Fixed protection: is it the best fix for your pension?

With the lifetime allowance for retirement benefits falling to £1.25m on 6 April 2014 more people are likely to have pension funds that will exceed this by retirement.

While electing for fixed protection at April 2014 gives an allowance of £1.5m, not everybody with benefits that will exceed the £1.25m limit should make this choice:

  • People in defined benefits schemes should consider carefully before deciding to opt-out.
  • Those in defined contribution schemes who are expecting significant investment returns and are many years away from drawing benefits.
  • Cases where any cash alternative offered by an employer is less than the contribution that would otherwise be paid into the pension scheme; cash may not be better value.

Fixed protection allows a slice of benefits between £1.25m and £1.5m to be taxed at (say) 30% rather than 55%, a difference of 25%. This assumes that one quarter of benefits is tax-free cash, and three-quarters is taxed at 40%. So the tax saving on protection would be 25% on up to £250,000, i.e. £62,500. It would be less if the actual benefits were less than £1.5m or if you took individual protection. But, no future contributions to pension schemes would be allowed under fixed protection.

Deciding whether you’d get a good deal by applying for fixed protection is broadly a comparison with the after-tax benefits that you’d receive if protection wasn’t taken. 

  • If you are an employee in a defined benefit scheme what is the value of losing future benefit accrual in the scheme, or losing future employer’s contributions if in a defined contribution scheme?
  • Is the facility to make future pension contributions, which would enjoy gross investment returns but be taxed at 55% on the way out, worth more than having to invest personal cash, taxed at say 47% with tax on investment returns?
  • If you are an employee, will your employer provide a (taxed) cash supplement in lieu of pension scheme membership and would this sufficiently offset the loss of future scheme membership?

Assuming the pension funds would be worth £1.5m, the facility to make future pension contributions would need to be worth more than £62,500 to offset the tax saving given up by not taking fixed protection.

If you have a pension fund worth more than £1.25m on 5 April 2014, you will be able to elect for individual protection. This will give you a better personal lifetime allowance than £1.25m and will be based on the value of benefits as at 5 April 2014, up to a ceiling of £1.5m. Importantly, with individual protection, you’ll be allowed to make future contributions to pension schemes but all benefits in excess of your protected amount would be subject to the lifetime allowance charge. In these cases the advantage of taking fixed protection would be less pronounced than where the lifetime allowance was £1.25m. The saving offered by fixed protection over individual protection would be 25% of the difference between the amount protected by individual protection at 5 April 2014 and £1.5m.

Fixed protection will be a valuable choice for some people but it might not be the best choice for all, even if you have benefits above £1.25m. The decision of whether to elect for fixed protection needs to consider the potential tax saved from a higher lifetime allowance against the after-tax cost of the loss of future pension scheme accrual, offset by any cash supplement offered by an employer and savings from not making future personal contributions to pension schemes.

As always, you should seek independent financial advice before making decisions in this complex area.

Tim Sexton is a director in our Pensions team. You can contact him on +44 (0) 20 721 23943 or by email at [email protected]