Home > News > 2003 > May 2003 > Pension taxation simplification proposals issues for senior executives
Pension taxation simplification proposals issues for senior executives
Marcus Whitehead, a member of Barnett Waddingham Investments Ltd's (BWIL) team in the Amersham office, summarises the key issues of the Government's proposed pension tax simplifications.
Summary
What are the key issues?
The Government proposes to replace all existing benefit limits on tax approved pensions with a single set of limits. These would be:
- a lifetime limit on the value of pension benefits that can receive tax relief, and
- an annual limit on the amount of pension saving that can receive tax relief.
The key difference to previous pension taxation changes is that these proposals would be retrospective, affecting all existing pension benefits and not just future pension provision.
In this article we raise some of the planning issues relevant to senior executives in the light of these proposals. For a comprehensive summary of the Government's proposals, including the planning issues below, please request a copy of our brochure.
Background
When are the reforms likely to take place?
The Revenue suggests that "A" Day (being the date the old rules cease and the new ones take over) should be 6 April 2004. They specifically ask for comments as to whether this is viable and, if there are concerns, suggest that "A" Day could be 6 April 2005. At the time of writing it seems clear that ministers are very keen to make the changes in April 2004 but this still seems optimistic.
When will we get further information?
The Inland Revenue have advised that a further consultation paper and draft legislation are already in preparation, which we are expecting to be published this summer.
Planning issues
Should those people planning to retire soon after "A" Day bring their retirement forward?
With the facility to certify the pension and lump sum benefits at "A" Day, and where they are above the lifetime limit and 25% respectively, there will be no sudden loss of benefits for those planning to take benefits soon after "A" Day. As such, there are no significant reasons to bring forward retirement to before "A" Day.
Should those people planning to retire just before "A" Day defer their retirement?
With regard to the popular tax free lump sum, a company pension scheme member who has capped lump sum benefits (i.e. joined the company pension scheme on or after 17 March 1987) and is close to retirement, may well consider deferring their retirement until after "A" Day. This is because their lump sum under the proposals would become 25% of their fund, which could well be higher than their present salary and service formula lump sum, as explained earlier.
For those members of company pension schemes with uncapped lump sums (i.e. joined the scheme before 17 March 1987), the position will depend more upon individual circumstances. However, those with pension benefits near the current Revenue maximum may well be entitled to a greater lump sum after "A" Day.
A further issue to consider in whether to delay retirement would be the ability to take advantage of the generous annual contribution limit to boost pension saving immediately before retirement. This could appeal to those whose pension benefits are below the lifetime limit of £1.4 million.
Should pension savings be maximised before "A" Day to boost tax approved pension benefits?
Only if the value of pension benefits will be over the lifetime limit at "A" Day. This is likely to only be possible for members of company pension schemes with uncapped pension benefits (i.e. they joined the scheme before 1 June 1989) or those funding retirement annuity pensions (i.e. pre 1 July 1988 personal pensions). Where benefits are not planned to be taken for a few years after "A" Day the individual should be aware that, if the value of the pension benefits were to grow by a greater amount than the indexation of their certified lifetime limit, then they would incur a recovery tax charge on the excess growth.
Should earnings be boosted before "A" Day to increase the tax free lump sum entitlement?
This is only likely to be attractive to members of company pension schemes with uncapped lump sums (i.e. they joined the scheme before 17 March 1987) and who would expect to have a certified lump sum well over 25% of the value of their pension benefits. Even for these individuals, if they have existing pension benefits well under the £1.4 million lifetime limit and have more than a few years to retirement, the boosted lump sum at "A" Day may still be less than 25% of the projected pension value, including future pension benefits, in which case there would be no advantage in boosting earnings before "A" Day.
What about future pension benefit commitments for senior executives that will exceed the lifetime limit?
The Revenue are clear that while benefits in excess of the lifetime limit that have already been built up at "A" Day can be certified and protected, there will be no protection for future pension benefit promises. As such, where a senior executive's prospective pension benefits at retirement are expected to be more valuable than the lifetime limit, there will need to be negotiation between the senior executive and the employer in order to agree an appropriate alternative compensation package in place of the excess pension benefits. This is most likely to be an issue for members of company pension schemes with uncapped pension benefits.
The first issue is for the terms of the pension commitment to be checked. If the employment contract or pension scheme rules state that pension benefits would be restricted to Revenue limits, there may be no legal obligation on the employer to provide benefits above the lifetime limit. As such, in an extreme case an employer may restrict benefits to the lifetime limit. This would, though, need careful legal interpretation, as the lifetime limit will not be a cap on benefits, but instead, will be a threshold limit above which benefits incur a higher tax charge.
Possible alternative compensation packages that could be negotiated are:
Salary supplement:
This is where the employer would simply pay additional salary to the executive, at a level calculated to be broadly equal in value to the excess pension benefits. Care would be needed to ensure that other elements of the executive's compensation package were not distorted. This would leave the executive with responsibility for arranging their own retirement provision in respect of these additional monies, which would give them flexibility, but may well be tax inefficient.
Advance funding:
Under this approach, the employer would grant additional pension scheme benefits to the executive (within Revenue limits) prior to "A" Day, to bring the benefits at "A" Day up to the prospective benefits at retirement, which could then be certified and protected. This would only be viable where the executive had a short period to retirement, and had sufficient Revenue pension limit scope at "A" Day. Also, the employer would, if deemed necessary by the scheme trustees, need to fund these benefits when they were granted, which could bring forward a significant cash flow requirement.
There would also be the issue of how the advancement of pension benefits would be dealt with if the executive left employment soon after "A" Day. It may be that some form of clawback in other parts of the exit package would need to be considered to compensate for the advancement of pension benefits.
Maintain scheme benefits:
Here the executive would be provided with the full pension benefit commitment from the pension scheme. The excess benefits above the lifetime limit would incur the combination of recovery tax and income tax in full, currently a combined rate of 60%. While simple, this is not tax efficient.
Funded Unapproved Retirement Benefit Schemes (FURBS):
A contribution broadly equal in value to the excess pension benefits could be made to a FURBS. This is a commonly used solution for executives whose benefits are currently restricted by the Earnings Cap. While not benefiting from full tax relief, the monies invested would benefit from a number of tax breaks that would make such investments somewhat more tax efficient than personal savings made by the executive. As noted above, though, we are yet to hear of the Revenue's proposals for FURBS post "A" Day, and any advice in this area would need to be in the light of these proposals that are expected shortly.
Unfunded Unapproved Retirement Benefit Schemes (UURBS):
The company would give a commitment to the executive to meet directly the balance of the pension promise beyond the value of the lifetime limit. When the Earnings Cap was introduced in 1989, UURBS were initially thought to be a simple effective way to compensate new executives at the time for the capping of their tax approved pension benefits. However, problems related to concerns over company solvency and questionable legal rights to benefits from UURBS for executives leaving employment prior to retirement have seen their popularity wane. Again, as for FURBS, we are yet to hear of the Revenue's proposals for UURBS post "A" Day, and any advice in this area would need to be in the light of these proposals.
Partners' Benefits:
A novel solution would be for the company to employ the executive's spouse in a nominal role, with a nominal salary, and provide them with significant pension benefits, such that the total pension provision for the executive (i.e. the lifetime limit) and their spouse would be broadly equal in value to the benefits the executive would have expected prior to the pension taxation changes. This would only be worth consideration in a relatively small, flexible organisation, where the executive's spouse did not have existing employment commitments or pension benefits that would interfere with the strategy.
Marcus Whitehead, May 2003.