Pensions

Pensions

Wholesale Change

How simple will the new pensions régime really be, asks ALLISON PLAGER.

WORRIED? YOU SHOULD be. If you are not saving towards some kind of retirement income, that is. Pensions are headline news these days, meriting regular features in the weekend papers. It all seemed to start with Maxwell back in 1991 (yes, it really is that long ago), and since then pensions hardly ever seem to have been out of the news.

The latest scare comes from the Turner report, published on 12 October, and which in essence concludes that people are not saving enough to provide themselves with a sufficient income in retirement. The Government's response is not expected until autumn 2005. However, important though that report is, the subject of this article concerns the previous and, indeed, continuing pensions excitement, namely simplification.

Anyone involved in the administration of a pension scheme knows that there are massive complications. Thus, it will have been a relief when, in December 2002, the Government published a consultation document, 'Simplifying the taxation of pensions: increasing choice and flexibility for all', in which it proposed a radical simplification of pensions, not least of which was culling the existing eight régimes and replacing them with one. A second paper, 'Simplifying the taxation of pensions: the Government's proposals' followed in December 2003, which concerned the technical details of the tax rules pertaining to pensions.

After consultation from interested parties and a report from the National Audit Office, the Chancellor, Gordon Brown, included final proposals in his Budget, subsequently embodied in the Finance Bill and finally in the Finance Act 2004. It is really due to pension simplification that this year's Finance Bill was so long, since 132 clauses and seven Schedules related to the subject; these converted to FA 2004, ss 149 to 284 and Schs 28 to 36. See 'Pensions!', Taxation, 15 July 2004, page 411 for a report of the relevant standing committee's debates of the Finance Bill clauses.

Registration

Schemes will no longer have to gain Revenue approval to benefit from the tax exemptions, instead they will have to register with the Revenue. Existing approved schemes are automatically registered, but new ones will have to apply for registration. In order to register, schemes will have to provide various information, including:

Tax relief will be allowed once registration is granted. Reporting requirements during the life of the scheme have been totally revised with the aim of being much simpler. Certain events will have to be reported, and these include:

Lifetime allowance

Perhaps it is the lifetime allowance that caused the most dissent during the consultation period. The lifetime allowance is the amount against which the value of an individual's prospective pension benefits will be tested immediately before they become payable. The Government first proposed that this amount be £1.4 million, to rise annually in line with inflation and rounded up to the next £10,000. The pensions industry claimed that this amount was too small, and that tens of thousands of people would be adversely affected by the limit, i.e. likely to have pension funds in excess of that amount. The Government suggested that it would be 5,000 people. The subsequent research by the National Audit Office fell somewhere in between the two camps, estimating the figure at 10,000 with the qualification that it was difficult to make an estimate due to lack of a single source of data.

In any event, the Government increased the allowance to £1.5 million for 2006-07 rising to £1.8 million for 2010-11, when the figure will be reviewed. Table 1 shows the annual rises in the lifetime allowance to 2010. The annual increases are more generous than suggested in the 2003 consultation paper, and it is not known if after 2010-11, the increases will be in line with indexation, as first proposed.

Table 1: Lifetime allowances

2006-07 1.5 million

2007-08 1.6 million

2008-09 1.65 million

2009-10 1.75 million

2010-11 1.8 million

In order to determine whether or not the lifetime allowance has been exceeded, a system of factors has been introduced.

The factor of 20:1 will be used for a defined benefit or final salary scheme. Thus a member will be able to be paid a pension of £75,000 a year, i.e. £1.5 million divided by 20. This factor applies regardless of the member's age, sex and retirement date. It applies where the pension in payment increase is limited to 5% and where the dependent's pensions are less or equal the member's pension. Where the pension scheme pays in excess of these, a different factor must be agreed. Where a pension is already in payment at A day, a factor of 25:1 will be used.

The Act refers to 'crystallisation' events against which the lifetime allowance must be measured. These events include:

Any amount over the lifetime limit will be charged to tax at 25%. If benefits are taken in lump sum form, the charge increases to 55%. As the pension payments will also be taxed under the PAYE system, higher rate taxpayers have an effective tax rate of 55%, i.e. 25% + 40% x 75%.

The pension scheme has to decide how to pay to the tax. It can do it either by reducing the member's benefits or by paying the tax on a grossed up basis. If tax is to be deducted from the member's benefits, it can be taken from the lump sum or pension. There is no prescribed basis for reducing a member's pension to take account of a tax charge paid by the scheme; the Finance Act just states that the pension should be reduced in accordance with 'normal actuarial practice'. Should the scheme decide to pay the tax on behalf of the member without making a corresponding reduction to the member's benefits, a recovery charge would be due on this tax payment.

The pension scheme member must declare any recovery charge due, with appropriate credit for the withholding tax paid by the scheme, on their self assessment tax returns.

Annual allowance

An annual allowance is to be imposed on the annual level of tax-relievable contributions or accrual of benefit to an individual's total pension plans. This has been set at £215,000 (£200,000 in the consultation paper), with specified increases to 2010-11, when it will be reviewed. See Table 2 for each year's annual allowance. For most people, this is a generous amount, particularly as individuals will be able to contribute up to 100% of their pay towards pension schemes with full tax relief, which for most is an unlikely event. The amount that employers can contribute with full tax relief in respect of employees is limited only by the annual allowance and by the normal Schedule D expense rules. If the total contributed exceeds the annual allowance in a year, the excess will be taxed at 40%.

In defined contribution schemes (also known as money purchase schemes), the amount of contributions will count towards the allowance, although the contracted out flat rate rebates and age related rebates will be disregarded. This is quite straightforward. However, for defined benefit schemes, it is a little more complex. The amount to be tested against the annual allowance is the value of accrual over the pension input period.

In the year in which pension benefits are drawn the annual allowance will not apply, so the member can make unlimited contributions. The pension benefit still, however, is subject to the lifetime allowance.

The aim of this allowance is to reduce potential tax loss through avoidance of the recovery charge, perhaps when an individual pays substantial contributions to a scheme which later is moved offshore.

Table 2: Annual allowances

2006-07 £215,000

2007-08 £225,000

2008-09 £235,000

2009-10 £245,000

2010-11 £255,000

Transitional rules

Protection for individuals with pension rights over the lifetime allowance accrued before A day has been built in. Under primary protection an individual with pension rights accrued to A day in excess of the lifetime allowance can register those rights with the Revenue, and an enhancement factor will be applied to the standard allowance. So, for example, a member with funds worth £3 million at A day, i.e. twice the allowance, will be able to draw pension benefits at double the lifetime allowance on retirement.

Alternatively, an individual can opt for enhanced protection. If he has accrued benefits valued at no more than the lifetime allowance at A day, he can stop paying into his registered scheme, and any benefits protected from the lifetime allowance charge. The member can, however, revert to primary protection if he wishes.

Benefits notes

The popular lump sum payment continues to be permitted under the simplification rules, despite some early hints that it may be abolished. Up to 25% of the value of the pension benefit with the lifetime allowance will be payable to the individual. As mentioned earlier, a lump sum payment may be taken from funds over that allowance, but will be subject to the 55% recovery charge.

The concept of a normal retirement date no longer exists, although schemes may retain one if they want to. Thus they do not have to notify the Revenue of a normal retirement age. The earliest age from which schemes may normally pay benefits is to rise from 50 to 55, and this change applies from 2010, although members who on 10 December 2003 had the right to draw pension benefits before age 55 may have that right protected. Pension payments can be deferred until the member is 75, but must commence thereafter.

If the scheme permits, the new régime allows pension benefits to be drawn while the member continues to work.

Where the member dies before reaching retirement, the pension benefits can be paid either as a lump sum or as a pension. A lump sum will be tested against the lifetime allowance and be tax-free up to that amount. The excess will be subject to the recovery charge. Pension payments do not, however, count towards the lifetime allowance.

Where the member dies in retirement, but before the age of 75, and no annuity is in place, the remaining fund becomes part of the member's estate, subject to tax at 35%. Where the member was receiving an annuity, a lump sum up to the value of the final pension less payments made can be paid, again liable to tax at 35%. Alternatively, it is possible to opt for the pension to continue to be paid for up to ten years. One or the other of these alternatives must be chosen, they cannot both be taken.

The five-year guarantee that could be paid as a tax-free lump sum is not available in the new régime.

Where the member dies aged over 75, no capital payments can be made.

Small matters

Members will be able to commute small pensions on grounds of triviality where the capital value of all their pension benefits is no more than 1% of the lifetime allowance. The amount may then be commuted to a lump sum provided that the member is aged between 60 and 75.

As under the previous rules, schemes will be able to refund a member's contributions on grounds of short service. In order to qualify, the member must not have qualified for or received any scheme benefits, and must be under the age of 75. The first £10,800 of the lump sum will be taxed at 20%, with any excess amount taxed at 40%.

Unapproved schemes

Funded and unfunded unapproved retirement schemes are redundant under the new régime and will not receive registration, unless they meet the conditions required. Instead, they will be treated as employer-financed retirement benefit schemes, and will have no tax benefits. Entitlements to A day will be protected, but thereafter:

On the plus side though, contributions to unapproved schemes will not count towards the annual allowance, nor will the fund accrued count towards the lifetime allowance.

Overseas schemes

Migrant relief replaces the existing corresponding relief for an individual who comes to the UK and is a member of an overseas pension scheme. Provided that the individual satisfies certain conditions:

he will qualify for the same tax reliefs that apply to UK schemes.

Welcome change

The new régime is undoubtedly much less complex than the previous system, and the Government has made an effort to ensure that individuals are not worse off under the new rules than they were before. A lot of fuss was created about the lifetime allowance, but for the vast majority of the population, £1.5 million is hopelessly unachievable as a pension fund and so they will be unaffected. Those affected have time to consider making the election for primary or enhanced protection. It would also be advisable to consider whether making other investments would be more tax beneficial than paying the lifetime allowance charge.

Overall, after 6 April 2006, the pensions system will look radically different from how it does now, and should be the better for it.

Table 3: Notable dates

5 November 2004 Consultation on first tax simplification regulations ends

1 January 2004 EU requires listed companies to adopt IAS 19, whereby pension scheme disclosures in their consolidated accounts must be prepared in line with IAS 19

April 2005 Draft Revenue manual on tax simplification is expected to be published

April 2005 Finance Bill 2005 is expected to fill in some of the gaps in tax simplification left out of FA 2004 because of lack of time

6 April 2006 A-day: new pensions tax régime is implemented

(Source: Punter Southall & Co)

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