Home > News > 2002 > May 2002 > Handling the pensions earnings cap
Handling the pensions earnings cap
The 1989 UK Finance Act caught pension observers by surprise. In his annual Budget speech to Parliament, the Chancellor of the Exchequer announced bad news and good news. The bad news was that employers could in future only provide pensions for employees through a tax-approved company retirement scheme on the first £60,000* of their earnings. This applied to anyone joining a company scheme after 1 June 1989. We were told that the 'Earnings Cap' would be revalued each year in line with price inflation (although, in the traditional political way of the UK, this 'promise' is not a binding obligation on future governments). In fiscal year 6 April 2002 to 5 April 2003, the Earnings Cap has reached £97,200 and so far the promise to increase it has been met. This same Earnings Cap also applies to other employees and the self-employed who have personal pensions, a UK alternative to occupational pension schemes. The good news, such as it was, drew less attention at the time. The Chancellor said, "Tax law constrains the overall pension an employer can pay his employee. This is neither desirable nor necessary." To emphasize this point, he announced the introduction of a new type of pension arrangement that could, indeed, provide unlimited retirement benefits, including additional retirement benefits for those caught by the new Earnings Cap (but not restricted to those with the maximum approved benefits or, indeed, any approved benefits at all). This was significant because, until then, the granting to an employee of any retirement benefits that were not approved meant that his/her tax-approved benefits were prejudiced.
*€1 = £0.61; US$1 = £0.70 as at 12 April 2002
So were born unapproved retirement schemes in the UK - a rather unfortunate name, as one could be forgiven for associating 'unapproved' with 'disapproved' though it was chosen only to distinguish them from conventional 'approved' UK pension schemes, which get the full blessing of the UK's Inland Revenue.
Tax treatment
Tax relief for UK approved schemes
Of more interest than the Chancellor's words themselves was the detail of how these new unapproved schemes would be taxed. It is, of course, important to know how UK approved schemes are handled. They have six tax advantages, namely:
- contributions by the employee and the employer are tax deductible;
- employer contributions are not treated as a taxable benefit in kind for the employee;
- investment income is free of UK income tax (although since 1997 tax deducted at source on dividend income cannot be reclaimed);
- investments are free of capital gains tax;
- a proportion of the retirement benefits can be taken as a tax-free lump sum; and
- lump sums payable on death normally fall outside inheritance tax.
This adds up to the traditional 'EET' package: exemption from tax on input and on roll up and not on the benefits.
Tax treatment of UK unapproved schemes
The tax regime for unapproved schemes is less generous, but there are still some tax advantages to be had. There has only ever been one publication by the Inland Revenue describing the tax arrangements for unapproved schemes. This is a brief, 16-page booklet issued in August 1991 called 'The Tax Treatment of Top-Up Pension Schemes'. Incidentally, the name 'top-up' used by the Inland Revenue did not stick, but is perhaps why some people mistakenly believed that unapproved schemes could only be provided for employees who already benefited from an approved scheme.
Unfunded schemes
At first sight the tax regime for funded unapproved schemes is unattractive. There are two types of unapproved scheme. First, those that are funded in the conventional British way and, secondly, those that are not funded in advance but are operated instead on a pay-as-you-go basis. The two types of scheme have become widely known by their acronyms FURBS (Funded Unapproved Retirement Benefit Scheme) and UURBS (Unfunded Unapproved Retirement Benefit Scheme). In the case of an UURBS, being unfunded, there are no tax consequences for investment as there are no investments. The benefits eventually paid to the member under an UURBS are a deductible expense for the employer against corporation tax and are a taxable payment to the employer regardless of whether the unapproved benefit is paid as a lump sum or a regular pension. This is subject to income tax for the employee at his/her marginal rate. For high earners this will invariably be 40%. In other words, a payment of £1,000 as an UURBS paid at the point of retirement is fully deductible for the company, but would be reduced to £600 for the employee after tax is deducted.
Funded Unapproved Retirement Benefit Schemes (FURBS)
The position for a funded arrangement, FURBS, is different. The income received by a funded unapproved scheme would be taxed at the basic rate, currently 20% or 22% according to source*. Capital gains are taxed at the special rate applicable to trusts of 34%. There is an annual allowance for capital gains of £3,600. Since 1998 taper relief has also been available to reduce the effect of the rate of capital gains tax on investments held for more than four years. After 10 years the rate of 34% falls to 20.4%. The tax on both income and capital gains is at a lower rate than would apply to the individual in respect of his/her own savings. However, it was the treatment of the employer's contribution to a FURBS that initially deterred many from considering funding. Any employer contributions to an unapproved scheme are tax deductible for the employer only if they are assessed to income tax as a benefit in kind on the employee. In other words, when an employer contributes £1,000 into an unapproved scheme this in effect is reduced to £600 inside the scheme. This taxable benefit in kind on the employer contribution to a FURBS can be dealt with in two ways. Either the employer pays £600 into the trust and £400 direct to the Inland Revenue as part of an agreed 'grossing-up' arrangement or he pays £600 to the trust and £400 to the employee as additional remuneration. The £600 paid to the trust results in a 40%, i.e. a £240, tax assessment for the employee which matches the net value of the £400 additional remuneration he/she will have received.
*The UK basic tax rate is currently 22% but there is a special concession on savings income, broadly bank interest, which is taxed at 20%.
When these tax arrangements for a FURBS were first seen, the general response to the Chancellor was "thanks but no thanks". The feeling was that, if payments to an unapproved scheme were taxed exactly as salary, we might as well pay extra salary and forget additional retirement benefits. However, this reaction was over-hasty for the three following reasons:
Quite apart from the tax situation, additional advantages of unapproved schemes compared with approved schemes were noticed and these concerned flexibility. Unapproved retirement benefit schemes have two particular advantages over conventional approved retirement schemes as regards scope for investment and the shape of the benefits. Those who noticed the flexibilities found them attractive.
Investment flexibility
The first element of flexibility, i.e. regarding investment, was greatly appreciated. If we look at approved schemes, many UK directors and high earners have 'do-it-yourself ' approved schemes where they can control the investments personally rather than leave the investment choice to an institution. However, to avoid abuse, the UK Inland Revenue imposes restrictions on how they may invest their personal approved schemes. Residential property is not permitted as an investment, for example, nor are personal loans, works of art, etc. The Inland Revenue rules for the investment of approved schemes are, in effect, that "you may not invest in anything that might give you personal pleasure". No such restriction applies for unapproved schemes. If this seems a little generous, remember that, unlike for an approved scheme, the Inland Revenue has had its tax take up front on a FURBS. However, this is not quite being given carte blanche inasmuch as an unapproved scheme must always make investments on an arm's-length basis. For example, whilst residential property would be an acceptable investment for a FURBS, it would not be acceptable for the member or his/her family to use the property unless a fair rent were paid.
Benefit flexibility
The second element of flexibility, the shape of the retirement benefit, is more attractive. The nearest thing perceived as a snag with UK approved schemes for highly paid executives is the fact that their pension savings 'disappear' at some point in the form of an insured annuity. Annuity purchases are compulsory (at present UK law lays down that insured annuities are purchased no later than at age 75), which is unpopular and may well be changed. People worry that, in the event of their death shortly after buying the insured annuity, the profit would fall to the insurer and it is no consolation that, if they live to be 108, the insurance company loses financially!
The point about unapproved schemes is that the benefits may be taken as a lump sum and not as a series of annual payments. This is an attractive feature for those who are already looking at an inflexible though adequate annual pension of, say, £50,000 per annum from an approved scheme. They might well prefer the next slice of their retirement savings to be in the form of a flexible lump sum. Indeed, some high earners have ceased to participate in approved schemes because they object to the pension commitment. For them, the unapproved schemes have opened up a new and attractive possibility.
Benefit design in a FURBS
In the early days of unapproved schemes, some were set up on a defined benefit basis seeking to replicate exactly the final salary pension promise that might have been given to the employee had the Earnings Cap never been invented. However, not only were these arrangements unnecessarily complicated, they became difficult to fund in what are essentially one-person arrangements. It matters less in a large defined benefit employee scheme that from time to time there are 'surpluses' or 'shortfalls'. These would be addressed by adjustments to the ongoing employer contribution rate. However, in a one-person defined benefit unapproved scheme, whereas an employer would arguably be obliged to make up any shortfall, the member on his/her part would need some persuading to surrender any surplus that emerged, particularly bearing in mind that he/she would have borne personal income tax on the contributions as they were made. Accordingly, it would now be quite unusual to see a UK FURBS set up on a defined benefit basis. Funded unapproved schemes could be set up for a group of employees or for each individual concerned. Not a great deal turns on this but separate individual schemes are probably preferable. Setting up individual schemes might appear to increase the administration but they are, in fact, easier to deal with as regards the annual tax returns (for example, in a multi-member scheme, who gets the benefit of the annual allowance of £3,600 against capital gains tax?) and they also mean that on leaving employment there need be no division or transfer, as the fund could either be cashed in and the benefit paid to the member or the trust could be taken as a continuing trust by the employee who is leaving. A FURBS established in the UK is relatively straightforward to administer. A tax return is needed as at 5 April each year but there are no other reporting requirements to the Inland Revenue or any other regulatory authority.
The extent of unapproved schemes
It is difficult to obtain any statistics as to how widespread FURBS and UURBS are in the UK. Unlike approved schemes, the Inland Revenue keeps no register of unapproved arrangements. Surveys have tried to address this question and they seem to suggest that at present about one-third of employers provide highly paid executives caught by the Earnings Cap with no additional retirement arrangements other than perhaps extra salary in lieu. The remaining two-thirds are possibly equally split between those who have set up a FURBS and those who have simply made unfounded promises, namely an UURBS. While the unfounded approach brings cash-flow advantages to the employer, the executives themselves often express concern about the lack of security (it being, after all, very much the habit in the UK to fund pension promises in advance of retirement). Some UURBS have addressed this point by creating charges on company assets to support the unfunded promise: care is needed to ensure that this is not done in a way that would actually turn the unfunded scheme into a funded arrangement which would then trigger an immediate tax on the benefit in kind.
1998 taxation changes
The UK Labour Government introduced two changes in the 1998 Finance Act that affected unapproved schemes adversely. First, it introduced the 34% rate of capital gains tax mentioned above: until April 1998 capital gains tax had been calculated at the basic rate of income tax, which was then 24%. However, this was also the time that taper relief was introduced on capital gains tax and this change was therefore not as bad as it seemed at first sight, unwelcome though it was. Secondly, and rather more importantly, from 6 April 1998 employer contributions into an unapproved scheme had become liable not just for income tax but also for national insurance. This removed one potential advantage to funding in advance, mentioned above. However, in my experience this change has not dissuaded many employers from funding unapproved benefits and FURBS continue to be established.
Offshore unapproved schemes
Funded unapproved schemes have been established off shore but not in such numbers since a change in the legislation in December 1993. Before that date, if a scheme was established outside the UK, there would have been no tax assessment on the investment income or capital gains. In effect, the investments would accumulate gross (for example, if the fund were based in the Channel Islands). However, from 1 December 1993 an amendment to UK law meant that, if income and gains were not taxed on the FURBS each year as they arose, the accumulated investment growth would instead be taxed on the UK member at his/her marginal rate of tax at the time he/she took the benefits. For UK residents this would usually be disadvantageous and new FURBS set up off shore are few and far between nowadays. They might still be considered for non-UK nationals currently working in the UK but who are confident that, at the time of retirement when they draw benefits, they will be outside the scope of UK tax.
More caught by the Earnings Cap
So 13 years on and unapproved schemes, both funded and unfunded, have become part of the UK pensions scene. They are likely to continue to be so. After all, although the 1989 Earnings Cap has been increased in line with prices, in terms of average earnings it is falling steadily year by year: more and more people are being caught by the Earnings Cap.
Reproduced with permission of the copyright owners fromBenefits & Compensation International magazine, Volume 31, Number 9,May 2002. © Pension Publications Limited, London, England.Tel: + 44 20 7222 0288. Fax: + 44 20 7799 2163. Website: www.benecompintl.com
Adrian Waddingham, May 2002.