Since the Government started reducing the Lifetime Allowance in 2012, the humble Death in Service Scheme has become a financial time bomb which could cause significant damage to the retirement planning of the unsuspecting executive.
The majority of Death in Service schemes are usually established under a deed of trust and registered with HMRC using the legislation for pension schemes. The main advantages of registration are that the employer receives tax relief on the contributions, it is not taxed as a benefit in kind and any benefits are paid out tax-free. However, setting up a scheme in this fashion can also have serious disadvantages. The concept of the Lifetime Allowance (LTA) was created in 2006 and it is the maximum pension fund that can be accumulated – any excess is taxed at the punitive rate of 55 percent. The LTA started at £1.5m and grew to £1.8m by 2011 but, since 2012, it has been reduced every two years – to £1.5m in 2012, to £1.25m in 2014 and it is reducing to £1m in April 2016.
Originally, those with pension pots in excess of the LTA were allowed to apply for Primary and Enhanced Protection thereby securing a higher personal LTA. Latterly, each time the LTA has been reduced, those with significant pension pots have been able to lock in the prevailing LTA by applying for Fixed Protection. However, a requirement of each type of protection is that no further pension contributions can be made and no new scheme can be joined or the protection will be lost. The first problem arises when an individual who has previously secured a type of protection moves company and inadvertently joins a Registered Death in Service Scheme. As the scheme is treated as a pension, the new employee will have broken one of the rules of the protection and, on the first anniversary of the scheme when the membership is fully ratified, the protection will be lost.
The problem can be compounded as it is the responsibility of the scheme member to notify HMRC that protection has been lost within 90 days and failure to do so could lead to a fine. However, the fine is of minor financial consequence when compared to the loss of the protected benefits. If an individual had secured £1.8m and joined a new DIS scheme at any time after April 2012, protection will have been lost and, from this April, their LTA will fall to £1m. Let us assume that, on retirement, the individual’s pension fund is also valued at £1.8m. That individual will have lost the option to take 25 percent tax-free lump sum from the difference (£1.8m – £1m = £800,000) which is £200,000 and there will be a 55 percent tax charge if they try to access the fund in excess of £1m.
The second problem with a reduced LTA of £1m is that, if a death claim creates a total pension fund plus life cover of in excess of £1m could create a tax charge of 55 percent on the excess. As the most likely claimants on DIS schemes will be older members of staff it is they who are likely to have higher pension funds and greater DIS benefits. There is a reasonably simple solution to this issue which is to rewrite the DIS scheme as an Excepted policy.
This involves establishing the DIS scheme under a separate trust rather than the pension trust and, provided the scheme meets the specific HMRC rules, the contributions can be treated by the employer as a business and the benefits will be paid tax-free via the trustees. It is possible to establish a Registered and an Excepted scheme for different groups of employees provided that the benefits of each scheme are consistent and the underwriting cost for each scheme will only vary according to the membership.
