Defined benefit schemes enjoy more favourable treatment

Where defined benefit schemes are treated much more favourably under pension tax rules is when it comes to measuring their value against the lifetime allowance. 

In 2006 as part of the overhaul of the pension tax rules, known as pension tax simplification, the concept of a lifetime allowance was born, with the standard lifetime allowance originally set at £1.5 million. This is a limit on the value of benefits that can be paid from registered pension schemes without triggering an extra tax charge. The standard lifetime allowance has subsequently been cut and is currently £1,073,100, fixed until April 5 2026.

Measuring defined contribution benefits is straightforward as it’s simply the value of the benefits at the time benefits start to be taken (crystallised) that is tested. But the story is a bit more complicated with defined benefits. 

To keep it simple, in 2006, HMRC decided to use a notional flat factor of 20 to value the initial annual pension, adding in the tax-free cash, to arrive at a total figure to measure against the lifetime allowance. This method is used regardless of the age the benefit is taken or the value of the ancillary benefits provided by the scheme, including survivor’s pensions, death benefits and annual pension increases. 

At the time, a factor of 20 seemed reasonable given the annuity rates used to turn a defined contribution pension into a guaranteed annuity income. 

Addressing the tax disparity 

Moving on over 15 years, the level of disparity has grown and it is now possible to receive around twice the annual pension from a defined benefit pension versus a defined contribution pension without attracting a lifetime allowance tax charge.

The current low interest rate, high inflation environment set against a frozen (and much lower) lifetime allowance combined with people living longer makes this disparity even more stark.

A fairer factor to use could be 30. The question is would a higher factor apply to the current lifetime allowance or might a new higher lifetime allowance be introduced of 30 times the current maximum defined benefit pension of £53,655 (ie £1,073,100/20). This would increase the standard lifetime allowance to over £1.6m. For fairness this would also have to apply to defined contribution pensions. But doing so would significantly add to the cost of pension tax relief.

Increasing the factor above 20, and not increasing the standard lifetime allowance, would mean far more defined benefit members exceeding the limit. 

It’s possible the Government may review this sometime in the future if it carries out a root and branch review of pension tax, but if this happens, the downside is that it could introduce new pension complexities, such as transitional protection for those defined benefit members affected. 

In reality, addressing this issue is likely to be way down the list of the Government’s priorities given the current cost of living squeeze and economic challenges. It’s possible that the disparity could reduce as interest rates start to rise and if longevity plateaus or even falls. But realistically I can’t see any change soon. 

Pensions doctor Kate Smith, of pension firm Aegon, solves your retirement issues. Write to Kate with your pension problem via pensionsdoctor@telegraph.co.uk. Columns are published twice a month on Tuesday mornings