For Use By Financial Advisors Only
This note is for general guidance only and is based on our understanding of the current position of the rules relating to capped drawdown. Specific advice should be sought in respect of each individual case to ensure that the requirements of HMRC and relevant legislation are being met.
Capped Drawdown Background
Capped drawdown is an option available to individuals who were in drawdown prior to 6 April 2015. This is a form of drawdown from a pension scheme where a maximum income level (the ‘cap’) is applied. The drawdown pension available to an individual is based on a number of factors. These include the value of the fund, Gilt Yields, and rates determined by the Government Actuary’s Department (GAD).
An individual can draw 150% of the amount specified, which equates very broadly to what could be obtained through a single life level annuity. It is possible for an individual to draw more income than the cap, but doing so will possibly affect future contributions that are payable to the pension scheme.
Capped Drawdown Summary
- Complications can arise where the employer wishes to make substantial contributions for directors or key employees whose relevant earnings do not support such contributions.
- Contributions made by employers, to be an allowable expense, must be incurred wholly and exclusively for the purpose of the employer’s trade.
- In order to put up a robust defence to any potential HMRC challenge, it is of great value to be able to demonstrate that a pension contribution made by the employer is pursuant to a contractual obligation.
- Many directors of small or owner managed businesses do not have formal service agreements in place.
- Agreements are straight-forward to implement, and their existence is a potentially invaluable aid to ensuring that the contribution is treated as an allowable expense.
Implementing the Service Contract
There are two elements to this:
- Service Contract – Pension Element 1 (BIM46020 – Appendix) Reward Structure Contributions made as part of a salary sacrifice arrangement can, in certain circumstances, be treated as allowable. Thus, whilst contracts can be open to challenge if they are not seen as an accurate reflection of underlying arrangements, the Service Contract should specifically state that such an arrangement would be acceptable as part of the terms of employment. In order to structure the risk and reward aspect of the director’s remuneration it is also essential that a significant proportion of the reward is directly linked to the performance of the director and the profitability of the business. Thus bonuses (especially if linked to objective factors) can play an important part in this arrangement.
- Service Contract – Pension Element 2 (BIM46025 – Appendix) Funding The second element is the funding of a pension arrangement to the maximum allowable without triggering any unauthorised payment tax charges. Employers have always regarded affordability as one of the important factors in the funding of pension schemes. This has in almost all cases been on an informal and ad hoc basis. This served good purpose as the actuaries report determined the allowable status of the contribution. Now, however, this needs to be formalised. Thus the Service Agreement should also specify that the employer undertakes to fund the director’s benefits to the Lifetime Allowance as long as it is affordable.
Where Trustees obtain actuarial advice on the funding and benefits of the Scheme on a regular basis, it ensures that if there are any contractual obligations on the part of the employer then these are evaluated and a planned funding strategy can be put in place.
In many cases this also meets the Trustees’ obligations as the Trust Deed & Rules of the Scheme may require them to obtain regular actuarial advice regarding scheme funding and benefits. Thus the contractual obligation can be complemented by an Actuarial Valuation Report.
If an individual has uncrystallised funds held as part of a capped drawdown arrangement it should be possible for further funds to be ‘designated’ to the capped drawdown arrangement. This is a further crystallisation of benefits, and will release tax free cash as well as resulting in a revised capped income calculation applicable to the crystallised benefits.
Lifetime Allowance Test
When an individual designates further benefits to a capped drawdown arrangement, the amount that is crystallised is tested against the Lifetime Allowance. Any amount being crystallised in excess of this will result in a tax charge of 25% unless the individual benefits from a form of protection (Enhanced Protection, Primary Protection or Fixed Protection).
The maximum amount of annual income is currently fixed and income can be drawn at that level irrespective of the value of the fund. The limit is reviewed annually regardless of age. This limit will apply even where a transfer to another pension plan takes place.
Exceeding the Income Cap
An individual can exceed the income cap if they wish, which automatically converts the arrangement to a flexi-access drawdown arrangement. The cap will no longer apply, and an individual can draw the balance of the fund as income (which will be subject to tax). The individual will also become subject to the Money Purchase Annual Allowance (MPAA), which is designed to prevent recycling of pension income into a pension scheme. When the MPAA applies, an individual is restricted to a maximum contribution of £4,000 per annum gross to money purchase arrangements, and is no longer able to use Carry Forward.