Pensions Simplification

There is no doubt that under the pensions simplification rules, planning for retirement will be less complex than now. However, the transition from the old to the new order must be managed. The purpose of these notes is twofold:

To explain the new system
To help readers to understand the transitional issues with which they may become involved

Key benefits of the new system

In many cases, people have used the tax regimes under the old system to exploit the differences between these regimes. With simplification, the plethora of regimes and products will be replaced by one overall system which will have the following benefits:

Less complexity which will lead to lower costs
No need to leave employment to access employer’s scheme
No need to choose between various schemes
Standardisation of tax free lump sum leading in some cases to higher permissible amounts when compared to previous regimes
Greater allowable contributions
One single lifetime allowance covering all pension arrangements
No limit on pensions benefits (e.g. 2/3 final salary)
No application of earnings cap

The new system

On 6th April 2006 (A day), all schemes will be subject to the new rules under pensions simplification. The schemes in question are:

Retirement annuity contracts and personal pensions
Occupational pension schemes
EPP/SSAS
S32
Unapproved schemes

From A day all pension schemes will be treated as conforming to the new rules and will be known as registered pension schemes (compared to exempt approved schemes) or unregistered schemes (compared with unapproved schemes). Additionally there will be no need to register a scheme under trust (or for a scheme to continue to be registered under trust) nor will there be a requirement for a pensioner trustee.

Retirement ages

The minimum pension age is to be increased to 55 by 2010. The earlier retirement age of 50 will still be allowed between A day and 5th April 2010 provided that:

The contractual right to retire existed as at December 2003
The pension is fully vested at the time of retirement
Employment terminates on pension vesting

Those with lower pension ages, for example, sportspeople, will no longer be able to retire at previously agreed ages. This rule applies to arrangements after A day. Existing rights to take benefits will be honoured, but subject to two conditions:

The full pension must be vested
The pension will be tested against a reduced lifetime allowance (see later), with a reduction of 2.5% for each year the pension is taken before 55

Members of the police, armed forces and fire services will be unaffected by this rule.

Early retirement will continue as a feature of pension schemes.

Contribution levels

Members of UK pension schemes may be

UK resident or
subject to UK income tax
or non residents who do not have any UK earnings

We will deal here with the predominant group which is UK residents or those subject to UK tax on earnings.

From A day, the maximum contribution that can be made by an individual to a registered scheme will be the greater of £3,600 and 100% or UK relevant earnings. Contributions in excess of theses amounts may be made, but tax relief will not be allowed except in one circumstance. This is where annual earnings exceed the annual allowance (£215,000 for 2006/07). However, in this circumstance a tax charge will be raised in respect of `benefit’ above the allowance. Similarly, an employer may make contributions to a registered scheme, but there will be no limit on the amount. Tax relief will be claimable in full as a business expense. It will be granted in the year the contribution is made unless it exceeds £500,000 and 210% of the contribution made in the precious chargeable period. Where it exceeds this figure it will be subject to spreading forward of relief.

Tax relief for employees

Employer schemes, defined contribution and benefits, will be able to receive tax relief in one of two ways:

via the net pay method or
via the tax relief at source basis

The same method must be used for all members.

Group personal pensions and group stakeholder schemes will be restricted to the relief at source basis. Retirement annuity contracts will continue to receive tax relief via self assessments unless pension providers choose to amend their rules to conform to the tax relief at source basis.

Annual allowance

Tax relief in any one year will be restricted to an overall amount known as the annual allowance. This annual allowance will be the maximum savings growth allowable and will be set annually. The current figures are set at:

2006/07	£215,000
2007/08	£225,000
2008/09	£235,000
2009/10	£245,000
2010/11	£255,000

The allowance will be reviewed every five years, although the amount in any one year cannot be less than that in a previous year.

To establish if the annual allowance has been exceeded, the aggregate of all the following will be included in the calculation:

all contributions to defined contribution schemes, plus
the increase in the capital value of defined benefit pension and lump sum rights from whatever source (excluding unregistered schemes and DIS rights) plus
the capital value of any increases in respect of defined benefit schemes (pension and lumps sum rights above RPI

With defined contribution schemes, the annual `benefit’ is transparent, but with defined benefit schemes things are a little more complex. Here, the value of the increase in pension savings from one year to the next is determined by a factor of 10:1.

Example 1
At A day, Tommy had twelve years pensionable service in a scheme with a 60th accrual rate. His pensionable salary was £57,000. One year later, his salary has increased to £60,000.

The capital value of the increase is 13/60th x £60,000 = £12,350
Less 12/60th x £57,000 = £11,400
= £ 950

The capital value of the increase is £9,500 which is within the limits allowable.

Any AVC made to support added years benefits will not count towards the annual allowance, but those made to defined contribution AVCs will count.

The lifetime allowance

From A day, the maximum retirement fund which can be built up will be £1.5m for the 2006/07 tax year. This will be increased over the following four years to £1.6m, £1.65m, £1.7m and £1.8m in 2010/11. The lifetime allowance will be reviewed every five years and will be rounded up to the nearest £10,000.

The allowance will be applied when any benefit comes into payment. This covers:

taking pensions, or part pensions, at retirement
any discretionary pension increases above the assumed factors which determined the lifetime allowance
any transfer to a non registered pension
invested funds when the member reaches 75

Where the aggregate of all registered pension funds amount to less than the lifetime allowance, then tax free cash and taxable pension will be allowed as now. However, where the aggregate exceeds the lifetime allowance, the excess fund will be subject to a recovery charge. This recovery charge will be 55% of the excess if the excess is taken as a lump sum and 25% if it is taken as income. Normal income tax applies to the subsequent income taken in this way.

The calculation of the lifetime allowance will be dependent upon the arrangement that is being assessed.

For money purchase schemes, the fund value will clearly be the amount of benefit and is assessed against the lifetime allowance
For defined benefit schemes a factor of 20:1 is applied to the promised pension. This factor assumes:
- that the aggregate of all survivors pensions is no more than the member’s pensions
- that the member’s pension is indexed by RPI
- no tax free cash is taken. Where tax free cash is taken it is added to the capital value of the pension

Example 2
Oona takes her defined benefit at retirement which equates to a pension of £18,000p.a. The pension is designed to increase in payment by RPI. Using a conversion factor of 20:1, it is valued at £360,000. Five years later the pension stands at £18,600 but the employer decides to augment this to £19,000. This `vesting event’ creates a further value of £8,000 (20 x £400)

Pensions already in payment will have a value based on a factor of 25:1. Income drawn from a pension fund withdrawal arrangement will also be included using a factor of 25:1, but it will be applied to the maximum permitted income that could have been paid.

Example 3
Maude is 64. She receives £18,500 p.a. from her employer’s defined contribution scheme. She has a retirement annuity contract with a value of £18,000 and next week will begin to receive a final salary pension of £15,000p.a. The aggregate of all pension benefits will be:

• £18,500 x 25 = £462,500
• £15,000 x 20 = £300,000
• RAC £ 18,000
• Total = £780,500
• This is within the lifetime allowance of £1.5m at 6th April 2006.

Of course not all pension funds will be within the lifetime allowance. Where pension funds exceed the lifetime allowance (or aggregate of funds), they will be subject to the recovery charge, as described earlier.

Example 4
Polly has reached her chosen retirement age and decides to vest some of her pension fund. She chooses to invest £1.125m (80% of the lifetime allowance of £1.5m) Of this £1.125m she takes tax free cash of £281,250, leaving the remainder to provide her with an income.

The remaining fund of £375,000 remains invested until 2010 when Polly decides to invest this as well. The fund has enjoyed good fund growth and is now valued at £550,000. 20% of this will be taken as pension benefits which is £360,000. Tax free cash of £90,000 can be taken leaving £270,000 to provide an income.

The remaining £550,000 less £360,000 will be subject to a recovery charge of 55% or if taken as income a reduced charge of 25% will apply.

Taking benefits

The way in which pension income may be taken from a registered scheme will be standardised from A day. A pension must be provided for the life of the member, but can be provided in one of three ways.

Secured Income, taken as promised pension from the employer or via the purchase of an annuity from a defined contribution scheme (pretty much as now) will be referred to as scheme pension. Alternatively, the member will be allowed to buy a lifetime annuity, which is similar to an open market option.
Unsecured Income is similar to pension fund withdrawal. Income may be drawn down from the invested funds based on a minimum of £1 p.a. and a maximum of 120% of the single life annuity that could have been purchased at outset (or subsequent review periods). Income can be varied between these parameters on an annual basis, but the whole arrangement must be reviewed every five years. Income must be secured by 75, either by way of an annuity or alternate secured income.
Alternate secured income will probably satisfy those people who do not agree with shared mortality pots and will apply from 75 onwards. The arrangement is similar to pension fund withdrawal except the maximum is restricted to 70% of the income which could have been taken from a single life annuity at 75. The maximum income will be reviewed based on fund values up to 60 days before reviewal date.

Death benefits

Death benefits may be paid out either as a lump sum or income, or a combination of the two. It may be paid to:

spouses
children up to the age of 23
financially interdependent individuals
dependants, either financially or as a result of disability

Where death occurs before vesting, a lump sum may be paid with no limitations (other than the lifetime allowance). Payments will be made gross and the legal representative must account to the Inland Revenue for any recovery charge, on funds in excess of the lifetime allowance. Dependant’s pensions will not count towards the lifetime allowance.

Where death occurs after vesting, but before 75, the benefits may be taken as follows:

secured income
unsecured income

Where unsecured income is provided, dependants may be provided with pensions (secured or unsecured), or they can take the fund within the lifetime allowance, taxed at 35%.

With secured income the maximum amount payable is ten annual instalments from the date the benefits first vested. However, if income is secured more than ten years after vesting, no guarantee can be provided. Dependant’s pensions may be provided in addition.

Where alternate secured income is provided, no part of it can be returned as a lump sum, but must provide a dependant’s pension. If no dependant exists, the fund must remain within the scheme or paid to a registered charity.

Trivial commutation

Where total pension benefits are less than 1% of the lifetime limit, the fund can be commuted for cash subject to a tax charge on 75% of the fund.

Leaving service

Employer sponsored schemes (not GPP) will be able to provide employees with a short service refund. Where the member leaves service less than two years after joining a scheme, a refund of member’s contributions may be provided. The first £10,800 will suffer tax at 20% with any excess taxable at 40%

Scheme investment

A single set of investment rules will apply to all registered schemes after A day.

There will be no restrictions on allowable investments
Up to 5% of the fund will be able to invest in shares of the sponsoring company
A scheme will be able to borrow up to 50% of scheme assets
A scheme will be able to lend funds back to the sponsoring employer for a maximum of five years and for an amount no more than 50% of scheme assets

Lump sum certificates

All lump sum certificates will be ignored post A day

Transitional Arrangements

There will inevitably be groups of people who exceed (or could exceed) the lifetime allowance by 6th April 2006. A once only opportunity exists to protect their fund build up by either primary protection or enhanced protection. The choice will depend upon circumstances.

Primary protection

The value of pension rights and benefits accrued up until A day, can be protected using primary protection, even though the total fund(s) may exceed the statutory lifetime allowance. This will work by indexing the pre A day value in line with the statutory lifetime allowance. Contributions can continue to be made after A day.

Example 5
Albert has £2.8m before A day as pension rights and benefits. When he vests the benefits the statutory lifetime allowance has increased to £1.8m, whilst the fund has increased to £3.5m. At A day, Albert’s personal lifetime allowance was £2.8m, which if indexed in line with the statutory lifetime allowance would have increased to £3.36m. A recovery charge would apply to £0.14m

Enhanced protection

This facility is available where individuals agree to cease contributing to a registered pension scheme after A day. They may take all pension benefits accrued without recovery charges being imposed. For defined contribution schemes, any growth in excess of the A day amount will be exempt from the recovery charge, while those in final salary schemes will have benefits based on salary at date of vesting rather than that at A day.

Example 6
Soroya has a defined contribution fund of £4.8m at A day. She agrees to make no further contributions to a registered scheme. When she eventually vests the fund it has grown to £6m and the indexed A day value is £5.2m. No recovery charge will result as membership ceased at A day. If Soroya started to contribute again post A day, then the fund would receive primary protection.

Tax free cash relating to pre A day rights

Where primary protection has been selected, any tax free sum on A day may be indexed at the same rate as the statutory lifetime allowance up to the date the benefits are taken.

With enhanced protection, the tax free lump sum will be calculated using the same percentage as that which applied on A day to the overall fund.

Example 7
Barney has a lump sum entitlement at A day of £400,000, but continues to contribute to the scheme. At vesting, the tax free cash can be indexed at the same rate as the statutory lifetime allowance.

However, if Barney had elected fro enhanced protection, any lump sum at A day would have been expressed as a percentage of the A day fund. This percentage would then be applied to the final fund on vesting.

Divorce

Where pension credits and debits are created after A day as a result of a pension sharing order effective after A day, this will have a knock on effect to the lifetime allowance of the donor/recipient. The donor will lose the value of the credit from their fund, whereas the recipient will gain the credit, thereby reducing the amount of their lifetime allowance. Neither debits nor credits will count towards the annual allowance.

Where pre A day sharing orders exist, the will be disregarded in respect of spouse’s lifetime allowances.