The Benefits of Tax-Free Cash: How Attractive is it Really?

I was recently working with a client concerning a pension transfer of his defined benefit (DB) pension scheme; and some questions which arose concerning his available PCLS.  Owing to the fact that this was not the first time such question has arisen, I thought it wise to write a brief piece on how the PCLS is calculated, and how to determine the attractiveness of such PCLS in light of the suitability of a possible pension transfer.  This is going to be a rather technical (bumpy) ride, so fasten your seatbelts; let’s go!

Unless a member has transitional protection (primary protection, enhanced protection, Fixed protection or individual protection), the maximum PCLS will always be limited by the standard lifetime allowance (currently £1,073,100).  This means for the current tax year the maximum PCLS from any arrangement is capped at £268,275 (25% of £1,073,100).  

When considering a money purchase scheme, the calculation is simple.  25% of the total fund, capped at 25% of the standard lifetime allowance.  In fact, the regulations are written to state that “one third of funds allocated to drawdown can be taken as a pension commencement lump sum”.  However, the math is the same.  If a member has a money purchase scheme with a fund of £1,000,000, and they take 25% PCLS; £750,000 would be allocated to drawdown.  One third of this £750,000 is £250,000 which is the same as 25% of the total fund.

However, when dealing with a defined benefit scheme, there is another, less known rule implemented by the HMRC, and it utilizes the commutation factor which the scheme chooses.  Before we look at the cap implemented by the HMRC, let’s clarify what we mean by “commutation factor”.

Most DB schemes will allow a member to take a PCLS through commutation.  Each fund would have a commutation factor, and this dictates how much of their scheme pension they need to “commute”, in return for the PCLS.  For example, if a scheme commutation factor was 16, then for every £16 of PCLS, the scheme pension would be reduced by £1 per annum.  For example, if a member was permitted to take a PCLS of £200,000, then their annual scheme pension would be reduced by £12,500 (£200,000/16).

What is less known, is that the commutation factor is also used to calculate the maximum PCLS permitted by a member of a DB scheme.  In doing so, the pre-commuted pension is required (based on accrual rate, pensionable salary and time of employment).  By using the formula (PCP X CF)/[1+(0,15 X CF)], one can ascertain the maximum permitted PCLS allowed under the scheme, (where PCP is pre-commuted pension and CF is commutation factor).  This is best illustrated by means of an example.

Assume a member has a pre-commuted annual pension of £35,000, and the scheme has a commutation factor of 16.  Then the maximum PCLS permitted would be:

(£35,000 X 16)/[1+(0,15 X 16)]

=£164,705.88

The annual pension would be reduced by £1 for every £16 taken as a PCLS, which, in casu, would reduce the members annual pension to £24,705.88 (£35,000 – (£164,705.88/16))

What is more important than calculating the maximum PCLS, is rather identifying the attractiveness of such PCLS.  This is normally undertaken when a member is considering a pension transfer and the transfer value is required to assess the attractiveness of the PCLS offered by the DB (ceding) scheme.  By following the same example above, and assuming the transfer value for the client is £875,000, we can run our assessments.

If the client were to transfer his pension benefits into a defined contribution arrangement, the maximum PCLS he would be able to withdraw would be £218,750 (£875,000 X 0,25).  This is clearly a lot higher than the maximum PCLS which would be available under his current DB scheme.  

Upon further consideration, we can deduce the following.  The client needs to forego 29,41% of his annual scheme pension ((£164,705/16)/£35,000) X 100), to receive 25% of his pension as tax free cash.  One may argue therefore, that this doesn’t represent good value and would support an argument to transfer out of his current scheme.

Using the formula’s above, and assuming that the commutation factor was 25, then the maximum PCLS permitted under HMRC rules would be £184,210.  This would result in a reduction of annual pension by £7,368.  As a percentage of the pre-commutation pension (£35,000), this represents 21,05%.  Therefore, in such a situation, a member would need to forego 21% of their annual pension for 25% tax free cash.  Unlike the example above using a commutation factor of 16; this represents good value and would support an argument in favour of remaining.  Generally speaking therefore, the higher the commutation factor, the more favourable this would be for the member (which makes sense as one would be receiving a higher PCLS amount for the same £1 reduction in annual pension).

Analysing the relative value of a PCLS in relation to forfeited pension is not the only factor which needs to be taken into consideration; however, it does support an argument either to transfer or not.  When dealing with DB schemes the available PCLS is not always simply 25% of the transfer value as is clear from the above.

As is apparent from the above, such analyses are rather technical and hence a pension transfer specialist should always be consulted.  If you would like to discuss your pension situation, please feel free to get in touch with me.

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