Determining payment of redress under FCA DISP App 4

The two main ways in which redress can be provided are augmentation or by cash payment – another way is by purchase of an annuity but that option is not covered in this note. The decision on the way in which redress is to be provided is a matter of both consumer choice and, if the preferred option is augmentation, whether augmentation is possible, the transaction and advice costs (including whether those charges will be made in the fund or will have to be paid in case) and any income tax relief that the consumer will receive or income tax charges that the consumer will have to pay. So far as we know the consumer can choose any personal pension but, if so, relative costs will need to be agreed between the respondent and the consumer.

Redress might be part augmentation and part cash – in particular if there are limits on the amount of augmentation or to avoid exceeding a limit that incurs income tax charges. Our understanding is that if it is decided to augment, the Secondary Compensation Sum and the Additional Compensation Sum will not be included in the augmentation but will be paid as cash.  Payment of redress in cash (in respect of the Primary Compensation Sum) requires a tax adjustment – a deduction. The purpose of the tax adjustment is that pension payments from the personal pension are subject to income tax but redress paid as cash is not and if this factor were ignored there would be over-compensation. But if augmentation enables further PCLS payments there is no tax adjustment in respect of those PCLS payments.

Actual loss

Actual loss cases are where, at the valuation date used for the calculations (the first day of the quarter in which the calculation is made), the consumer would have already reached the retirement age of the defined benefit scheme.  Unlike prospective loss cases, for actual loss cases the Primary Compensation Sum has to take account of historical payments, both for the counterfactual situation, ie assuming that the consumer had remained in the defined benefit scheme, and for the actual situation.

Historical payments would have been paid (under the counterfactual situation) or have been paid (under the actual situation) to the consumer and both interest roll-up and income tax deductions (but only where income tax deductions are applicable) have to be taken into account for these payments.

For the counterfactual situation the historical payments are the Pension Commencement Lump Sum (“PCLS”) and the pension payments from retirement age up to but not including the valuation date. The PCLS is tax free but the pension payments are subject to income tax. The appropriate marginal income tax rate has to be agreed between the respondent and the consumer and applied to the pension payments.  For the actual situation the calculations require any historical payments to be determined and whether they were non-taxable (ie PCLS payments) or were taxable pension payments. All payments before the valuation date must be included, whether before or after the retirement age determined for the calculations.

As a procedural matter it is possible that the actuary has produced figures which take account of interest roll-up, but do not take account of income tax, on historical payments because he is not in a position to determine the appropriate marginal income tax rate. If so he will have provided the appropriate figures that will require the tax adjustment. If the marginal income tax rate is determined to be, for example, 20%, the provided figure will be reduced by 20%. Note that if this is done the Primary Compensation Sum has to be redetermined (and if it ceases to be a positive amount this means that no redress is in fact due).

Given that we are dealing with an actual loss case, and with the actual situation, the specific facts should be available and will need to be determined between the respondent and the consumer.  If it is determined that no further PCLS payments are possible then the tax adjustment will be a deduction at the marginal tax rate agreed between the respondent and the consumer – if the marginal income tax rate is determined to be, for example, 20%, the provided figure will be reduced by 20%.  But this should not be assumed without the investigation which we have indicated.  It is also necessary to consider the consumer’s entitlement to means-tested state benefits and whether that entitlement is affected by the provision of redress. This will need to be agreed between the respondent and the consumer.

If the process above is completed it will also provide the information required for any Secondary Compensation Sum. The process will inevitably mean that there is a period of time from the valuation date used for the calculation and the actual provision of redress so an Additional Compensation Sum will require to be calculated and paid in addition – we suggest that a proposed latest settlement date is suggested in any offer letter at say 28 days following the date of the offer letter but the amount of the Additional Compensation Sum will need to be revisited if the settlement date is going to be later.

Prospective loss

Prospective loss cases are where, at the valuation date used for the calculations (the first day of the quarter in which the calculation is made), the consumer would not have reached the retirement age of the defined benefit scheme.  For the counterfactual situation there are no historical payments.  For consistency if there have in fact been historical payments under the actual situation they need to be ignored – this is done by increasing the amount of the personal pension used in the calculation to the amount that would have applied if the historical payments had not applied. The amount must be determined by, or determined according to methods approved by, an actuary.

The other difference for purposes of this note is in regard to how the PCLS impacts the tax adjustment for payment of redress in cash. The calculation methodology is that at retirement age the PCLS will be taken and will be 25% (unless exceptionally for large cases the amount of PCLS is limited by HMRC rules).

The standard assumption in regard to the PCLS means that where payment of redress in cash (in respect of the Primary Compensation Sum requires a tax adjustment the rate will be (100% – 25%) = 75% of the marginal tax rate agreed between the respondent and the consumer. If that marginal tax rate is 20% the tax adjustment will be 75% of this or 15%. By comparison for actual loss cases because the consumer has reached retirement age it is necessary to consider the actual situation to ensure that a correct result is obtained for the tax adjustment for payment of redress in cash.

The various other considerations mentioned in regard to actual loss cases will apply.