It's been over a year since the Lloyds Bank case confirmed that there is a legal requirement for occupational pension schemes to address the inequality between men and women in the design of guaranteed minimum pensions (GMPs). Few pension schemes have done so, partly because of uncertainty over the tax consequences. HMRC has now sought to address this uncertainty by publishing the first in a series of newsletters on the subject.
We analyse what this means for trustees and employers.
1. GMP equalisation should be an active project
Schemes that do not have a pressing need to complete GMP equalisation in the short term have generally stopped short of implementing an equalisation method for future pension payments, pending clarity from HMRC on the tax treatment of the various equalisation methods. However, there are some actions that all pension schemes containing GMPs should be carrying out now, supported by their legal and actuarial advisers.
There is also going to be a further court hearing on past transfers and guidance from the GMP Equalisation Working Group, the likely timings of which will form part of any project plan. In this article however, we focus on the tax questions.
2. HMRC guidance provides some useful answers...
For schemes that have ruled out GMP conversion as a solution, the latest guidance will be helpful. Broadly, it confirms that there should be no annual allowance or lifetime allowance difficulties if schemes adopt the default equalisation method set out in the Lloyds Bank case ("Method C2").
3. But it leaves other questions unanswered and creates some problems...
The new guidance does not address lump sum and death benefit payments, but states that further guidance will follow on those.
It also states that trustees may need to revisit past lifetime allowance calculations, back to 2006. This may be difficult, or impossible, for many pension schemes, whose trustees will need to discuss with their administration service providers and their legal advisers.
Individuals who were close to, or already above, the lifetime allowance will also potentially face additional taxation.
4. Schemes considering GMP conversion still have a dilemma
GMP conversion is a potentially attractive solution to GMP equalisation, because it can be done as a one-off exercise without requiring the administration team to run dual records, as well as enabling the benefit design to be simplified.
However, it gives rise to particular tax problems, which are not addressed in this guidance - HMRC suggests that separate guidance may follow on this, but there is no timeframe.
There are potentially significant tax risks in proceeding with GMP conversion in the meantime. These do not normally pose an insuperable obstacle if schemes have a pressing need to complete the exercise, but other things being equal, it would be better to wait for the HMRC conversion guidance to be published. Schemes that need to move ahead because of an impending buy-out will need to engage with their insurers at an early stage.
Schemes that are keeping GMP conversion open as an option and which do not have a pressing reason to get started with the exercise are therefore in a bind, because they are under a clear legal obligation to equalise GMPs, and are underpaying pensions every month, for as long as they do not equalise. Such schemes should be in active discussion with their legal and actuarial advisers to ensure that there is an acceptable plan for when and how to commence the exercise, in order to protect themselves from member claims.
GMP equalisation: the story so far
Occupational pension schemes were frequently contracted-out of the state earnings-related pension scheme. The conditions for this have varied over time, but between 1978 and 1997, one of the requirements was that a contracted-out occupational scheme should pay at least a "guaranteed minimum pension" (GMP), calculated on much the same basis as the state benefits the pension scheme members were giving up.
The GMP incorporated the unequal treatment of men and women that was part of the state system at the time, but with effect from 17 May 1990, occupational pension schemes have been obliged to treat men and women equally.
The High Court ruled, in the Lloyds Bank case in 2018, that occupational schemes were breaching equality law by paying unequal pension benefits as a consequence of the GMP element of the pension, and that this should be redressed by levelling up benefits. More detail on the issue, and why it is so difficult, can be found here.
Over a year later, few schemes have actually equalised benefits to take account of the effect of GMPs. In large part, this has been because of uncertainty over whether they would be exposing members (and the schemes themselves) to tax charges if they did so - the disadvantage to members from getting the tax treatment wrong could outweigh the benefit of removing the unequal treatment.
HMRC has now published guidance to address some - but not all - of that uncertainty.
Why is tax an issue with GMP equalisation?
Because public policy is to encourage retirement saving, registered pension schemes enjoy a range of tax privileges. In order to maintain these privileges, it is necessary for benefits to stay within certain limits.
For present purposes, the relevant tax limits are as follows:
- the annual allowance, which limits the amount of pension saving an individual can make in any given tax year, and
- the lifetime allowance, which limits the overall value of tax-privileged saving over an individual's life.
The amounts have changed, but these limits have existed since the pensions tax system radically changed on 6 April 2006. Exceeding the allowances causes penal tax charges, known respectively as the "annual allowance charge" and the "lifetime allowance charge".
The following features of these allowances are particularly relevant.
- The annual allowance is targeted primarily at members who are still accruing pension. Deferred members are largely excluded from the annual allowance, even though the value of their benefits will usually increase every year through inflation-proofing. The legislation provides that such increases, provided that they stay within specified limits, do not count towards the annual allowance. This exclusion is often called the "deferred member carve-out".
- Benefits are tested against the lifetime allowance when they "crystallise", on what is known as a "benefit crystallisation event". The most common benefit crystallisation event is the pension coming into payment for the first time, i.e. when the individual retires, although there are others.
- To avoid retrospective taxation when the lifetime allowance was introduced, members whose benefits were already above the allowance were given the option of electing to have a higher lifetime allowance in return for committing not to accrue any further benefits in a registered pension scheme. Accruing further benefits would cause the protection to be lost. A similar system was used on the occasions when the lifetime allowance has been cut. These protections are called "enhanced protection" and "fixed protection".
GMP equalisation raises numerous tax questions, but the biggest ones are:
- If the pension entitlement of deferred members is increased, to compensate them for GMP inequality, does this increase take their benefits outside the deferred member carve-out, such that their benefits may be hit by an annual allowance charge?
- If members have enhanced or fixed protection, does conferring additional benefits to compensate them for GMP inequality cause the protection to be lost?
What answers has HMRC provided?
HMRC has confirmed that it views a right to compensation for GMP inequality as a benefit that accrued at the same time as the GMP itself, i.e. between 1990 and 1997, not as a new entitlement arising as a result of the 2018 court case.
The Good News
As the 1990-1997 period predates the introduction of the annual and lifetime allowances, it follows that equalising benefits, provided that a scheme does not go beyond the minimum necessary, does not cause the annual allowance to be exceeded in any tax year, nor does it cause a member with lifetime allowance protection to lose the protection.
Insofar as existing pensioners are concerned, HMRC has also confirmed that they can be paid an arrears payment to equalise past instalments of pension as a one-off lump sum. Although this will be subject to income tax, members can claim back excess tax from HMRC if it results in them paying more tax than they would have done had they received the money at the correct time.
The Bad News
Any current pensioner who took their pension under the current tax system, i.e. from 6 April 2006 onwards, will have had the value of their pension tested against the lifetime allowance, on the benefit crystallisation event. However, if he or she is due an uplift to compensate for GMP inequality, and if the uplift accrued in the 1990-1997 period, then it follows that the value of it ought to have been taken into account at the benefit crystallisation event, because it was already an accrued right at the time of the benefit crystallisation event.
HMRC's guidance implies that schemes need to correct this, in order to ensure that the lifetime allowance test is accurate. In practical terms, revisiting benefit crystallisation events that are up to 14 years old is, for many schemes, going to be either difficult or impossible. Such schemes will need to consult their administrators and their legal advisers to understand what to do about this.
Correcting past benefit crystallisation events also means that individuals who were over, or close to, the lifetime allowance face a potential lifetime allowance charge as a result of GMP equalisation increasing the value of their benefits.
What questions remain unanswered?
The biggest unanswered question relates to GMP conversion.
GMP conversion is a statutory power that allows pension schemes to reshape the pensions they provide, so that GMPs are no longer treated as a special class of benefit with their own rules. This is conditional upon the actuarial value of the benefits not being reduced.
GMP equalisation can be built into a GMP conversion exercise. An explanation of the possible attractions of conversion compared to the other methods for equalising GMPs can be found here.
There are several tax pitfalls to avoid when it comes to GMP conversion, but a particularly acute problem relates to deferred members if the scheme provides "fixed rate revaluation" of GMP in deferment. The issue, in a nutshell, is how to avoid creating increased exposure to the annual allowance charge.
- If the fixed rate revaluation is included in the post-conversion benefits, the conversion is likely to take it outside the deferred member carve-out.
- If the fixed rate revaluation is not included post-conversion, though, the deferred pension may need to increase in order to maintain actuarial equivalence, and this increase is also unlikely to be covered by the deferred member carve-out.
Lifetime allowance protections also pose a problem.
There are solutions to these problems, but it would have been helpful if HMRC had indicated either that no tax would be levied (HMRC has the power to make extra-statutory concessions in certain circumstances, e.g. where there are gaps in the law) or that the Government has plans to legislate to address these issues.
Although there is nothing on GMP conversion in the new guidance from HMRC, it does indicate that there may be further guidance on this, at an unspecified future time.
What to do next
So what should pension schemes with GMPs be doing as a result of all this?
Given the uncertainty, the temptation is to do nothing and wait for further guidance. For many schemes that may indeed be the best course of action. However, it carries a risk: pension schemes with GMPs are knowingly underpaying their current pensioners if they do not address GMP inequality.
Fortunately, there are some things that trustees of pension schemes with GMPs can - and should - usefully be doing now, with the support of their professional advisers, whilst still awaiting further guidance before committing to a full GMP equalisation exercise. Carrying out these early steps can help protect trustees from members who may complain that the scheme has not implemented the requirements of the Lloyds Bank case.
- Speak to your legal and actuarial advisers to understand how the issues affect your particular scheme.
- Carry out any necessary data cleansing, in particular, completing the reconciliation of your GMP data with that of HMRC, in order to be ready to equalise GMPs.
- Take legal and actuarial advice on how to deal with members who are taking all their benefits out of the scheme in a single payment, i.e. those who are taking a transfer value or a full commutation. It is much easier to equalise a one-off payment covering all scheme benefits than it is to equalise a pension that will be paid in instalments over a long period of time.
- Take legal advice on the extent to which back payments due to current pensioners in respect of GMP equalisation are limited by any forfeiture provisions in the scheme rules.
- Consider, with advice from your legal and actuarial advisers whether, in principle, GMP conversion would be an attractive method for equalising GMPs in your scheme.
- If it would, discuss with your advisers whether it is reasonable to delay carrying out any form of GMP equalisation exercise until the tax position on conversion is clearer - generally the answer will be yes, unless the scheme has a pressing reason to proceed sooner - and what would constitute sufficient clarity to be able to proceed. Schemes that need to press ahead on account of an impending buy-out should engage early with their insurers on this point.
- If GMP conversion is not attractive, discuss the alternative methods with your advisers.
Gowling WLG has one of the largest teams of pensions lawyers in the UK and has specialists on GMP equalisation who would be happy to assist with any of the above.
 The obligation to equalise benefits in respect of GMPs therefore only relates to GMPs accrued in the period from 17 May 1990 until 5 April 1997 (the date GMPs stopped accruing). References in this Insight to GMPs, in the context of equalisation/inequality, are to GMPs accrued in that period only.
 Other forms of protection exist but are beyond the scope of this Insight.