Chapter 5 – Defined Contribution Schemes (6 marks, 2 multiple choice)

Question 1

Popular R04 subjects from this chapter include:

SIPP versus an SSAS
Retirement annuity contract mechanics – what makes this type of RPS unique
Death benefits pre-crystallisation
Early leaver options
Section 32 buyout bond

Question 2

DC schemes are broken down in 2 categories

broken down into two categories.

Occupational DC schemes are established by a sponsoring employer for employees. DC schemes have become increasingly popular with employers.

Individual schemes are taken out by the member, or provided by the employer through a group scheme arrangement. These may or may not benefit from employer contributions.

Answer 2

They are now tested against the LSA and LSDBA. Since the introduction of flexible pension benefits, they can also be subject to the MPAA.

Question 3

Individuals could, historically, contract out of earnings-related state pension schemes through a DC occupational scheme, or through a personal pension plan from 1988.

The contracting-out portion of a personal pension plan was known as an Appropriate Pension Plan or APP, and the individual built up benefits known as Protected Rights in both a contracted out occupational or individual DC schemes.

Question 4

DC schemes can be either trust-based or contract-based.

Answer 4

Occupational DC schemes tend to be trust-based.
Individual DC schemes tend to be contract-based.

Trust-based schemes are established using a trust deed, with trustees safeguarding employee member rights.

Individual schemes that are contract-based are set up with a third party, such as an insurance company or pension provider. The provider then manages all areas of the pension scheme under a ‘contract’.

Question 5

Tell me the difference between trust and contract-based schemes in realtion to the following: (see table in 5.1)

Contribution tax relief

Short service refund

Member protection

Answer 5

Larger occupational schemes tend to be trust-based and are more costly and time consuming for a sponsoring employer.
Smaller employers, with fewer employees, tend to utilise contract-based schemes. Such schemes are cheaper and less time-consuming, yet still provide a valuable pension scheme to employees.

Question 6

Master trusts

A master trust, as mentioned in chapter 4, is a multi-employer scheme, where each employer has its own ‘section’ or ‘division’ within the master trust arrangement.

There is one legal trust and, therefore, one trustee board. The trustees retain decision-making independence under a trust-wide governance structure. The decisions over benefit and contribution levels still rest with the employer.

Answer 6

The trustees of master trusts are independent of the provider and the employers participating in the plan, so it is clear that the trustees have the interests of members as their highest priority.

The original trust-based schemes were developed in the 1950s. At this time, several insurance companies set up schemes allowing any number of employers to participate, avoiding the costs associated with an employer running its own trust-based scheme. This became known as a master trust.

Master trusts are now more popular again, since the introduction of workplace pension legislation. It is one trust that can be used by a variety of different employers and different schemes.

Question 7

What type of employers may consider using master trusts?

Master trusts may appeal to employers who are looking to offer a trust-based occupational pension scheme, benefit from the good governance which accompanies this, but only require minimal involvement with running the scheme.

They may also appeal to employers with existing trust-based DB schemes who no longer feel able to bear the higher cost burden

Question 8

What regulations does TPR apply in relation to master trusts?

In 2014, TPR introduced a master trust voluntary assurance framework.

This aim of this framework is to enable trustees to show employers considering utilising a master trust, that the trust is managed to a high set of standards. This framework is based on several control objectives, linked to governance and administration.

TPR also publish a list of independently-assessed and verified master trusts, to help employers select one with confidence. All master trusts are now authorised by TPR and, if not authorised, must be wound up.

Answer 8

Important:

All master trusts are now authorised by TPR and, if not authorised, must be wound up

TPR introduced a master trust voluntary assurance framework.

Question 9

DC occupational scheme types include:

Contracted-in Money Purchase Scheme (CIMPS)
Contracted-out Money Purchase Scheme (COMPS)
Executive Pension Plans (EPP)
Small Self Administered Scheme (SSAS)
Targeted Money Purchase Scheme (TMP)
Section 32 Policy

DC individual scheme types, include:

Retirement Annuity Contracts (RACs)
Personal Pension Plans (PPP)
Stakeholder Pension Plans (SHP)
Self Invested Personal Pensions (SIPP)
Group Schemes

Tell me about each:

Question 10

Minimum contributions

All DC pension schemes are subject to the rules that we covered in Chapter 2, in relation to qualifying as a relevant UK individual, maximum contribution levels for both individuals and employers, and how tax relief can be received.

Question 11

SEE EMAMPLE 5.1

What is pensionable earnings as defined by HMRC?

Question 12

How is tax relief given on scheme contributions?

For member contributions, the scheme has the choice of either using the net pay or relief at source method, but can only use one method per scheme. Usually a DC OPS uses the net pay method (for the exam at least!).

An employer will pay contributions gross and, if wholly and exclusively rules are satisfied, will offset these contributions against either corporation or income tax, depending on the employer’s status.

Employer contributions will be classed as a deductible or allowable business expense.

Question 13

Occupational DC Scheme NPA

The rules regarding an occupational scheme’s normal retirement date will be set out in the scheme rules.

This may be the same for all members, or differ for different types of employee. The scheme must ensure that no breach of age or gender discrimination laws takes place.

Question 14

Contracted out Money Purchase Scheme (COMPS)

Contracted out schemes no longer exist, as DC contracting out was abolished by the government from 2012.

We will cover the basics here, just to complete your knowledge in this area.

Protected Rights

If a DC occupational scheme, or individual scheme such as a PPP, was contracted out, the benefits accrued were known as Protected Rights (PR). These rights were subject to certain rules such as: WHAT

Since the abolition of DC contracting out, any Protected Rights funds have been converted to Ordinary Rights.

These rights are treated the same as any other DC fund, without the restrictions above being imposed on them.

This means Ordinary Rights funds can be used to: WHAT

Question 15

The only way an OPS member used to be able to be contracted out post-2012 was through a DB occupational scheme. This ceased from April 2016 when the single-tier state pension was introduced.

This means that both ‘contracted-in’ and ‘contracted out’ are obsolete terms for DC schemes as they are the same, and can now just be referred to as ‘DC Occupational Schemes’.

Question 16

look at example 5.2 regarding SSAS

Question 17

Illustrations

Most DC schemes must provide their members with a certain type of annual illustration, from 6th April 2003, known as a Statutory Money Purchase Illustration (SMPI).

RACs and SSASs are exempt from this rule, but all other scheme types must provide this type of illustration on an annual basis, and must show the amount of future pension available in today’s terms.

The Financial Reporting Council (FRC) sets the assumptions that this must be used when producing SMPIs.

Question 18

Regulatory requirements

The FCA is very keen that all members of an individual DC scheme are informed of their right to use an open market option (OMO). An OMO is the option to buy a lifetime annuity from any provider, not just the scheme you have accumulated your pension fund through.

Continued
Why should an individual use an OMO?

Different annuity providers offer different rates. One provider may wish to attract annuities from single individuals that require inflation-proofing, whereas another may want more annuities from married individuals or those in a civil partnership.

They will adjust the rates they offer, to attract the types of business they want.

As annuity rates have been poor for a while now, it is important that an individual buying a lifetime annuity gets the best rates possible. Poor rates are due to increased longevity and low interest rates for the best part of the last decade. The best rates will usually be achieved by shopping around and the use of OMO.

Question 19

5.2.3: Independent Governance Committees (IGCs)

These were introduced by the government for contract-based workplace pension schemes. Their aim is to ensure that workplace pension schemes offer good value for money, so that members can feel more confident that plan charging levels are not set
too high.

These committees must have a minimum of five independent members.

Workplace pension schemes are independently reviewed, and IGCs take a lot of interest in default investment funds and plan charges. IGCs have several key areas of focus which include:

Such committees are currently only concerned with the accumulation stage of pensions planning but plans are afoot to include decumulation.

Providers with smaller and less-complex schemes can now establish a Governance Advisory Arrangement (GAA) with a third party, instead of the more expensive IGC. Though cheaper, the desired GAA outcomes are identical in ensuring members receive good value for money.

In December 2019 some new rules came into force following a FCA consultation period. These rules increased the scope of both IGCs and GAAs in two key areas.

Additional reporting requirements including environmental, social and governance issues.

The requirement to oversee the value for money of investment pathway solutions for drawdown pension (where the members does not take advice, the firm offers a range of investment solutions that broadly meet their objectives).

Following these changes / improvements in 2019, further rules came into force in October 2021.

What’s the aim of these further rules?

The FCA wanted to make it easier for IGCs and GAAs to compare the value for money (VFM) of pension products and services. This means setting up a more transparent VFM assessment framework, especially for work-based pension schemes and their members.

Before coming up with these new rules the FCA surveyed individuals within the industry asking for feedback on their proposed new rules.

Question 20

5.3: DC scheme benefits on ill-health and death

We will now consider a few areas in relation to ill-health and death benefits.

Waiver of contribution & Pension Contribution Insurance
Income Protection Insurance
Early Retirement on Ill health & Serious Ill health grounds
Death pre crystallisation
Death Post crystallisation

Tell me about each

Question 21

Provision of a lump sum
On death, pre-retirement, pre age 75, any lump sum payment will be classed as an RBCE. An income tax charge will be due if benefits exceed the relevant LSDBA.

If the member dies aged 75 or above, all the lump sum death benefits will be subject to income tax at the marginal rate of the beneficiary.

Regardless of the age at which the member died, if this lump sum is left to a trust or personal representative, it will suffer the 45% tax charge.

If this payment is made to a registered charity, no tax will be due, whatever age the member was at death. The member must have no dependants to be able to utilise this option.

Question 22

Provision of pension benefits
If a dependant chooses to use some of these DC funds to provide an income in the form of a lifetime annuity or FAD, this will be paid income tax-free if the member dies pre age 75. Income will be taxable at the recipient’s marginal rate if death occurs age 75 +.
The taxation does depend on the method of income provision.

o If a scheme pension is selected, income payments will be taxable at the recipient’s marginal rate, regardless of whether the original member died before or after age 75.

o If a lifetime annuity or FAD are selected, income is tax-free if the member’s death occurs pre-age 75.

Any lump sum payment will be affected by the size of the DC pension fund on death.

This could represent a small payment if death occurs early on the individual’s retirement planning journey, or if they have not contributed a great deal.

To increase the lump sum death benefits, there are a couple of options which include:

Personal pension term assurance
Group death in service
Personal pension term assurance

This allowed an individual with a personal pension or stakeholder plan to provide themselves with additional life cover. The life cover provided was dependent on the contribution paid and the individual’s age and gender.

As you can imagine, these schemes were very popular, as the individual was providing themselves with greater life cover, and premiums attracted tax relief, so cost them less as a net payment.

HMRC’s view, however, is that the generous RPS tax benefits are given to encourage individuals to save for their retirement income, not subsidise the costs of life cover.

As a result, a review of pension term assurance took place in 2006, and resulted in changes which included:

Question 23

5.4: Early leavers and transfers

Employees, on average, stay with the same employer for between three and five years before moving on.

In terms of DC schemes and transfers, this is not an issue if the individual has an individual or group scheme, as these are portable.

If, however, the individual has an occupational DC scheme, the process is not quite as straightforward.

A member of an occupational scheme could have a number of options if they leave employment, including:

READ 5.4

Answer 23

Short service refunds
Preserve Benefits
Take a CETV and transfer benefits
Crystallise benefits immediately

Question 24

see 5.4. Here is a comparison table that compares a DB occupational scheme to a DC one, to help with your revision.

Question 25

1: Occupational DC schemes

Occupational DC schemes are trust-based, which means they are established under a trust deed with trustees safeguarding all member rights.
There were a variety of occupational DC schemes historically: COMPS, CIMPS, EPPs, SSASs, TMPs and section 32 policies.
Tax relief is usually given through the net pay method.
EPPs and SSASs are director / executive schemes.
An SSAS can lend and borrow up to a maximum of 50% of its net scheme assets.
A TMP combines both DB and DC scheme features.
A section 32 policy is a DC OPS, historically used for accepting a transfer from a contracted out DB scheme, as it maintained the GMP on transfer.
Benefits available from an occupational DC scheme include PCLS and retirement income in the form of a scheme pension, lifetime annuity, UFPLS or drawdown pension.
This starts to cover the syllabus learning points:

5.1: Analyse the types of DC schemes, their main attributes and benefits

5.2: Explain the legal bases of DC schemes and their impact on an individual’s pension planning

2: Individual DC schemes

Individual DC schemes are contract-based, with a third-party provider.
A master trust can be used for these types of DC scheme, which is a trust arrangement where each employer has its own section or division within it.
There are a variety of individual DC schemes: RACs, PPPs, SHPs, SIPPs, and group schemes.
Tax relief is usually given through the relief at source method, with the exception of RACs, which use the relief through a claim method.
RACs (the predecessors of PPPs) were introduced in 1956, with new plans not available since 1st July 1988.
SHP plans were introduced in 2001 and are simple, low cost plans.
An SIPP has access to both direct and indirect investments, and can also borrow up to 50% of its net scheme assets to make the most of investment opportunities such as commercial property.
Group schemes are offered by an employer through a third party, such as an insurance company.
Group schemes are not occupational schemes: they are a collection of individual schemes.
This continues to cover the syllabus learning points:

5.1: Analyse the types of DC schemes, their main attributes and benefits

5.2: Explain the legal bases of DC schemes and their impact on an individual’s pension planning

3: DC scheme benefits on ill-health and death

These include WOC, PCI, income protection insurance (IPI), early retirement on ill-health and serious ill-health grounds, and benefits provided on death both pre and post crystallisation.
Both WOC and PCI protect pension contributions if the individual is unable to work, after an initial 26-week period, IPI provides a regular income from which pension contributions may be maintained, if the individual is unable to work due to sickness or accident.
Early retirement on the grounds of ill-health is available if the member is unable to carry out their normal occupation, early retirement on the grounds of serious ill-health is available if the member has less than 12 months’ life expectancy.
Pension term assurance premiums used to receive tax relief, making costs substantially cheaper. This was abolished from 2007.
Death benefit pre-crystallisation is normally return of fund. Pre-75, the benefit is tested against LSDBA and tax-free - if paid out within 2 years of death and if no excess (it is taxed at member’s marginal rate if there is an excess). 75+ the benefit is taxed at recipient’s marginal rate.

This covers the syllabus learning point:

5.3: Outline the benefits on leaving, and death before and after age 75

4: Early leavers and transfers

A DC early leaver has a variety of options: leave benefits preserved, take a CETV or crystallise benefits.
A short-service refund is now not available if service is more than 30 days in an OPS DC scheme.
It is not available at all in an individual DC scheme.
A DC CETV is the fund value less any disinvestment charges.
There are no statutory revaluation or escalation requirements for preserved DC benefits.
A financial adviser must consider a variety of transfer factors such as charges, fund choice, plus loss of any benefits on transfer such as a GAR, guaranteed bonus or growth rates and protected tax-free cash.
The FCA has strict rules in place for ‘pension switching’ cases, which include a pro-forma with questions, data, and relevant factor sections.

Question 26

Paul is self-employed and usually has net profits of £60,000 annually. He has received a £40,000 inheritance, which he pays as a single premium (gross) into his personal pension plan. He has no carry forward. When his accountant confirms his earnings for this tax year, they are £35,000. What will happen as a result in relation to this £40,000 contribution?

There will be a £5,000 tax charge.

£5,000 will be classed as an unauthorised payment.

Lump sum allowance charge will be triggered.

£5,000 will be taxed at Paul’s marginal rate.

Answer 26

£5,000 will be taxed at Paul’s marginal rate.

Tax relief is only available on the greater of 100% gross earnings or £3,600 with no reference to earnings. The £5,000 will incur a tax charge at Paul’s marginal rate which appears to be basic rate.

Question 27

Jane, aged 52, has left her DC occupational scheme after one year, on 1st December 2024. Which of the following options will NOT be available to her?

Short-service refund.

Short-service benefit.

Leaving benefits preserved.

Transferring a CETV.

Answer 27

Short-service refund.

DC OPSs do not offer the option of a short-service refund after 30 days’ service in the scheme.

Question 28

Sharon has the following pension schemes:

Section 32 GMP

£20,000

Retirement Annuity Contract

£90,000

Personal Pension Plan

£70,000

How much is the maximum PCLS available for Sharon?

£25,000.

£40,000.

£55,000.

£65,000.

Answer 28

Sharon cannot use her section 32 GMP for PCLS. Only the RAC and PPP combined can be used to generate cash tax free.

£90,000 + £70,000 = £160,000 x 25% = £40,000 PCLS available.

Question 29

Jane has died and left £80,000 from her pension in a trust for her three sons. How much tax, if any, will be due on this payment?

None.

£40,000.

£44,000.

£36,000.

Answer 29

£36,000.

Jane’s age when she died is immaterial, as she has left a lump sum in trust for her three sons. This will be taxed at a flat rate 45% so £36,000 tax will be due on this payment (£80,000 x 45%).

Question 30

Jenny is an additional rate taxpayer. She has an SIPP and is considering alternative forms of investment instead. Which of the following statements are TRUE?

Placing £20,000 into an EIS would provide more tax-relief than into her SIPP.

Jenny can purchase commercial property with her SIPP and receive tax-free rental income.

Jenny can transfer unlisted company shares via an in-specie contribution, into her SIPP.

Dividends on shares held in an EIS would be tax-free.

SIPP in-specie contributions would receive 20% contribution tax-relief.

Answer 30

Jenny can purchase commercial property with her SIPP and receive tax-free rental income.

Dividends on shares held in an EIS would be tax-free.

EIS contributions receive 30% tax-relief. In-specie transfers no longer receive tax relief. B and D are true.

Question 31

Which of the following pension scheme members will require specialist transfer advice from a financial adviser with the relevant technical qualifications?

George with £33,000 in a section 32, which includes £25,000 in GMP.

Saka with £35,000 in a RAC with a guaranteed investment value.

Karina who has £42,000 in an executive pension plan.

Mustapha with £66,000 in a RAC with a guaranteed annuity rate.

Answer 31

George with £33,000 in a section 32, which includes £25,000 in GMP.

Mustapha with £66,000 in a RAC with a guaranteed annuity rate.

Both George and Mustapha have safeguarded benefits. They must therefore take independent financial advice from a pension transfer specialist before being allowed to transfer these benefits. As both the GMP and GAR guarantees would be lost on transfer.