Until recently, the majority of people could save into a pension without ever concerning themselves with the lifetime allowance. Thresholds were high, and - with interest rates at 5-6 per cent - pension pots went a long way. However, as the chancellor has progressively brought down the threshold over which onerous tax penalties apply, and interest rates have fallen, nudging up against the lifetime allowance is a far greater concern for prospective retirees.
The problem is two-fold: the first challenge for retirees is that the allowance has fallen. As little as five years ago, if investors had either spare cash or a generous employer, they could save as much as £1.8m into a pension subject to annual contribution limits. If they happened to hit the jackpot on an investment held within their pension, they could usually enjoy the full benefits of that in retirement. But the lifetime allowance has been falling since 2012, almost halving in the past four years. This represents a sea-change for would-be retirees.
The second problem is low interest rates, which in turn, affect annuity rates. In 2008, with interest rates hovering around 5 per cent and a lifetime allowance of £1.65m, retirees with the maximum pension fund could have used it to buy an income of around £129,000. The allowance has been cut progressively, from £1.8m in 2010/2011 to £1.25m in 2015/15 and - from April 2016 - to £1m. At the same time interest rates have fallen, pushing down annuity rates, meaning that the same pension pot only buys an income of around £56,000, according to Sharingpensions.co.uk.
The penalties for exceeding the lifetime allowance are painful. When a retiree draws benefits from their pension scheme, or if they die before taking their benefits, this is deemed to be a 'benefit crystallisation event' (BCE). At this point the value of all an individual's pensions is tested against the lifetime allowance. If these benefits exceed the lifetime allowance, any excess attracts a tax charge of 25 per cent if it is withdrawn as an income, or 55 per cent if it is withdrawn as a cash lump sum.
People can apply for lifetime allowance 'protection' subject to certain rules. This means that their pots can grow in excess of the prevailing lifetime allowance, but neither they nor their employer can contribute further to any pension fund held by the individual. There are different types of protection for those who already have a fund in excess of the limits and those who believe their fund might exceed the limits in future.
Steve Patterson, managing director of Intelligent Pensions, is clear that anyone with a sizeable pot should review their arrangements where possible, preferably with the help of an expert: "People can obtain protection subject to meeting certain criteria. The impact of getting it wrong is huge - potentially a six-figure sum, so anyone with more than £500k in their pension pot should be taking advice sooner rather than later."
Even those who are some way from retirement can hit the limits. According to the most recent Barclays Equity Gilt study, the long-run performance of the stock market is a little over 5 per cent. Someone who is 10 years from retirement with pensions worth £650,000 would exceed their allowance if their money grows at 5 per cent a year with no further contributions. It is also worth noting that the lifetime allowance will be linked to inflation from 2018, but even with this in mind, the limit might be exceeded.
If someone fears they might hit the lifetime allowance, there are two decisions to be made. The first is a decision on contributions; the second is on the investment strategy that should be pursued with the existing pension pot. The first question sounds straightforward, but may not be as simple as it looks: There are still circumstances in which it can be beneficial to continue contributions even if there is an onerous tax charge:
David Thurlow, director, Mattioli Woods, says: "Most employees will opt out of their company scheme when they hit the lifetime allowance limits given the punitive penalties involed. Also, the vast majority of companies will take a pragmatic view. It will probably be its more senior people who have this problem and the pension scheme, which is designed to be provided as a benefit, ceases to be a benefit if retirees are feeling the full force of the charges. Most employers will add pensions contributions to overall remuneration.
"However, for those employees with more intransigent employers who would lose the benefit completely were they to opt out, the decision is more difficult, but it usually makes sense to keep the contributions and pay the tax."
Mr Patterson also argues that if employer pension contributions are stopped and paid as salary, employees need to be careful that it does not push them into the zone where they start to lose their personal allowance (from £110,000 upwards).
Then there is the question of how much investment risk to take with the existing fund. In theory an investor could go to cash to ensure that they don't exceed the limit, but there is a danger that this is a pyrrhic victory. After all, if they remained invested they would still get a chunk of any growth, even if they do have to pay tax on it.
Mr Patterson says: "The upside may be diluted by the lifetime allowance tax charge. It begs the question of whether investors are getting enough reward for the risks they are taking. They won't see a significant reward for upside performance, but a move to cash is not desirable. The solution is a modified level of risk rather than no risk. Investors would be scoring an own goal by taking too little risk.
Mr Thurlow adds: "Many of the people who are nudging up against the lifetime allowance are used to taking risk. That is how they have got to where they are. Moving into cash to prevent further growth in the portfolio does not sit easily with them. In normal circumstances if you make 50 per cent on the investments in your pension, you receive the whole lot. If you are close to the lifetime allowance, you only get 45 per cent of any profit you make, and if you make a loss, you lose the whole amount. This means that the whole risk/reward is skewed."
This affects the decision on where to invest, says Thurlow: "If an investor takes more risk, they suffer a disproportionate fall in value. They should perhaps be taking the bigger risk elsewhere, such as in Isas."
Carolyn Jones, head of proposition at Fidelity International, is clear that investors shouldn't be changing their investment strategy: "You should stick with the right investment strategy for your long-term goals. If you're over £1m, it's almost a no-lose situation. Look what the market has done over the past two weeks - you never know whether you are going to get to £1m."
For those who decide it is worth retaining some investment risk in their portfolios and who therefore exceed the lifetime allowance, there are ways to mitigate the tax bills. For example, as there are different rates payable for money taken out as an income or as a lump sum, investors can decide which approach is more appropriate for their needs. This will depend largely on their other income. If they are a lower rate tax payer, the 45 per cent tax rate (basic rate + 25 per cent) will be better than the 55 per cent payable on a lump sum.
Ms Jones says that they are seeing more demand for alternative investments. This is even true for companies, which are increasingly looking at ways they can reward their senior executives and higher earners to help them build replacement income for retirement, rather than just giving them cash. This includes, for example, looking at venture capital trusts (VCTs) or Enterprise Investment Schemes (EIS) .
Mr Thurlow agrees that VCT investments are becoming increasingly popular. He says: "VCTs are higher risk, but there are a number of reliable, well-established trusts with a good record of producing income and returns. At a time when aggressive tax avoidance is increasingly frowned upon, EIS and VCTs are supported by the government - they are the acceptable face of tax mitigation. As such, for funding at a higher level, VCTs and EIS are ideal options."
The message is that the lifetime allowance limit is not to be feared. There may be a tax bill, but it will only occur if investors are reaping the benefits - through strong investment growth or continued employer contributions. Nevertheless, potential retirees need to understand the situation and when any tax may fall due, so they can plan accordingly.
