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Jacqueline Clezy: Don’t let lump sums blind clients

The right advice is crucial to avoid instant gratification at the expense of long-term income needs

Where a member’s pension benefits exceed their lifetime allowance, LTA excess charges are unavoidable.

Well, perhaps they can be avoided, but it would mean reducing uncrystallised funds by paying a pension debit directed in a divorce order.

This is a pretty drastic and expensive course of action, so it’s one to rule out. Assuming the member will take all their benefits, the order they use to take benefits can affect how much they actually receive.

What does the member want to achieve? Do they want to minimise LTA excess charges? Is maximum pension commencement lump sum their dream? Are they focused on securing the highest lifetime income available? Remember that when it comes to defined benefit transfers, the FCA has said a client’s needs are more important than their objectives.

The case

Let’s consider Pamela, who’s already taken some uncrystallised funds pension lump sums and used 50 per cent of her LTA. She holds Individual Protection 2014 with a protected LTA of £1.4m and has benefits still to take (see table 1).

Pamela wants to reduce her outstanding mortgage amount of £350,000 by taking the maximum income tax-free lump sum allowed, i.e. not UFPLS. She needs income of around £1,500 each month.

The options

We’ll compare four scenarios:

  • Taking money purchase benefits first, DB schemes pay LTA excess charges, excess as scheme pension.
  • Same as (1) but LTA excess as lump sum.
  • Taking all DB scheme benefits first, MP scheme pays LTA excess charges, excess designated to drawdown.
  • Same as (3) but LTA excess as lump sum.

***A summary of benefits paid using each scenario is included in table 2, with full workings detailed in the box on the right.***

Option 2 generates the maximum lump sum but doesn’t meet the income requirement, providing only £7,503 per annum and a drawdown pot of £375,000 for future income needs.

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The solution

Pamela’s adviser recommends option 4. While this doesn’t achieve the maximum lump sum, it provides secure income to meet Pamela’s needs, which is the first priority.

There are many ways Pamela could take her benefits, each producing a different outcome. The options available under a DB scheme may also influence the order but, essentially, what the client needs to consider is whether they would rather give up some of their PCLS entitlement from their MP arrangement to have more guaranteed income for life through the DB scheme pension, or vice versa.

Giving the right advice is crucial so the client is not blinded by the instant gratification of a larger lump sum at the expense of potentially long-term income needs.

Jacqueline Clezy is technical manager at Prudential UK

The workings

MP first

MP fund £500,000 (PCLS £125k, £375k to drawdown) LTA used £500,000/£1.4m = 35.71 per cent
DB scheme 2 LTA used 8.57 per cent
Total LTA used = 94.28 per cent (50 per cent + 35.71 per cent + 8.57 per cent)
LTA remaining  £80,080
DB scheme 1 LTA required 20 x £12,000 + £80,000 = 320,000
Pension £3,003 and PCLS £20,020 uses remaining LTA
Paying LTA excess from DB schemes depends on scheme rules, options available and commutation factor
Commutation factor here is 10:1
LTA excess £239,920
Taken as lump sum: charge at 55 per cent £131,956, balance to Pamela £107,964
Taken as pension: charge at 25 per cent £59,980, residual pension of £6,002 (£12,000 – (£59,980/10)). Pension payments taxed at marginal rate
DB scheme 3 £80,000, all LTA excess
As lump sum: charge £44,000, balance to Pamela £36,000
As pension: charge £20,000, using commutation factor 15:1, residual pension is £2,667 (£4,000 – (£20,000/15))

DB first

DB scheme 1 LTA used 22.85 per cent
DB scheme 2 LTA used 8.57 per cent
DB scheme 3 LTA used 5.71 per cent
Total LTA used = 87.13 per cent
MP fund £500,000
LTA remaining £180,180
Maximum PCLS £45,045
£135,135 to drawdown
Remaining £319,820 is LTA excess.
As lump sum: charge £175,901, balance to Pamela £143,919
As drawdown: charge £79,955, balance to drawdown £239,865. Income from drawdown taxed at marginal rate.

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