Feature

posted 24 Mar 2005 in Volume 10 Issue 3

Pensions simplification: The start of a new age

In an examination of the implications of pensions 'A-day' on 6 April 2006, John Dunseath highlights the more significant changes and outlines some potential planning opportunities for ECA readers and their clients forthe post A-day world

The government has decided to simplify the taxation, rules and regulations of pensions. The various sets of rules that constitute the current pensions tax regime are the result of largely piecemeal changes, introduced over many years. So, reform at some stage was inevitable. The new rules will come into force on 6 April 2006, which is known as ‘A-day’. The most widely discussed aspects of these proposals have been:

The limiting of tax breaks to a single lifetime allowance on every person’s aggregate pension fund;
A restriction on the amount of tax-free cash that can be taken at retirement. Everyone will now be entitled to the same percentage of their pension fund;
The freedom for people in occupational pension schemes to draw retirement benefits while still continuing to work;
The removal of restrictions, so that people will be able to contribute to different types of pension schemes at the same time;
Greater flexibility in the types of annuity that may be arranged and when they must be implemented.

In future, a single set of rules, with limited exceptions (the new rules will not apply to judges, for example), will apply to all registered schemes.

The lifetime allowance

For tax-benefit purposes, everyone’s pension fund will now be limited to a maximum figure known as the lifetime allowance. This will initially be £1.5m.

It will increase in tranches annually up to £1.8m by 2010, and it will be reviewed at five-yearly intervals after that.

Any ‘defined benefit’ pension will be treated as having a value equal to 20 times the annual pension. That is, regardless of the member’s age at retirement or the actual cost of buying an annuity. If, under the scheme rules, tax-free cash is provided in addition to the pension, the actual amount of the tax-free cash sum is added to the pension value.

The pension fund will be tested against the lifetime allowance at the time of taking benefits. Any excess funds will then be subject to the ‘lifetime allowance charge’ detailed below.

A pension scheme member who already has a (pre A-day) pension fund of more than £1.5m will qualify for ‘primary protection’. Provided that the higher figure is registered with the Inland Revenue within three years of A-day, it will become the member’s personal lifetime allowance. Inland Revenue will issue a certificate stating that the member is entitled to the appropriate higher percentage (e.g.120 per cent) of the standard lifetime allowance. This means that the member will also benefit from any subsequent increases in the statutory lifetime allowance.

Provided that they cease to be an active member of a pension scheme before A-day (although they can continue to be covered for death benefits), a person can register for ‘enhanced protection’. This means that a member of a money purchase scheme will be entitled to their full fund value at the date of retirement including full growth since A-day. Benefits for a member of a defined benefits scheme can be based on their pensionable service to A-day and final salary at date of retirement. The definition of ‘final salary’ will depend upon when they first joined the scheme as different definitions apply to pre 87, 87-89 and post 89 members. In other words, the new lifetime allowance will not apply. However, if the person subsequently resumes active membership of, or accrues benefits under any other registered pension scheme, the entitlement to ‘enhanced protection’ will be lost (by now many ECA readers may also feel rather ‘lost’ in this simplification).

Lifetime allowance charge

If anyone’s pension fund exceeds the lifetime allowance, a lifetime allowance charge will be imposed in order to repay to the government the ‘extra’ tax relief and tax privileged fund growth that the member has enjoyed. The amount of the lifetime allowance charge will depend on how the excess value in the pension fund is used:

If it is applied to provide the member with additional pension, the lifetime allowance charge will be 25 per cent of the excess pension fund;
If it is taken as a cash lump sum, the lifetime allowance charge will be 55 per cent of the excess pension fund.

The reason why the tax charge is lower if the pension is selected is because pension in receipt would be taxed at the member’s marginal rate of tax. So, it is not as generous as it may look.

Pension splits on divorce

If a pension fund is to be divided between a divorced couple under a ‘pension sharing’ arrangement (‘sharing’ and ‘divorce’ being mutually exclusive, this is usually a misnomer), the amount of a pension share will count against the recipient’s lifetime allowance but it can be ignored for the purposes of the donor’s lifetime allowance. There will be transitional protection for pre A-day pension-sharing arrangements.

In calculating members’ pre A-day rights, the value of the pension share will be ignored for the purposes of the donor’s lifetime allowance. An ex-spouse who registers a pre A-day pension credit within three years of A-day will have their personal lifetime allowance increased proportionally to account for the pension credit (divorce lawyers need to be alerted to this).

Contributions

Employees will qualify for income tax relief on contributions up to £3,600 per year or 100 per cent of earnings, whichever is the greater (subject to the annual allowance – see below). Higher contributions may be paid but the excess amounts will not be tax-privileged. The methods of giving tax relief will be either the net-pay arrangement (which currently applies to occupational schemes) or the relief-at-source arrangement (which applies to personal pension schemes).

As at present, higher-rate tax relief will be claimed using the member’s self-assessment tax return.

Employers may contribute unlimited sums to their employee’s schemes and will be able to receive tax relief on the contributions as a business expense. This may be helpful to employees looking to secure/retain staff whilst not seeking to pay the earth for them.

The annual allowance

An individual and/or their employer will be able to make an annual contribution, and/or have their benefits under a defined benefits scheme increased, up to a maximum figure, known as the ‘annual allowance’, without any adverse tax consequences for the individual. This will be £215,000 in 2006/07 and will rise by £10,000 a year to £255,000 in 2010/11. The annual allowance will then be reviewed every five years.

As a concession, the annual allowance will not apply to the contributions paid by and for a member in the final year before retirement, provided that the member takes all their benefits from the scheme in question at retirement. This concession is mainly intended to protect people who decide to draw enhanced immediate benefits, due to ill health or redundancy.

If, in any year, the total combined contributions to the member’s pension fund exceeds the prevailing annual allowance, any excess contribution will create a 40 per cent tax charge for the member.

Retirement age

From 2010, the earliest age from which benefits may be taken will rise to 55. Anyone in an existing pension scheme with an earlier retirement age (for example, professional footballer) will retain the right to start drawing their benefits earlier. However, these people will be subjected to a reduced lifetime allowance. The reduction will be 2.5 per cent for each year the pension is taken before age 55.

Drawing a pension up to age 75

Until the member is aged 75, the pension may be taken as ‘secured income’ or ‘unsecured income’.

‘Secured income’ is an income which is guaranteed to be paid for life by an insurance company (i.e., an annuity) or by a pension promise provided by the employer.

‘Unsecured income’ is an arrangement under which the member can draw an income of up to 120 per cent of the annual income that they could have received using the Financial Services Authority’s (FSA) comparative annuity tables. The maximum level of income must be reviewed at least every five years.

From age 75, pensions must be either ‘secured’ or ‘alternatively secured’ (as described below).

An alternatively secured pension

An alternatively secured pension will only be available at age 75. The maximum income will be 70 per cent of the income the member could have received based upon the FSA’s comparative annuity tables. The pension scheme will remain responsible for the payments and should the scheme subsequently be wound up, the remaining pension fund must be used to buy an annuity for the member. The maximum level of income must be reviewed annually.

A member who is taking benefits under income drawdown at A-day, and is under 75, will become subject to the new rules for unsecured income. However, the changeover to the new rules may be deferred until its next triennial review.

Tax-free cash

A maximum of up to 25 per cent of the pension fund may be taken as a tax-free cash sum. As the maximum tax-favoured pension fund will initially be £1.5m,

the maximum tax-free cash sum will be 25 per cent of £1.5m, which equates to £375,000. If the total pension fund exceeds the lifetime allowance, any excess cash taken will be subject to tax unless transitional arrangements apply (as described below).

People will be able to protect their tax-free cash entitlement. This concession will apply to anyone whose current pension arrangements entitle them to a pre A-day tax-free cash sum of 25 per cent of the value of their pension fund where the pension fund at A-day exceeds £1.5m.

People who choose primary protection will have their higher tax-free cash entitlement indexed to rises in the lifetime allowance (or on the same basis as enhanced protection, whichever is the lower).

If enhanced protection is chosen, the pre A-day tax-free cash sum will be expressed as a percentage of the pre A-day pension fund. The same percentage will be applied to the value of the pension fund at retirement.

Investment

There will be a single set of investment rules which will apply to all registered pension schemes.

The range of allowable investments is considerably enhanced and includes some that were not even previously available under a SSAS (small self-administered scheme or SIPP (self invested personal pension).

Schemes may hold shares in a ‘sponsoring employer’. Up to a maximum of five per cent of the fund may be used to purchase shares in each participating employer subject to an overall maximum of 20 per cent of the fund.
They may also invest in residential property, commercial property plus ‘alternative investments’, including works of art, classic cars and fine wine.
Members will be able to enjoy the benefit of certain scheme assets, such as rent-free accommodation or a work of art in a member’s home. In these circumstances, the member will be liable to a tax charge on the ‘benefit in kind’. Alternatively, the member can pay a commercial rent to the scheme and avoid the tax charge.

Connected party transactions will be allowed but all such transactions must be on commercial, arms-length terms.
Borrowing by the pension scheme (‘gearing’) will be limited to 50 per cent of the fund value.
Transitional arrangements will be introduced to allow pre A-day investments to continue to be held, subject to the current (rather than the new) rules.

An inheritance tax (IHT) planning scenario

Mr and Mrs Brown are retired. They live off their pension and investment income. The value of their estate is approximately £1m. It is comprised of a property worth £800,000 and investments worth £200,000. They have two children and five grandchildren. Ideally, they would like to receive a higher level of income but they would also like to minimise the IHT liability faced by their children. To generate additional income, some of the options available at present would be:

To ‘downsize’ to a smaller residence and invest the balance of the proceeds of that property sale;
To release some equity from their residence;
To withdraw greater amounts from their investments.

To reduce their IHT liability, some of the options available to them at present would be:

To change the ownership of the property to tenancy-in-common and create nil rate band discretionary trusts (with loan arrangements) within their wills;
To invest monies using a ‘discounted gift trust’ or ‘gift and loan’ arrangement;
To make gifts to the children and/or grandchildren;
To place assets in trust for the benefit of the children and/or grandchildren;
To set up a life insurance policy arranged on a ‘joint life second death’ basis.

The Browns’ son has a pension fund valued at £1.2m and other significant assets. His parents are reluctant to ask him for assistance, however, post A-day an alternative option would be for him to buy their property using his pension fund. The main consequences of this approach are as follows:

The property would be outside of their estate from an IHT perspective. There would be no capital gains tax (CGT) on the sale of the property as it is their primary residence benefiting from the principal private residence exemption;
They would have to rent the property from their son’s pension fund. The rental yield is likely to be relatively low on a property of that value;
The value of their estate will not have immediately reduced, however IHT planning with £1m of cash/investments is simpler than with £800,000 of property and £200,000 of investments. They could even gift some of the money back to their son;
Their income will increase significantly;
They will not feel as if they have ‘taken advantage’ of their son as they might do if he were to give them capital or income for nothing in return;
Rent paid to their son’s pension would reduce their estate over time and pass still more wealth to the next generation;
Long-term care fee planning is simpler with cash and investments than with property.
On the second death, their son can choose to hold on to the property and rent it to someone else or sell it. If he sold it, there would be no CGT to pay within the pension fund;
Note: The pension fund will have to pay stamp duty on the original purchase of the property.

The wealthy businessman

Richie Rich is retiring shortly with a pension fund worth £3m, a property worth £2m and £1m in cash. Richie has expensive tastes and would like a higher income than would be permitted from his pension fund. He has his eye on a couple of business opportunities to keep him occupied in his ‘dotage’ which he believes are ‘sure winners’. These investments cannot be made through his pension fund. He’d also like to buy a villa in the south of France and spend a couple of months a year there. He is loathe to tie up some of his cash in the business ventures or the villa as this may compromise his lifestyle, and he does not wish to borrow at this stage of his life.

Post A-day, Richie could buy his own property using his pension fund. The result of this would be as follows:

No CGT would be payable on the sale as it is his primary residence.
He would have £2m (in addition to his £1m cash) for his business ventures and to invest for income – the level of income would be determined by him and not pension scheme regulations;
He would have to rent the property from his pension scheme although the rental yield would be relatively low for a property of this value;
He could draw the rent back out as pension income (subject to maximum permitted income levels) although this would be subject to income tax;
He would maintain control of his property and could continue to live there;
The pension scheme would have to pay stamp duty.

He could use the remaining £1m (ignoring for this purpose the stamp duty) in his pension fund to buy a villa in the south of France. If the villa were to cost £750,000 he could use the remaining £250,000 to fill it with (small) Rembrandts and a lot of fine wine!

Richie would have to pay rent to the pension scheme for the two months a year he spends in France. This would boost his pension fund and increase the amount of pension income. Should he decide to sell the property in future, there would be no CGT payable within the pension scheme.

John Dunseath is an advisor with Whitehall Financial Independent Limited. He can be contacted via telephone 0114 2554241 or e-mail: johnd@wfiltd.co.uk