DC transfers from hybrid schemes: Have you considered protected tax free cash?

Protected tax free cash is an area that employers and trustees need to be aware of at the outset of any proposal to transfer the DC section of a hybrid scheme.

Increasingly, sponsoring employers of hybrid pension schemes, concerned about the on-going costs and governance responsibilities associated with DC sections and mindful of employees wanting greater flexibility when accessing their DC benefits, are looking to transfer their DC sections into master trust arrangements.

Typically, the legal issues surrounding such transfers are straightforward: do the trustees have the power under the scheme’s governing documentation to make the transfer and, assuming the transfer involves a bulk transfer of members’ benefits without consent (which is the common approach given the impracticalities of seeking individual member consent), are the requirements of the preservation legislation satisfied.

Where issues do arise is when the trustees are considering whether they should agree to the transfer, having regard to their legal duties to the scheme’s beneficiaries. This will usually involve consideration of a number of wide-ranging issues, such as fund charges, out of market risk, range of investment funds etc. Whilst these issues can typically be resolved through discussions with the employer and/or receiving scheme provider, one area that trustees, employers (and advisers!) are not always aware of and which has the potential to be a “show-stopper” relates to those members with protected tax-free cash entitlements.

We expand on this further below.

The technical bit…

Readers will recall that prior to April 2006 the maximum tax-free cash a member could take from his pension was calculated by reference to his length of service and remuneration. This was replaced by a formula which (broadly) allows a member to take 25% of the value of his benefit as tax-free cash.

For the majority of members 25% is likely to be an increase from the maximum under the old formula. However, for some members, the old formula would have resulted in a tax-free cash entitlement, based on benefits as at 5 April 2006, in excess of 25%. To address this, the Finance Act 2004 (the Finance Act) included provisions to protect existing cash entitlements in excess of 25%.

What does this mean for DC transfers from a hybrid scheme?

In the context of pension scheme transfers, this protection is only maintained where the transfer meets the requirements under the Finance Act for a “block transfer”. A block transfer must relate to the whole of the member’s benefits under the scheme and at least two members must transfer their benefits in a single transaction.

Where the transfer does not constitute a block transfer the member will lose the protection in respect of the benefits transferred (although will retain it in respect of the benefits that remain in the scheme). Therefore, for any members with benefits in both a DB and DC section and who were, based upon their benefits as at 5 April 2006, entitled to a maximum tax free lump sum in excess of 25%, a transfer of just their DC entitlement will reduce the level of tax-free cash they can take on retirement (N.B. our interpretation of the legislation is that this would be the case even where the transfer relates exclusively to DC rights accrued after 6 April 2006). For trustees looking to ensure the transfer will not materially prejudice beneficiaries’ interests, this can be a major sticking point.

What should be done?

We would recommend that, at the outset of any proposal to transfer the DC section of a hybrid scheme, the employer and trustees seek confirmation as to whether any members with benefits in both DB and DC sections have protected tax free cash status.

To the extent there are such members, thought will need to be given as to whether the transfer can proceed. Possible options include:

• Leave the protected members in the scheme whilst transferring all DC-only members to the receiving scheme. This will have the advantage of ensuring those members remaining in the scheme do not lose their protected tax free entitlement but will mean the employer and trustees continue to have the on-going costs and governance responsibilities associated with those remaining members;
• Proceed with the transfer of all members to the receiving scheme if the trustees are satisfied that the reduction in the total tax-free cash entitlement is proportionate to the value of benefits being transferred and the other advantages of the transfer (for example, the increased flexibilities and possibly reduced charges available under the receiving scheme) outweigh any loss that the protected members may suffer. Alternatively, the employer may be willing to make good any loss to the members. This is only likely to be a realistic option where members have been accumulating benefits in the DC section for a relatively short period; or
• Elect not to proceed with the transfer.

What will be appropriate will depend on the circumstances of scheme and in particular the materiality of the values involved. However the earlier it is that the issue can be identified, the more likely it is a satisfactory outcome can be achieved for all parties.

And finally…

Another related point to consider is whether members with both DB and DC benefits have a right under the rules of the transferring scheme to use their full DC fund to provide their tax-free cash entitlement before exchanging any of their DB pension. If they do, then whilst transferring-out their DC entitlement (thereby breaking the link with their DB entitlement) would not (apart from those with pre-2006 entitlement) affect the tax-free cash they can take, it might materially worsen the terms upon which they can take it.