I’ve written numerous articles on the lifetime allowance (LTA), including whether or not it’s beneficial to continue to fund a pension where the individual expects to have an LTA issue.
One scenario I haven’t covered, although I’ve had questions on it, is where the individual already has money purchase arrangements that exceed their LTA, and they’re at the point of taking benefits prior to age 75. The question posed is, is it better to crystallise all their benefits and take the LTA charge ‘hit’ now or, crystallise up to their LTA and leave the balance that exceeds this figure until some future date, either being the earlier of the individual’s death, or age 75?
The apparent justification for the former is it locks in the value of the crystallised fund, and if the member were to die before age 75 there’d be no further LTA test, and a beneficiary’s flexi-access drawdown would be free of any income tax if they choose that option.
The inference for the latter was that while there’d most certainly be a future LTA charge, the compounded return on the initial untaxed amount would be a higher net amount at the time of the actual charge, than on the compounded initially taxed excess.
Ultimately, the choice may depend on individual clients’ personal circumstances, their needs, their future plans and perhaps their intentions as to how they’d like to pass on their wealth.
As I’m not party to these nuances, I’ve always been mindful to tread the middle ground, suggesting that it’s a discussion the adviser needs to have with their client, and that they may need to do some number crunching.
To date, I’ve not had an adviser come back to me and say I’ve crunched the numbers, and this was the outcome of the exercise. Therefore, out of curiosity, I thought I’d devote some time to doing so myself.
Working through some scenarios
The approach I took was on crystallising benefits, the 60-year-old ‘individual’ took the maximum pension commencement lump sum (PCLS) and designated the remainder to drawdown.
The starting income was 4% of the initial drawdown fund (75% of their LTA), increasing by 2% per year.
They’d always hold three years’ worth of income in cash as a hedge against any falls in the market, although I’ve not factored in any falls in the scenarios and simply assumed an investment return, net of charges etc., of 4% per year. I also assumed there’s no interest earned on the cash, as it’s effectively neutral across each scenario. In the event of the death of the individual I assumed the beneficiaries elect for the drawdown option, meaning any LTA charge would be at a rate of 25%.
Consider the situation in year one for someone with a fund of £1.25m and an LTA of £1.0731m (cash pot value is prior to taking income).
If the individual were to die before any income was taken in year one, then the net amount under the partial crystallisation would be the same as under full crystallisation, namely the beneficiaries, after factoring in the LTA charge, would also have access to £937,500.
Continuing with this approach, at age 74, I get the following:
The uncrystallised rights would be subject to an LTA charge of £76,584. Adding the net amount after the charge to the drawdown fund gives £878,730, again the same as the full crystallisation drawdown fund.
Intuitively you’d think the compounding on the uncrystallised element would ultimately produce a higher result, however, it seems there’s no difference in the outcome, no matter which approach is taken. If that is the case, then it’s at least one less thing for an adviser to worry about when discussing such scenarios with their clients.
A couple of final points to make
The LTA charge on death needn’t be paid from the ‘inherited’ pension fund, meaning in the partial crystallisation approach more could be retained in a tax-efficient environment, which may be preferential in certain circumstances.
Lastly, the individual might also feel inclined to adopt a more aggressive investment approach for their £176,900 uncrystallised fund, with the potential for a higher return, than they would for their fully crystallised drawdown fund.