TRIVIAL COMMUTATION RULES - Legal & General

PENSIONS PROFILE DECEMBER 2012TRIVIAL COMMUTATIONRULESSummary• Trivial commutation allows individuals to take their benefits as a taxed lump sum in certaincircumstances.• The upper age restriction of 75 on trivial commutations has been removed from 6 April 2011.• From 6 April 2012, the trivial commutation limit was fixed at £18,000 and thereforede-linked from the Standard Lifetime Allowance (SLA) (which was reduced to £1.5 million).• The Government published draft Finance Bill 2012 clauses including the commutation ofsmall personal pension funds, for individuals with pension pots that do not exceed £2,000.IntroductionIt is for schemes to decide whether to offer a facility for commutation on grounds of triviality. There arefive types of payment that may be paid on these grounds, which are:=• Trivial commutation lump sums• Trivial commutation lump sum death benefits• Winding-up lump sums• Winding-up lump sum death benefits• Stranded pots• Small potsANY QUESTIONS?If you have any questionsor comments in relation tothis article, please emailpensions.technical@landg.com

2 PENSIONS PROFILEOptions available from trust based and contract based schemesType of commutationOccupationalschemesPersonalPension PlansTrivial commutation lump sum „ „Trivial commuation lump sum death benefit „ „Winding-up lump sum „ NoWinding-up lump sum death benefit „ NoStranded pots „ NoSmall pots No „Trivial commutation lump sumsUnder this option:• The member must be at least 60 years of age.• The member must make all such commutations within a period of 12 months.• A lump sum may be paid when no trivial commutation lump sum had previously been paid to themember (by any registered pension scheme). Trivial lump sums paid before A-day, do not countfor this purpose. Or if such a lump sum had previous been paid, a further lump sum may be paidbefore the end of the 12 month commutation period. (see later section on ‘Timing’ for a definitionof the 12 month commutation period)• Commutation must extinguish all pension rights or payments due to the member from thescheme or the annuity.• The member’s benefits (from all registered schemes) must not exceed the limit, which is currentlyset at £18,000 on the ‘nomination date’.• At the point at which the triviality payment is made the member must have available lifetimeallowance.• For individuals who are aged 75 or over, where the lump sum is being paid from uncrystallisedrights or funds, those rights or funds will have been tested against the member’s lifetimeallowance under Benefit Crystallisation Event (BCE) 5 or BCE 5B respectively when the memberreached age 75. This BCE will have used up some or all of the member’s available lifetimeallowance at that time. So, solely for the purposes of deciding whether the member satisfies thecondition that they have available lifetime allowance, the fact that a BCE 5 or 5B has occurred isdisregarded. As a result, when calculating whether the member has available lifetime allowance,any lifetime allowance used up by that BCE does not count.• However, if the member has already taken benefits from the same or another arrangement undera registered pension scheme after reaching age 75 or some other event has occurred that wouldhave been a BCE but for the fact that the event occurred on or after the member reaching age75, then, again solely for the purposes of calculating whether the member has available lifetimeallowance, those events are treated as though they were BCEs.Furthermore, there has recently been an important easement to the rules so that, for members withinoccupational schemes with very small benefits, ‘stranded pots’ can be paid as a lump sum. These rulesare outlined later in this document. There has also been legislation around ‘small pots’ within personalpension plans, allowing individuals to take up to two small pots of £2,000 or under as a lump sum.

3 PENSIONS PROFILEBenefits that need to be valuedAn individual should be aware that both crystallised and uncrystallised benefits are taken into accountwhen assessing the value of their benefits against the £18,000 limit, for commutation on the grounds oftriviality. This must include any pensions in payment being paid on 5 April 2006.Post A-DayFor defined benefits that are uncrystallised the value used is 20 times the pension that the individual isentitled to at the nominated date plus any separate lump sum. Where this is through commutation, thenthe tax-free cash taken will be included in addition to 20 times actual scheme pension payable. In caseswhere HMRC has allowed a higher valuation factor with the scheme administrator, this factor will beused instead.For defined contribution benefits, the fund value at the nominated date must be used.In valuing any benefits that have already crystallised since A-day for the purpose of testing against the£18,000 limit, the value at the time of benefit crystallisation will be taken. This will then be increased inline with the change in the SLA from the date of the benefit crystallisation event up to the nominateddate.Pre A-DayWhere benefits have been taken prior to A-Day, the pension in payment must be multiplied by a factor of25 (this factor is used on the assumption that a tax-free cash lump sum was taken before A-Day) andsubsequently indexed in line with the increase in the lifetime allowance from 6 April 2006 to the tax yearthe nominated year falls into.The formula for this is as follows:(25 x annual rate of pension at 5 April 2006 x SLA at nominated date) / £1,500,000However, the standard lifetime allowance is currently £1.5m and so no indexation is necessary.For income taken in the form of drawdown, the fund will be valued at 25 times the maximum available inthe year in which the benefits are tested.ExampleClive has been receiving a pension of £300 per annum since 5 April 2006. He also has £8,750 ofuncrystallised funds within a personal pension and would like to commute these benefits on the groundsof triviality in December 2012. The value of his existing pension is £300 x 25 = £7,500 which whenuplifted in line with the current lifetime allowance of £1.5m provides the same result: £7,500 x£1.5m/£1.5m = £7,500. Accordingly, the total value of Clive’s benefits is £7,500 + £8,750 = £16,250.So provided that Clive has met all the other conditions for triviality, he would be able to commute hispersonal pension benefits, as this amount would fall within the £18,000 limit.A member’s GMP or other contracted out benefits (where these still apply) may be commuted ontriviality grounds where the above rules are met. Similarly a member’s divorce pension credit may alsobe commuted on triviality grounds.Pre A-Day pension in payment - (£300 x 25) £7,500Uncrystallised personal pension £8,750Total value of benefits £16,250

4 PENSIONS PROFILETimingA registered pension scheme may only pay a member a trivial commutation lump sum if their pensionrights are valued at no more than the commutation limit on what is called the ‘nominated date’. Themember must have the opportunity to nominate this date. This date cannot be earlier than three monthsbefore the first trivial commutation lump sum paid to the member by any registered pension scheme. Ifthe member fails to select the nominated day, it will always be the first day of the commutation period,(see below).The legislation gives a member one 12-month period for them to commute any trivial benefits they hold,under any registered pension scheme, through the payment of one or more trivial commutation lumpsums. This is referred to as the commutation period and is set by reference to the date of the first trivialcommutation lump sum payment made (so runs for 12 months from that date). An individual can onlyhave one 12-month commutation period in their lifetime and therefore it is important that all the pensionsto be commutated are identified in advance of this period. Once this period expires, it is no longerpossible to commute any further small pension funds (with the exception of the new rules on smalloccupational pension funds below £2,000 otherwise known as ‘stranded pots’ which became effectivefrom 1 December 2009 – see below). Trivial commutations that occurred before 6 April 2006 do notcount for this purpose.As a trivial commutation lump sum can only be paid on or after the member’s 60 th birthday, thenominated date cannot be set earlier than three months before the member’s 60 th birthday (the earliestdate the commutation period can start from).If the member holds benefits under more than one scheme they are not required to commute theirbenefits under every scheme. They can commute benefits held under one scheme, but not those underanother.Tax chargeAll trivial commutations of benefits in payment must be taxed in full as income of the recipient. However,where the member has not drawn any benefits from the scheme, 25% of the commuted fund may bepaid tax-free. If the member has protected tax-free cash of more than 25%, then it would not bepermissible to take the protected tax-free cash amount and commute the balance on the grounds oftriviality. However, it would be possible to pay out any tax-free cash greater than 25% and thensubsequently trivial commute the residual pension in the instant it comes into payment i.e. it neveractually comes into payment, provided that the total benefits fall into the £18,000 limit.The pension or annuity payers of a trivial commutation lump sum payment must account for tax inrespect of the payment under the PAYE procedures set out in booklet CWG2 (2011) (Employer FurtherGuide to PAYE and NICs) within paragraph 23. Once the payer has been handed form P45 parts 2 & 3from the former employment, the payer must use the emergency code, on a week 1 or month 1 basis, todeduct tax from the lump sum. However, HMRC has published draft legislation that looks to amend thisprocess so that trivialities are taxed at the basic rate, with any under or over payment of tax being takenup between the individual and the HMRC.If however the payer or recipient believes that the recipient’s tax code from the previous employment oranother code is more appropriate, they can approach HMRC before the payment is made and askHMRC to issue such a code.As PAYE deductions frequently do not match the recipient’s actual tax liability for the tax year (in factalmost all recipients of a trivial commutation payment will have been significantly over taxed), HMRChas established an ‘in-year tax repayment’ claim procedure which allows those individuals who haveoverpaid tax to reclaim the excess amount immediately rather than wait until the end of the tax year.The scheme administrator has been advised by HMRC to include a note in their correspondence whenthe payment of the trivial lump sum is made.

5 PENSIONS PROFILEFurther contributionsAny contributions made by or on behalf of the member after the nominated date may not be commutedand paid as a trivial commutation lump sum. This similarly applies to any new rights that have accruedafter this date. This is because those contributions or rights represent new pension rights that were notin existence on that nominated date (and not valued within the pension right calculation).Any investment growth that occurs on any rights held on the nominated date may however be includedin the payment.Action by the scheme administratorTo ensure that the payment of the trivial lump sum is an authorised payment, the onus is on the schemeadministrator to obtain sufficient information from the member to confirm that the conditions, as laiddown in the legislation, are all met – specifically that all that member’s pension rights are within thecommutation limit on that nominated date. If they fail to take such steps, and it transpires that apayment made is an unauthorised member payment, the scheme will become liable to pay a schemesanction charge.Schemes will need to retain documentary evidence of any member statement or information they haverelied upon in making the trivial commutation payment.Trivial commutation lump sum death benefitsIt is possible for a dependant’s benefit paid on the death of a member to be commuted from any form ofarrangement:=• The dependant is entitled to death benefits in respect of the member and all the dependant'sentitlement under the pension scheme is extinguished.• The amount payable is not more than £18,000.The recipient is treated as having received taxable pension income, for the tax year in which payment ismade, equal to the lump sum.HMRC has confirmed that where a protected rights fund of less than £18,000 (where this is still relevant)can be paid out as a trivial lump sum death benefit even if the deceased was married or in a civilpartnership at the time of death and also had a non-protected rights fund. The example given by HMRCwas where a deceased member who was married and had a non-protected rights fund of £25,000 and aprotected rights fund of £14,000. As the non-protected rights fund would be paid fully as a lump sumdeath benefit, the £14,000 remaining in the protected rights fund could then be used to provide a trivialcommutation lump sum death benefit instead of providing a dependant’s annuity. The non-protectedrights lump sum must be paid at the same time or before the trivial lump sum death benefit. Protectedrights ceased to exist from 6 April 2012 for defined contribution schemes.Winding-up lump sumsWhere an occupational pension scheme is winding-up, it will be able to commute members' trivialbenefits subject to the following conditions being met:• It is paid when a member's lifetime allowance has not been used up.• It extinguishes the member's entitlement to benefits under the scheme.• The amount paid does not exceed £18,000. Importantly, this limit is only by reference to thelump sum payment being made under the scheme and there is no aggregation with benefits heldwithin other schemes, both crystallised or still accruing.

6 PENSIONS PROFILEFurthermore, a member below the age of 60 may only commute benefit on the grounds of triviality wherethe following conditions are met:• The employer, or former employer, who has paid contributions to the scheme in respect of themember is not making contributions to any other registered scheme in respect of the member.• The employer or former employer must undertake to HMRC not to make any such contribution toanother scheme in respect of the member for at least one year after the commutation payment ismade.HMRC’s Pensions Tax Simplification Newsletter No.19 has clarified that for employers that are no longerin existence, the undertaking that no further contributions will be made for at least a year after thecommutation payment is made will be treated as having been complied with.The tax treatment of the benefits will be the same as for a member’s trivial commutation. If a memberhas received a winding-up lump sum, this will not affect their future ability to voluntarily trivially commutebenefits from other schemes within the normal rules as set out earlier in this document.If applicable, where the scheme holds a contingent dependant’s pension entitlement, this entitlementmay be commuted with the member’s benefits, and paid as part of the winding-up lump sum payment tothe member.Where the winding up of a registered pension scheme has begun, and HMRC consider that the schemeis being wound up wholly or mainly for the purpose of facilitating payment of one or more:• winding up lump sum(s) or• winding up lump sum death benefit(s)The scheme administrator will become liable to a penalty of up to £3,000 in respect of each member orrecipient paid such a lump sum by the scheme.Note that for both trivial commutation/winding up commutation, although the payment does not trigger abenefit crystallisation event and is not tested against the lifetime allowance it can only be made providedthe member’s lifetime allowance has not been exhausted at the time the lump sum is paid.Winding-up lump sum death benefitsWhere the scheme providing the dependant’s death benefit is being wound-up any trivial pensionbenefits in existence at that time may be fully commuted in this way and paid as a winding-up lump sumdeath benefit. This applies whether or not the dependant’s entitlement is in payment.The legislation limits the level of payment to £18,000 on the date the lump sum is paid. As this couldinvolve a dependant’s scheme pension, legislation appears to require the amount payable to be withinthe £18,000 limit.A lump sum payment is only a winding-up lump sum death benefit if:• The registered pension scheme making the payment is being wound-up,• It is paid to a dependant entitled under the scheme to pension death benefit in respect of themember, and• It extinguishes the dependant’s entitlement under the pension scheme to a pension death benefitand lump sum death benefit in respect of the member.Any amount paid over and above the £18,000 will not be a winding-up lump sum death benefit.

7 PENSIONS PROFILEA winding-up lump sum death benefit is taxable as pension income on the recipient of the dependantreceiving the payment.Changes to ‘stranded pots’ within occupational schemesBecause the A-Day rules embraced all pension pots belonging to one individual, it meant that someonecould be left with a very small amount in one scheme. For example, if someone had a final salarybenefit worth £17,000, and benefits in a money purchase occupational scheme worth £2,000, then intotal benefits would be above the £18,000 threshold. The money purchase scheme was likely to pay25% (£500) as a tax-free lump sum, leaving the individual to buy an annuity with £1,500. As this isbelow the minimum annuity purchase price of most providers, it is likely the individual would be stuckreceiving a small amount with their existing pension provider.The government introduced legislation in the Finance Act 2008 and the accompanying RegisteredPension Schemes (Authorised Payments) regulations 2009 – SI2009/1171, which provided easementsallowing individuals to take very small benefits in some circumstances. These were subsequentlyamended by Regulation 8 of SI2011/1751 to take account of the age 75 changes made by the FinanceAct 2011.1) Payments made after a transfer or a scheme pension is set up or an annuity purchase is made whichis not a contribution or transfer from another scheme. Examples given are rebate payments from acontracted out scheme, dividend payments or late payments as a result of unit pricing errors. Thesepayments could be returned to the member as a lump sum provided the following conditions are met:-• The scheme administrator was not aware of it and could not reasonably have been aware of it atthe time of the relevant accretion event• It is under £2,000• It extinguishes the member’s entitlement to benefits under the scheme• It is not greater in value than the original transfer/scheme pension/annuity purchase• It is made no later than 6 months after the relevant accretion date.2) Payments under the Financial Services Compensation Scheme (FSCS) are acceptable provided:-• It extinguishes the member’s rights to benefits under the scheme;• It does not exceed £2,000• The payment was made on or after the 1 December 2009.3) One of the conditions of trivial commutation lump sums is that they should extinguish the member’sentitlement to benefits under the registered pension scheme making the payment. This third easementrecognises that in some circumstances annuities have been purchased but small uncrystallised benefitshave been left behind which are too small to buy an annuity with. The example is given of protectedrights left behind on account of the historic disparity on the age at which you could take these benefits.You could not take these benefits under the normal trivial commutation rules, as they do not extinguishthe member’s entitlement. This third easement only applies to members for whom an annuity is set tocontinue (this can include an annuity that has been purchased by the scheme, in the member’s ownname - so now appearing to be outside the scheme). The other conditions that must be met include:-• The payment must not exceed the £18,000 limit.• The payment must be the first trivial commutation lump sum the member has received.4) The fourth easement is a de minimus easement where pension rights are valued under £2,000 eventhough the aggregate value of benefits held under all registered pension schemes exceeds the £18,000limit. This easement is for public service pension schemes or occupational pension schemes. TheGovernment has published draft Finance Bill 2012 including the commutation of small personal pensionpots which is explained later in the document under ‘commutation of small personal pension pots’.The conditions under which "stranded pots" of money under this fourth easement are:-• The member is at arms length to the sponsoring employer

8 PENSIONS PROFILE• The total value of benefits under this scheme and all schemes relating to the same employmentdoes not exceed £2,000, and,• No individual transfers out have been made for the member in the last three years and• Individuals need to be aged 60 or over.5) The fifth easement is again a de minimus easement for the application to public service andoccupational schemes only. It is similar to the fourth easement except that the restriction that the valueof the benefits not only under the paying scheme but also under all related schemes of the sameemployment is lifted. The additional conditions are that:-• The scheme must have at least 50 members• 20 members of that arrangement must have sums and assets in excess of £2,000• No transfer was received into the scheme on behalf of the member in the five years before thepayment• No transfer was made out of the scheme in the last three years before the payment• The ‘small lump sum’ does not exceed £2,000, and• The payment extinguishes the member’s entitlement to benefits under the paying scheme (wherethe member also has rights in a related scheme, those other rights do not have to be paid as aone-off lump sum as well) and• Where the payment is in respect of a defined benefits arrangement, the scheme holds more thanhalf of the value of its sums and assets for the purposes of the defined benefit arrangements (i.e itis majority funded for defined benefit provision)Commutation of small personal pension fundsOn 6 December 2011, the Government published draft Finance Bill 2012 clauses including thecommutation of small personal pension funds.The draft regulations introduced will enable individuals to access ‘small pots’ held within personalpension scheme under the following conditions:• The payment to the member must be from a registered personal pension scheme;• The member must have reached the age of 60;• The payment does not exceed £2,000;• The payment extinguishes the member’s entitlement to benefits under the arrangement; and• The condition must be met that the member has not previously received more than one paymentunder this regulation; i.e. two commutations of small personal pension funds are permissible perindividual in total.These regulations came into force on 6 April 2012 in relation to payments made on or after 6 April 2012.This is not a consumer advertisement. It is intended for professional financial advisers and should not be relied upon by private customers or any otherpersons.This document is based on Legal & General’s current understanding of tax law, HMRC practice and legislation, which may change. It should not beconsidered a definitive statement in law.Legal & General Assurance Society LimitedRegistered in England No. 166055Registered office: One Coleman Street, London EC2R 5AAAuthorised and regulated by the Financial Services Authority.PP12/12 Non GASDwww.legalandgeneral.com