Paying redress when an individual has a pensions loss needs individual consideration.
A pensions loss often means that it has been agreed that the individual concerned has a personal pension which has insufficient funds to provide the applicable target pension at the required level, where the applicable target pension means the pension that the individual would have received if he had retained benefits in a defined benefits pension scheme but where, as a result of mis-selling, a transfer value has instead been paid into a personal pension. This note considers that situation (there are other situations where pensions loss can occur).
The target pension is first determined as an amount per annum, for the individual and/or spouse, from a particular age, subject to some type of inflation increases and possibly also with alternative benefits (in the event of not surviving to the pension age) or additional benefits (on death after pension age). The shortfall is then determined as a capital sum – called the redress amount. That capital sum is calculated actuarially to take into account the target pension, the probability that the individual / spouse will live to receive instalments of the pension, and the probability that alternative and other benefits would have become payable. Inflation and discounting of future amounts are also allowed for.
Sometimes the probability is taken into account that the target pension will actually be paid, as opposed to being reduced because the sponsor has not or might not be able to maintain the required level of funding. Sometimes the individual may have a changed entitlement to State Pension benefits as a result of the transfer and that might be taken into account. Occasionally there may be other issues.
Questions then arise how that capital sum is to be paid and in that context whether income tax has been correctly taken into account (or an adjustment will have to be made on that account).
The principal objective is as far as possible to put the individual back into the financial position he would have been in if it had not been for the mis-selling. On the face of it that means paying the redress amount into the personal pension. The Financial Conduct Authority (under its various names since it started business in 1988) has been considering the issue of pensions mis-selling since 1993 and it has generally assumed that that is the approach that should be taken in order to treat a customer fairly. It has acknowledged that this may not always be possible because of the details of the regulations that apply to contributions to a personal pension on account of the individual concerned and his history and circumstances.
In general where redress is determined as a result of litigation, whether by a legally negotiated settlement or by order of the Court, the manner of redress will invariably be decided during the process because the parties and the Court will want to know that the amount determined is appropriate to the method to be used including tax considerations. In most such cases we believe that redress will be provided by cash-in-hand and only exceptionally by payment into the personal pension,
The principle with pension funding is that tax relief is provided on contributions, and also on investment earnings in the personal pension fund, but when benefits are paid they are subject in full to tax (this contrasts with a purchased life annuity bought by an individual where the cost has to be met out of after-tax income or assets and the capital element of the annuity is free of tax). Given this situation, paying the redress amount into a personal pension fund seems to be counter-productive because tax relief is not available when the amount is paid in but when benefits are paid they are fully taxable. The investment earnings component is neutral because although income tax is generally not applied within the personal pension it is applied when benefits are payable. (For sake of completeness we should mention that the question can arise whether the individual will have to pay tax on the redress amount but that question is outside the scope of this note except to say that where this is the case we assume that fact would be taken into account when the redress amount is determined).
We believe that the Financial Conduct Authority has chosen to ignore these tax issues in favour of saying that unless it is not possible redress amounts should always be paid into the personal pension. They have referred to the fact that this may not always be possible but said nothing about how the redress amount needs to be adjusted where redress is paid as cash-in-hand.
However, an adjustment is appropriate, especially for an individual who is expected to be a higher or additional rate taxpayer. By way of example, if the tax rate applicable is 40% the individual is only going to benefit from 60% of the pension payments if the redress amount is paid into the personal pension fund. By contrast if the redress amount is paid cash-in-hand he is expected to invest it and spend it gradually after he reaches the pension age he has chosen without paying any tax on it (he will invest the money, and pay tax on the interest, but as we have mentioned above this is mainly a timing difference because interest earned in a pension fund is taxable when benefits are paid).
Given this situation why don’t more respondents paying redress as a result of the complaints procedures (as opposed to litigation), pay cash-in-hand. We assume the reason is that Financial Conduct Authority rules are licence-to-trade requirements and respondents feel they should do what the Financial Conduct Authority prefers. However they should, of course, in every case consider the possibility that paying redress into a personal pension fund will not be possible and ensure that the complainant knows that where this applies the Financial Conduct Authority method (FG17/9) will not apply directly but will have to be adjusted and the method of adjustment is not prescribed but will have to be determined fairly.
The question then arises whether a complainant can ask for redress to be paid cash-in-hand even where payment into the personal pension fund is possible. We suspect that the answer is to consider whether that is actually an informed choice taking into account that having the redress paid into the personal pension fund is a more secure solution for most individuals – the Financial Conduct Authority will consider, we think, that treating customers fairly requires the respondent to consider this from the individual’s financial situation and indeed, to recognise that they have to deal differently with an individual who is vulnerable and to regard premature spending of money that is required for retirement as a vulnerability that needs to be taken into account.
An issue that is only ever going to affect some individuals, but probably an increasing number, is the further income tax called the lifetime allowance charge where pension funds exceed about a million pounds. The impact of this is apparent if one realises that the capital cost of a pension with full inflation protection and a generous spouse pension means in present financial conditions and with mortality improvement that a multiplier of between 30 and 40 needs to be applied to the initial amount of pension to determine what size the personal pension fund will need to grow to. This indicates that a pension starting at over £25,000 needs to be considered as a potential candidate for a lifetime allowance charge (the figure for any individual needs individual attention but the purpose of this illustration is that for many individuals the matter does need consideration). Where a lifetime allowance charge is payable on part of a pension the effect is cumulative with “normal” income tax. For a basic rate taxpayer the cumulative tax rate is increased from 20% to an effective 40% and for a higher rate taxpayer the increase is from 40% to 55%. We consider that a respondent who proposed to provide redress by payment into a personal pension fund needs to consider the possibility of a lifetime allowance charge.
We add a final note about how an individual decides he has a preference for cash-in-hand and the role of his claims adviser (if he has one) in this decision. A claims adviser will want payment for his services. In its capacity as regulator of claims advisers the Financial Conduct Authority warns against the conflict that can arise where it is in the interests of the individual to have redress paid into his personal pension fund but he needs cash to pay the claims adviser. A pre-contract requirement is for the claims adviser being considered for appointment to advise the individual that “the firm’s fee may become payable before the customer has access to their pension; and that the customer will, where necessary, need to pay the firm’s fees from their own funds”. But the Financial Conduct Authority goes further in respect of individuals who are unable to pay the fees including having policies and procedures for such instances, procedures for recognising vulnerable individuals, and for treating a customer who cannot pay with forbearance and due consideration; further, before they seek to enforce a claim for their fees they must check that their fees are no higher than the amount necessary to cover the costs of the claims adviser firm.