For many years I never paid much attention to the Lifetime Allowance for pensions, assuming that I’d never hit it. But with my 55th birthday only a few years away, it’s dawning on me that might no longer be the case.
Of course, I realise this is very much a nice problem to have and I’m certainly not after any sympathy. However, when you consider that exceeding the Lifetime Allowance could cost you an additional 25% in tax, on top of whatever income tax is normally due, it tends to sharpen the mind!
Doctors in the firing line
It was the recent stories of doctors cutting back on their hours to avoid massive tax bills that got me checking my own pension situation and the tax implications.
The particular problem that doctors are facing is different, of course, as it involves limits on how much you can put into your pension each year. The annual allowance tapers down from £40,000 to £10,000 for those earning in excess of £110,000 a year.
The Lifetime Allowance is at the opposite end of the puzzle, as it affects the total amount you can eventually take out of your pension.
Like all tax legislation, the rules relating to the Lifetime Allowance are pretty complex. Google “Lifetime Allowance worked examples” and you’ll see what I mean.
What follows is my understanding of how it works, but I am not a tax professional and this is definitely an area where you might need financial advice.
I’m in good company
Royal London, where ex-pensions minister Steve Webb now works, released a report earlier this year outlining the scope of the problem. It reckoned:
- 290,000 non-retired people currently have pensions in excess of the Lifetime Allowance;
- half of these are continuing to contribute to their pension; and
- a further 1.25m non-retired people currently below the Lifetime Allowance could exceed it by the time they retire.
Senior public sector workers, particularly those with long service records, and employees earning between £60,000 and £90,000 were thought to be most likely to face Lifetime Allowance issues.
If these figures are accurate, then about 5% of those currently in work can expect to exceed the Lifetime Allowance.
That’s perhaps a little more than I might have guessed, given all the scare stories we hear about the small sizes of most people’s pension pots. But when you consider some 4m people are higher-rate taxpayers, it doesn’t sound too unreasonable.
A-Day: where it all began
The Lifetime Allowance was introduced back in April 2006. It was part of A-Day, which was when a radical overhaul of the UK’s pension system came into effect.
The A-Day reforms were designed to simplify the pension process. In reality, while it solved some legacy problems, it paved the way for a viper’s nest of new ones.
The Lifetime Allowance sets a maximum limit for the amount you can withdraw from your pension without incurring additional rates of tax. This tax year it’s £1,055,000.
Lump sums taken out over the Lifetime Allowance incur a tax rate of 55%. Income taken out incurs a lower rate of 25%, as any income withdrawn might also be subject to income tax as well.
There are numerous situations that can trigger a Lifetime Allowance test. These are given the fancy term of Benefit Crystallisation Events (BCEs). You might be tested just once or perhaps several times, depending on your particular pension situation.
Each BCE will typically use up a percentage of your Lifetime Allowance. So the first test might use up, say, 80% of your allowance.
In this case, the remaining 20% of your Lifetime Allowance would be carried forward and can be used at a later date.
The Lifetime Allowance changes each year, so it would hopefully be a little higher by the time you needed to use the remaining 20%.
The history of the Lifetime Allowance
If I recall, the introduction of the Lifetime Allowance attracted very little attention back in 2006.
It was initially set at £1.5m, which seemed well out of reach for pretty much everyone. Then it was raised to £1.8m by 2011/12.
With the global financial crisis still fresh in the mind, such a sum seemed even more fanciful. But then the cuts began…
Over the next five years to 2016/17, the allowance was cut back down to £1.5m again, then £1.25m, and finally £1m.
Contrary to what you might expect, the increase from £1.5m to £1.8m was under a Labour government, while the cuts were under the Conservative/Liberal Democrat coalition and the current Conservative government.
The last couple of years, the Lifetime Allowance has been increased in line with the Consumer Prices Index (CPI) measure of inflation. We’ve been told to expect similar increases in future tax years but given how politicians love to meddle, who knows what might happen?
CPI has increased by about 44% since A-Day. If the original allowance of £1.5m had been increased by CPI from the start, it would now be £2.16m, more than twice its current level.
Who’s paying these excess charges?
The number of people currently being affected by the Lifetime Allowance is relatively small.
The first year it was introduced just over 200 people paid the excess tax charge, bringing in just £5m.
In 2016/2017, the latest year for which HMRC statistics are available, 2,120 people paid the charge bringing in a total of £102m (that’s an average of £50,000 each).
That’s a tenfold increase in the number of people and a twentyfold rise in the tax take over the course of a decade.
It’s still a tiny proportion of overall tax revenues. But we’ve had three years of surging global markets since then, so many more people could be affected in the current tax year and in the years ahead.
Doing the sums
My pension investments had been relatively conservative for a long time, consisting largely of UK trackers and UK equity income funds.
A few years ago, I decided to take a much more global view with my investments, using funds like Lindsell Train Global and Fundsmith.
I reckon my pension is now around 60% higher than it would have been had I not made that change.
That’s great news, of course, but it’s also meant that I am much more likely to hit the Lifetime Allowance.
Doing some very crude sums, should the Lifetime Allowance rise at 2% a year and my pension investments rise at 15% a year, then I could hit the Lifetime Allowance sometime in my mid-50s.
Now, 15% a year is pretty punchy, I’d be the first to admit. But it’s not outside the realm of possibility. Many global funds have produced these sort of returns in recent years.
Even if I were to assume 10% annual growth, then this would push back hitting the Lifetime Allowance until roughly my 60th birthday.
Such is the power of compound interest.
Thankfully, since I started researching this article, global markets have done their best to help me out by plunging across the board!
Another testing time at 75?
My rough plan for my pension was to take out the maximum tax-free lump sum and move the rest into drawdown and leave it mostly invested in shares.
I would take out a bit each year to fund our living expenses, probably keeping my income below the level at which 40% income tax kicked in.
I hadn’t decided when I would do this, but I was thinking it would probably be sometime between the age of 55 and 60.
As I understand it, my pension would first be tested against the Lifetime Allowance when I moved to drawdown.
However, assuming I still have funds left in it and I live that long, it will also be tested again when I am 75 (remember, there are many circumstances where you might be tested against the Lifetime Allowance).
So, even if I am at or just below the Lifetime Allowance at 55, if I only take out an income of, say, 4% a year from that point on, it’s possible that my drawdown pot could continue to grow at more than this rate and I would have to pay a tax charge at age 75.
In practice, the Lifetime Allowance should continue to increase a little each year, and the sequence of returns might have something to say as well.
What I plan to do
I don’t plan on making any major changes to my investing strategy due to the Lifetime Allowance. It’s a case of “something to be aware of” rather than “drastic action required”.
If I end up paying some excess tax, it will mean my investments have done very well. Nevertheless, I like to be aware of large bills coming my way!
One thing I might do is to stop putting additional amounts to my pension (I don’t have an employer match at the moment) and just use ISAs. I can then revisit that plan as needed.
It seems more likely that I will move as much as possible into drawdown at age 55, as I’d expect my investments to grow faster than inflation.
And once I do move into drawdown, I might take out a little bit more than I need and reinvest the surplus in ISAs.
I’ll also be watching what happens to the Lifetime Allowance in future Budgets. Although we’ve had a few years of inflation increases, radical overhauls of the pension system seem to happen on a regular basis.
I’d be surprised if it was dramatically reduced from its current level, given that would affect a sizeable number of public sector employees. When it has been reduced in the past, there have been ways to protect any pension you’ve already built up.
Of course, given how pensions are used as a political football, it’s entirely possible that the Lifetime Allowance could be raised significantly or even abolished.
As many people have said, the practice of limiting both how much you can put into a pension each year and the amount you can eventually take out seems to be doubling up when it comes to restrictions.
There’s a lot to be said for simplifying the whole system and bringing a halt to the endless tinkering with the rules so people can be sure of where they stand.
A flat-rate of tax relief and a maximum annual contribution level for everyone would seem to be the most sensible way to go.
Please note that I may own some of the investments mentioned above. You can see my current holdings on my portfolio page and the index page summarises all my posts by category. Nothing in this article or on this website should be regarded as a buy or sell recommendation as this site is not authorised to give financial advice and I'm just a random person writing a blog in his spare time. Always do your own research and seek financial advice if necessary!
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