age.
A scheme may permit a member to commute the full value of their pension, except the value of any GMP, in the circumstances of exceptional ill health. Provisions contained in the Child Support, Pensions and Social Security Act 2000 relax the rules for protected rights held in an occupational money purchase scheme.
In circumstances of exceptional ill health, it will be possible to commute the protected rights fund. If the member is not married, the whole protected rights fund may be commuted; if they are married, only half the fund may be commuted. The Act does not allow the commutation of protected rights from a PPS.
The definition of circumstances of exceptional ill health is interpreted to mean that expectation of life is less than one year. Adequate medical evidence must be provided to justify the payment. For controlling directors, notification must be given to the Inland Revenue at least 14 days before benefits are due to be paid.
For all members of small self-administered schemes (SSASs), prior agreement from the Inland Revenue must also be obtained. Where full commutation is granted, any part of the value paid in excess of the normal tax-free cash sum will be subject to tax at 20%.
An employee may retire at any age before their NRD on the grounds of incapacity, subject to the scheme rules and trustees allowing this. The maximum benefits on ill health early retirement are those that would have been payable at the NRD based on current remuneration.
For controlling directors, the documents permitting retirement must be submitted to the Inland Revenue. If no objection to the early retirement is received from the Inland Revenue within 28 days, the pension may commence.
On 30 June 1999, the Inland Revenue published its Pensions Update number 54. This introduced with immediate effect the flexibility to commence the payment of benefits under AVC and FSAVC arrangements at any time between ages 50 and 75 without the need to retire. However, if the AVC and/or FSAVC benefits are to be taken before the main scheme benefits, this must be carried out in the form of income withdrawal.
This added flexibility is available only with the agreement of the trustees/ provider and is unlikely to become widely available. After leaving pensionable service early without taking main scheme benefits, an individual who contributed to an FSAVC may commence benefits from age 50 ' leaving pensionable service breaks the link with the main scheme.
It is also possible, where the link is broken, to transfer to a PPS and take the benefits from age 50. This does not usually apply to an AVC arrangement as AVC benefits cannot be transferred in isolation unless they are in a completely separate scheme with its own trust deed and rules.
Under a defined benefit scheme, the actuary will, in most cases, impose an actuarial reduction factor for members who wish to draw their benefits early. The rate of reduction can vary between schemes and typically ranges between 3% and 5% per year.
The reduction factor may even compound year on year for those who are retiring a number of years earlier than the scheme's NRD. For example, a member retiring five years before the NRD with a compounding 4% per year reduction factor would effectively be subject to a 22% reduction in the pension benefits.
Where a defined benefit scheme or Section 32 contains an element of GMP, all the benefits can be taken early as long as the payment of revalued GMP at age 65 (men) and 60 (women) can be covered.
For money purchase schemes, the member will be entitled to the fund that has accrued at the point of retiring, possibly subject to early discontinuance penalties. The appropriate annuity rate based on the member's age would be applied to calculate the benefits. Annuity rates based on lower retirement ages will be less than those available at the NRD, consequently providing smaller pension benefits.
It is not possible to phase the taking of benefits through a Section 32 contract. Where benefits in respect of the same employment have been transferred to a number, or cluster, of Section 32 contracts, retirement from one policy cannot come into payment in isolation.
However, it is possible to transfer one or several policies at a time to a PPS, subject to the Personal Pension Schemes Transfer Payments Regulations 2001, and draw benefits through income withdrawal or annuity purchase.
This may be particularly useful to regulated individuals who do not wish to limit lump sum death benefits payable before vesting to a tax-free sum of 25% of the fund.
Unlike an occupational scheme member, a member of a PPS may draw non-protected rights benefits at any time from the age of 50 and continue to work for the same employer. There are various retirement planning options available, comprising annuity purchase, phased annuity purchase, income withdrawal and phased income withdrawal.
Phasing the purchase of annuities is a particularly useful retirement planning tool for those individuals who are gradually cutting down on their working commitments.
Most personal pensions can be arranged into a number of segments. A member can then purchase an annuity by converting a segment, or a number of segments, to provide a desired income. As part of the segment can be taken as a tax-free sum, converting segments on a regular basis effectively means using the tax-free cash as well as the annuity to provide income.
Phasing the purchase of pension benefits provides more flexibility for survivors in the event of the member's death. The segments that have not been converted to annuity can provide an annuity or a lump sum for the survivors, depending on the terms of the contract.
For those members who do not wish to buy an annuity, it is possible to take an income directly from the fund where this is permitted by the terms of the contract. When considering income withdrawal, any maximum tax-free cash sum entitlement must be taken before income withdrawal commences. No further entitlement from that policy/segment will be allowed in future.
Annuity rates provided by the Government Actuary's Department are used to establish the maximum that may be drawn from the fund. The member may then draw down an income of between 35% and 100% of the maximum. The maximum level of drawdown must be reviewed every three years.
It is also possible to combine income withdrawal with the phasing of benefits if the personal pension is written with a number of segments. Income withdrawal involves additional costs and greater investment risks compared with buying an annuity at outset.
• Occupational scheme members wishing to draw benefits before their normal retirement date must leave the employment to which the pension relates.
• Those who don't want to leave their employment can transfer benefits to a personal pension/stakeholder scheme or a Section 32 contract.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress