In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].
Question: Why is the unfair money purchase annual allowance (MPAA) allowed to exist? A friend had a £50,000 defined contribution pension which he had to liquidate during Covid. I had a defined benefit pension which was significantly larger but did not exceed the old £1m lifetime allowance. We both went back to work after Covid “retirement” and earn over £100,000. I can put up to £60,000 into my pension out of current earnings. My friend earns the same but is limited to £10,000 MPAA and he needs the pension more. Why hasn’t this unfairness been addressed?
Answer: Let’s cut through the main bits of jargon before getting into your central question. A “defined benefit” (or DB) pension is a promised retirement income from an employer, usually based on your average or final salary, from a specified “normal retirement age”. The normal retirement age is set by the scheme and is often, but not always, aligned with the state pension age.
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For each year you are in the scheme, you will build up or “accrue” an entitlement to a proportion of your average or final salary. For example, someone who is a member of a 1/60ths career average scheme for 30 years will be entitled to 30/60ths, or half, their average salary as a guaranteed, inflation-protected income from their normal retirement age.
Defined contribution (or DC) pensions, by contrast, are simply a pot of money built up over your lifetime. Contributions to DC pensions benefit from the boost of upfront tax relief and tax-free investment growth, with the fund accessible from age 55 (rising to age 57 in 2028). When you access your DC pension, up to a quarter is available tax-free, with the rest taxed in the same way as income.
To keep the cost of providing tax relief on pension contributions under control, there are limits on the amount you can contribute each tax year while receiving tax relief. First, there is an overall “annual allowance” set at £60,000, covering employer contributions, personal contributions and tax relief. Second, the maximum you can personally contribute to a pension (inclusive of tax relief) each tax year is limited to 100 per cent of your earnings.
To complicate matters, there are two different annual allowances that can apply in certain circumstances. If you are a very high earner, you could be affected by the “tapered annual allowance”, which reduces your annual allowance to between £10,000 and £60,000 dependent on the level of your earnings. You can read more about how this works here.
Additionally, if you “flexibly access” taxable income from a DC pension, as your friend has done, the “money purchase annual allowance”, or MPAA, is triggered, lowering your annual allowance from £60,000 to £10,000.
Flexibly accessing your pension primarily includes taking taxable income through “drawdown”, where your pot is invested and you take an income to suit your needs, or taking an ad-hoc lump sum (referred to in the jargon as an “uncrystallised funds pension lump sum” or UFPLS), where a quarter of that lump sum is tax-free and the rest taxed as income. Triggering the MPAA also means you lose the ability to “carry forward” unused annual allowances from the three prior tax years in the current tax year.
The MPAA doesn’t apply where someone just takes their tax-free cash, accesses a DB income or buys an annuity (a guaranteed income for life paid for by an insurance company). In addition, it is possible to take up to three “small pot lump sums” worth £10,000 from personal pensions – and an unlimited number from occupational DC pensions – without triggering the MPAA. To qualify as a small pot lump sum, the withdrawal has to extinguish the entire pot.
In terms of why the MPAA exists, the logic behind the allowance is that it prevents people excessively recycling their pensions in order to generate extra tax-free cash. While there are specific rules around recycling, the government felt the extra protection of the MPAA was necessary to mitigate this risk to the Exchequer when the “pension freedoms” reforms were introduced almost a decade ago.
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