Home > News > 2003 > December 2003 > Pension Taxation Simplification - Second Consultation Paper
Pension Taxation Simplification - Second Consultation Paper
One year ago HM Treasury and the Inland Revenue published the first consultation document on the simplification of the taxation of pension arrangements.
On 10 December 2003 they issued a further substantial document: "Simplifying the taxation of pensions: the Government's proposals".
As we have already written, these changes are far reaching, and we have arranged a series of seminars in January and February around our offices to go through the paper in detail and summarise the key implications.
Proposals for Pension Taxation Simplification at a glance
- Implementation: The final decision on whether to proceed with the simplified pensions regime will be announced in the 2004 budget.
- A Day: The proposals are expected to come in to force on 6 April 2005, 'A Day'.
- Lifetime Allowance: The £1.4 million individual pension value limit stays, being renamed the lifetime allowance.
- Indexation: The lifetime allowance is to be increased with RPI, and only from 2005.
- Recovery Tax: The tax charge for funds above the lifetime allowance will be 25%, rather than the 33.33% initially proposed.
- Annual Allowance: The allowance for pension benefits built up in any year is to be £200,000 as at April 2005, and subsequently indexed by RPI.
- Pension Valuation Factor: Pensions from Defined Benefit (DB) schemes will be valued against the lifetime allowance using a factor of 20 to 1 at all ages.
- Maximum Tax Free Lump Sum: This will be 25% of benefit value below the lifetime allowance.
- Funded Unapproved Retirement Benefit Schemes (FURBS): These will no longer benefit from tax-favoured status (though existing FURBS will keep their inheritance tax and tax free lump sum protection).
- Divorce: The treatment of pension sharing orders on divorce has been improved.
- Protection for Existing Benefits: Protection for funds over £1.4million at A Day is improved from the first consultation paper, adding the option for members to ring-fence their benefits at A Day and thereby avoid any possible recovery tax charge.
- Trivial Commutation: To be made more readily available.
Proposals in more detail
Implementation
The Government will formally declare within the 2004 budget whether the pension taxation simplification proposals are to be implemented. This will be following a National Audit Office report into the level of the lifetime allowance, the 20 to 1 defined benefit conversion factor and the number of people that will be affected by the proposed lifetime allowance.
Given that the key elements of the first consultation paper have been maintained, and also considering the Government's desire to be seen to be taking action on the complexity of the current pension system, we believe it likely that the proposals will go forward as they stand on 6 April 2005.
If the proposals are taken forward, the implementation date, 'A Day', is expected to be 6 April 2005.
We now have a short final period of consultation up to 5 March 2004.
Lifetime Allowance
The lifetime allowance is the maximum value of pension benefits from all pension arrangements that can be accumulated under the tax-approved umbrella for an individual. The lifetime allowance is to be set at £1.4million from April 2005.
The Revenue claims that £1.4million is approximately the same value as the maximum pension that can be earned by a member of an occupational pension scheme subject to the earnings cap, i.e. a pension of two-thirds of the earning cap (the earnings cap for 2003/4 is £99,000).
The Revenue has not moved from the figure in the first consultation paper despite heavy lobbying. They remain adamant that only about 5,000 people will be immediately caught by the lifetime allowance and only a further 1,000 each year for the next ten years.
As a further sting, the first consultation paper had proposed a £1.4million allowance as at April 2004, we now have the same figure for April 2005!
Increases to the Lifetime Allowance
The allowance is to be increased in line with RPI (and not the new harmonised index of consumer prices - HICP).
As we had feared, real growth in earnings and investments will erode the real value of the lifetime allowance over time, gradually catching more and more people.
Valuation of Defined Benefits
There will be a pension valuation factor of 20 to 1 applied at all ages for both men and women. This factor will be used for schemes granting pension increases up to RPI or up to 5% per annum fixed, and also allowing for spouse's pensions of up to 100% of pre-commutation members pensions.
The factor will be applied to the residual pension after any lump sum commutation, with the lump sum taken at face value against the lifetime allowance.
Where pension increases or spouse's benefit above these levels are granted (which will be rare) a bespoke factor will have to be agreed with the Revenue.
This is good news for DB Schemes, as they will be able to provide a pension of up to £70,000 per annum. The Defined Contribution (DC) pension fund required to produce a £70,000 pension for a male aged 60, with RPI increases and a two-thirds spouse's pension would be of the order of £1.85million (considerably more than the £1.4million lifetime allowance). Also, as the factor is the same at all ages an even more valuable pension of £70,000 could be provided from age 55! This is the first time the playing field has been tilted in the direction of DB from DC for quite some time!
Benefits Above the Lifetime Allowance
The lifetime allowance is only tested at the time or times when benefits will be taken. If the allowance is exceeded, then a recovery tax charge of 25% of the value of benefits in excess of the lifetime allowance will be levied on the fund. Marginal rate income tax will also be levied on all benefits above the lifetime allowance, resulting in an effective tax rate of 55%.
The Revenue has relented slightly, reducing the recovery tax charge from the 33.33% initially proposed. This reduces the aggregate tax charge on excess benefits to 55% from 60%.
Assessment of Recovery Tax Charge
The recovery tax charge will be assessable on the member. The pension scheme will have the choice of whether to withhold benefits to meet the charge or pay the tax on a grossed-up basis on behalf of the member.
This suggests that DB schemes will not have to bear the burden of any recovery tax charge, and that it can be passed on to the member. However, pension lawyers may have different views.
The Revenue has now conceded that all benefits above the lifetime allowance can be taken as lump sum, albeit taxed at 55%.
This common sense concession is to be welcomed.
Benefits taken at different times
Each time benefits are taken the percentage of the lifetime allowance that they represent will be recorded. A check will then be made, taking into account pension entitlements already taken, to determine whether the total lifetime allowance has been exceeded. Responsibility will be on the member to certify whether they have sufficient unused lifetime allowance; with any recovery tax liability to be disclosed on the member's self assessment tax return.
Pensions already in payment at A Day will count against the lifetime allowance, using a factor of 25 to 1 (to include an arbitrary allowance for lump sums already taken). Dependents' pensions being received will not count against the lifetime allowance.
There appears to be no de-minimis limit beneath which certification of benefits is ignored. As such each and every person in the country will have to have a benefit certificate for each and every pension benefit drawn - this does not seem to be in the spirit of simplification.
Protection of Benefits Above £1.4Million at A Day
There will be the option of:
Primary protection: The value of DB and DC benefits at A Day can be registered as a percentage of the lifetime allowance. This registered allowance will then be linked to RPI. No recovery tax charge will be due on benefits taken up to the indexed registered value. DB benefits will be valued using the factor of 20 to 1, based on the accrued pension as at A Day.
This is as proposed in the first consultation paper. It would have been nice to have a DB conversion factor higher than 20 to 1, to boost the protected value of benefits at A Day.
Or
Enhanced protection: All existing benefits at A Day will be protected from any recovery tax charge, including allowance for future salary and/or investment growth on benefits, provided the member ceases to accrue any further service or make any future contributions from A Day.
There will be a three year period after A Day, during which pre-A Day rights can be registered.
This is a welcomed additional protection. There have been real concerns that those with large DC pots, in particular, at A Day could incur a significant recovery tax charge if future investment growth exceeds the RPI indexation. Under this approach there is full ring-fencing of all existing benefits. The price to pay of not adding any further benefits post A day will probably be acceptable in most cases.
Annual Allowance
The allowance is to be £200,000 as at 6 April 2005, with subsequent increases in line with the RPI.
If the value of pension inflows in a year are within the £200,000 allowance, there will be no tax charge on the individual. The pension inflows will be the sum of DC contributions and the growth in value of DB pension entitlement from the current employer (valued using a factor of 10 to 1 at all ages for men and women). DB pension from previous employments revalued by up to RPI are ignored for testing against the annual allowance.
There has been no change to the proposed annual allowance, which is set at a generous level. This allowance will dramatically simplify and increase the scope for contributions to DC arrangements for the vast majority of people.
Within the annual allowance, tax relief on employee contributions is available up to 100% of earnings or £3,600 if greater.
The annual allowance will not be applied in any year in which a scheme benefit is taken in full.
This is another welcome concession from the initial proposals. A particular concern had been breaches of the annual allowance where, for example, a member is granted an enhanced early retirement DB pension on redundancy. With this concession, this risk is removed.
Tax Free Lump Sum
This is to be 25% of the value of benefits. As we have previously highlighted, this will result in a greater lump sum for many current members of occupational pension schemes subject to the 87-89 and post-89 limit regimes.
The maximum lump sum at present for a capped post-89 member of an occupational pension scheme is at most 1 1/2 times the earnings cap, i.e. just under £150,000. Those occupational pension scheme members subject to the 87-89 limits regime have a maximum lump sum of £150,000. The new rules will allow a tax free lump sum up to 25% of the fund, subject to the lifetime allowance, and so this could reach £350,000.
Protection of Lump Sums at A Day
Where members have a lump sum entitlement at A Day of over 25% of the value of their pension benefits, this can be registered in a similar way to the registration of pension benefits above the lifetime allowance. The maximum lump sum that could be paid when benefits are taken would then be the greater of the certified lump sum, indexed with RPI, and 25% of the lifetime allowance at the date benefits are taken.
Where pension benefits are protected using enhanced protection, a tax free lump sum can be paid equal to the same percentage of pension benefits as applied at A Day.
This revised proposal is not as generous as those in the first consultation document, where it had been proposed that the tax free lump sum could be 25% of the registered protected benefits. This original proposal could have dramatically increased the tax free lump sum entitlement, in particular for 87-89 regime members with benefits significantly in excess of £1.4million. Under the new proposals, though, their revised tax free lump sum will be capped at £350,000, which is still a nice improvement on £150,000!
Death Benefits Before Retirement
Benefits can be paid as a dependent's pension, subject to income tax, but with no test against the lifetime allowance.
Alternatively, death benefits can be paid as a lump sum, free of any tax up to the lifetime allowance. Any lump sum in excess of the lifetime allowance would be subject to a recovery tax charge of 55%.
This proposal brings occupational pension scheme death benefits into line with those for personal pension arrangements, and could lead to far more death benefits being provided as a lump sum rather than pension.
Lump Sum Benefits After Retirement Prior to Age 75
Where benefits are paid under income drawdown, the option to pay out the residual fund subject to a 35% tax charge will now be maintained.
Alternatively, a lump sum of the initial capital cost of the pension less pension paid to death can be paid, subject to a 35% tax charge.
This relaxation from the first consultation paper is to be welcomed, maintaining the pre A Day position for income drawdown death benefits.
Benefits from Age 75
Income must still commence from age 75. However there will no longer be the requirement to purchase a secured annuity with DC funds. The new alternative will be called an Alternatively Secured Income (ASI). This will be similar to the current income drawdown arrangements, though with a lower maximum income and no option to pay any lump sum benefits on death to beneficiaries.
The removal of the requirement to secure an annuity with DC funds from age 75 is a hollow victory without the option to have residual funds paid as a lump sum (even if this were taxed) to beneficiaries.
Protection of Death Benefits at A Day
The proposals provide protection of death benefits, such that where pension benefits are registered at A Day, the lump sum on death before retirement can be paid free of tax up to the protected registered pension benefit amount.
The first consultation document was quiet on the issue of protection of death benefits. This proposal is an acceptable and pragmatic solution.
Other Proposals of Interest
Trivial Commutation: This will be permitted for any benefit up to 1% of the lifetime allowance, i.e. £14,000 in value. This is subject to all trivial commutations being taken within a twelve month period designated by the member (between age 60 and 75), any benefit being commuted being taken in full and the total of benefits commuted for triviality being less than 1% of the lifetime allowance. This could provide schemes with a real opportunity to 'tidy up' small member benefits to reduce the administrative burden.
Minimum Retirement Age: To be increased from 50 to 55 by 2010, with each scheme being able to decide on whether this increase would be phased in over the period to 2010.
Minimum Income Drawdown: As set out in the first consultation paper, the minimum income level will be just £1 per annum.
Early Retirement: Benefits will be able to be taken early, even if the member continues in the same employment. This has always been the case with personal pension plans, but not for occupational pension schemes.
Concurrency: The second consultation paper confirms that it will be possible to be a member of both an occupational and a personal pension scheme at the same time.
Contracting Out Rebates to DC Schemes: National Insurance rebates will not count against the annual allowance.
Divorce: Both partners in a pension sharing on divorce will retain their full £1.4million lifetime allowance.
Investments: Investment freedom has actually been increased, permitting investment in just about all types of investment, including residential property and personal chattels [STOP PRESS: IMPORTANT CHANGES - please follow this link for details]. The main proviso will be that all investments must be dealt with on commercial terms. Loans to employers are also to continue post A Day, albeit it subject to greater restrictions. The only real negative is a reduction in permitted scheme borrowing to just 50% of scheme assets.
Unapproved Pension Schemes
Funded Unapproved Retirement Benefit Schemes (FURBS): These will cease to benefit from tax favoured status after A Day, with investments taxed at the rate applicable to trusts (to be increased to 40% in most cases), and with no inheritance tax protection. FURBS benefits in respect of pre A Day contributions will still be able to be paid as a tax free lump sum and will retain their inheritance tax shelter status. FURBS benefits will not be included within the life time allowance.
Further investigation of the changes to FURBS is required, although our preliminary view is that it will not be appropriate to make FURBS contributions post A Day.
Unfunded Unapproved Retirement Benefit Schemes (UURBS): These arrangements will continue in their current form. In addition, employers will be able to insure against the risk of UURBS benefits defaulting on the insolvency of the company. The cost of the premium will be taxable as a benefit in kind on the employee, but will provide greater benefit security for the member.
What's Next
We are now entering a final period of consultation. This newsletter summarises the key issues from the second consultation paper. Our client seminars in January and February will go over these areas in more detail and more importantly, consider their implications for pension benefit provision for employees and employers.
Please speak to your usual Barnett Waddingham contact to discuss the above.
Barnett Waddingham, December 2003.