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Pensions Tax Simplification - Impact for Senior Executives

Summary

What are the key issues?
The 2004 Finance Act set out that the Government is to replace all existing benefit limits on tax approved pensions with a single set of allowances. These will be:

  • a lifetime allowance on the value of pension benefits that can receive tax relief, and
  • an annual allowance on the amount of pension saving that can receive tax relief.

The reforms go much further than had been expected and in particular sweep away all previous regimes, and introduce for the first time a single regime for all tax approved benefits, be they defined benefit or money purchase, company sponsored schemes or personal arrangements.

The key difference to previous pension taxation changes is that this legislation is retrospective, affecting all existing pension benefits and not just future pension provision. Senior executives who were unaffected by past changes, such as the Earnings Cap, will be affected by these changes - important decisions will have to be made by employers and senior executives now!

How have the reforms been received?
Very well! The radical reforms have received a broad welcome from the pensions world. However, many commentators have expressed concern about the effect for high earners. There are also areas that need further consideration, and we are, along with others, continuing to lobby the Revenue.

Background

What prompted the reforms?
The pensions world had been very critical of the over-regulation of pension schemes for some time. These reforms came out of a review carried out jointly by the Inland Revenue and Treasury, with the aim of cutting back on the multitude of limits and rules.

When will the reforms take place?
'A Day' will be 6 April 2006, the date the old rules cease and the new ones take over.

The Broad Details
 
What is the lifetime allowance?
Initially it will be £1.5 million. This is the maximum pension benefit value from all pension arrangements that can be built up under the tax-approved umbrella for an individual.

Why £1.5 million?
The Revenue claimed that this was broadly the same value as the maximum pension that could be earned by a new member of a company pension scheme, i.e. a pension of two-thirds of the earnings cap (the earnings cap for 2004/5 is £102,000). There has been well documented concern that this lifetime allowance is too low, with the current cost of an open market annuity to provide these maximum benefits actually being almost £1.9 million.

How will a pension be valued against the £1.5 million allowance?
For a defined benefit scheme, each £1 p.a. of pension is valued as £20 against the lifetime allowance. As such there will effectively be a defined benefit pension allowance of 1/20th of the lifetime allowance, i.e. £75,000 p.a. initially - actually greater than the current earnings cap limit! There is further good news, in that there is provision for a member of a money purchase scheme buying an annuity to effectively choose between the better of the £1.5 million fund allowance and £75,000 p.a. pension allowance. Where there is a combination of different types of benefits, they will be aggregated against the lifetime allowance.

Will the lifetime allowance be increased from year to year?
Yes, the 2004 Budget set down that it will be increased up to £1.8 million by the 2010/11 tax year. However, the Finance Act does not state how increases will be granted in subsequent years, only that the lifetime allowance will be reviewed by the Treasury, and cannot be reduced.

What happens is benefits exceed the lifetime allowance?
A lifetime allowance tax charge of 55% of the value of benefits in excess of the lifetime allowance will be levied on the fund. The lifetime allowance is only tested at the time or times when benefits are taken.

Is 55% reasonable as a tax charge on excess funds?
This charge is not as penal as the initial government proposal of a 60% charge. Considering that pension contributions will have benefited from income tax relief and certain national insurance exemptions, with subsequent tax reliefs on investment gains, the 55% tax charge is not an unreasonable offset to these tax breaks for funds invested over the medium term that exceed the lifetime allowance at retirement.

What happens if pension benefits are taken at different times?
Each time pension benefits are taken the percentage of the lifetime allowance that they represent will be recorded by the pension administrator for those benefits and notified to the individual. It will be the individual's responsibility to disclose to the pension administrator, when a benefit is taken, whether the benefits being drawn will take them over their lifetime allowance.

What about people who already have £1.5 million or more before the date of the change?
These benefits can be protected from the 55% tax charge. There are two alternatives available to choose from:

Primary Protection:
Applies, where benefits at A Day valued above £1.5 million can be certified, to create that individual's own personal uplifted lifetime allowance. This personal lifetime allowance will then be increased at the same rate as increases in the standard lifetime allowance. When benefits are taken, they will be checked against the personal lifetime allowance, and only benefits above this uplifted allowance will be subject to the 55% tax charge.

Therefore, with money purchase benefits in particular, strong growth in the value of the primary protected benefits after A Day will result in a 55% tax charge on the growth in excess of the lifetime allowance indexation.

Future pension contributions or pension accrual are permitted after A Day under primary protection. However, unless the benefits already built up at A Day fail to keep pace with the lifetime allowance indexation, these benefits earned after A Day will be subject to the 55% tax charge.

Enhanced Protection:
Benefits at A Day protected under enhanced protection will avoid the 55% tax charge irrespective of their final value when they are taken, i.e. allowing for salary and/or investment growth on benefits. (Defined benefits subject to the earnings cap at A Day will have subsequent pensionable earnings capped at 7.5% of the lifetime allowance.) There can though be no further pension contributions after A Day under enhanced protection. The defined benefits that can be paid under enhanced protection are based on those accrued at A Day. However there is scope for further accrual if benefits are taken early - this results in a delicate balancing act, which will need very careful planning.

There are also provisions, under both types of protection, to restrict benefits protected at A Day to 20 times the Inland Revenue maximum pension under the current regime. To be able to obtain enhanced protection, benefits above this limit would need to be 'surrendered'.

Which type of protection will be appropriate?
Just which protection option should be chosen will depend very much on each executive's circumstances:

  • With money purchase benefits above £1.5 million, enhanced protection is likely to be attractive.
  • With defined benefits above £1.5 million, the appropriate protection will be influenced by a number of factors, including when the executive plans to retire, expected benefit growth and the non-pension benefit alternatives offered by the employer.
  • With benefits approaching £1.5 million, the executive will need to consider when they plan to retire and their expectations for future benefit growth (salary and/or investment), alongside any alternative non-pension benefits offered, in deciding whether to claim enhanced protection.

What about new benefits after A Day?
There will be an annual allowance, initially £215,000, on contributions and/or defined benefit growth each year, known as 'pension inflows'.

If the value of pension inflows in a year for an individual are within the annual allowance, there will be no tax charge on the individual. The pension inflows will be the sum of contributions into defined contribution pension schemes and the growth in value of defined benefit pension entitlements over each year. Defined benefit pension entitlements will be valued using a standard factor of £10 for each £1 increase in pension entitlement. Included within the annual allowance, there is a maximum employee contribution each tax year of the lesser of 100% of their earnings and the annual allowance.

This is a generous annual limit, which for the vast majority will significantly increase the scope for pension saving. Those who will benefit the most will be older individuals, subject to the earnings cap, with limited past pension savings, especially those contributing to personal pensions.

Will the annual allowance be increased?
Yes. In the same way as for the lifetime allowance, the 2004 Budget set out increases in the allowance up to £255,000 for the 2010/11 tax year, and increases in subsequent years will be set down by the Treasury.

What about the tax free lump sum?
This will be 25% of the value of benefits, subject to an overriding limit of 25% of the lifetime allowance. This new lump sum calculation will result in a larger tax free lump sum for many members of company pension schemes. For defined benefit schemes, the lump sum will be based on 25% of the value of the residual pension after commutation, valued using the 20:1 factor, plus the lump sum. This leads to a confusing chicken and egg calculation!

Why will the lump sum be bigger for many current members of company pension schemes?
The maximum tax free lump sum at present for a capped member of a company pension scheme (those joining the scheme on or after 1 June 1989) is one and a half times the earnings cap (and that is provided the individual has long company service), resulting in a maximum lump sum that is currently just over £150,000. Those joining a company pension scheme between 17 March 1987 and 1 June 1989 have a cap on the lump sum of £150,000. New rules will allow a tax free lump sum of up to one quarter of their benefits, subject to the lifetime allowance, so this could reach £375,000.

What about people with lump sums currently greater than £375,000 or 25%?
Where individuals have a lump sum entitlement at A Day of over £375,000 or 25% of the value of their pension benefits, this can be protected in a similar way to the protection of pension benefits above the lifetime allowance. The maximum tax free lump sum that could be paid when benefits are taken would then be the greater of the protected lump sum, revalued to the date benefits are taken, and 25% of the benefit value (up to the lifetime allowance).

Are there any other aspects of the reforms that are welcome?
Yes, several:

  • Normal retirement date: The concept of normal retirement date will disappear. All restrictions about whether employees may start to draw retirement benefits before they have completely stopped employment will be removed. Benefits will just either be in payment (known as 'crystallised') or yet to be put into payment (known as 'uncrystallised').
  • Income drawdown: There will be greater flexibility under income drawdown arrangements, with a higher maximum income permitted and no minimum income level.
  • Early retirement: For those with money purchase pensions, the removal of the requirement to take a minimum drawdown level, linked in with the removal of restrictions on continuing in employment, means that individuals could take their benefits as soon as they hit the lifetime allowance, providing they are above the minimum retirement age. The 25% tax free lump sum could be taken, the lifetime allowance tax charge (which is only checked at the time benefits are taken) would be avoided and the income could be deferred until the pension income was needed. The residual pension fund would continue to be invested on a tax approved basis.
  • Concurrency: There will be full concurrency. As such, a member of a company pension scheme could also pay contributions to a personal pension plan - with the aggregate benefits counting towards the annual and lifetime allowances.
  • Transfers: There will also no longer be restrictions on transferring after normal retirement date.
  • Death in service lump sum: There will be provision for the death in service lump sum to be the whole of the fund/benefit value up to the lifetime allowance rather than the previous limit of four times salary in company schemes.
  • Death after retirement lump sum: There will be additional flexibility to provide lump sum death benefits (albeit subject to tax at 35%) in the event of the death of a pensioner before age 75. If a pensioner has not used all their lifetime allowance, then a tax free lump sum can be paid on the death of the pensioner, utilising their residual lifetime allowance.
  • Annuity purchase: The need to buy an insured annuity from age 75 will be removed, although income must commence by age 75 and no lump sum death benefits after age 75 will be allowed.
  • Death after age 75: There is, though, provision for any remaining income drawdown funds, in the event of an individual's death after age 75, to be passed across to other members of the scheme. Depending on the exact circumstances, this may provide the opportunity to pass pension funds down to children after age 75.
  • Investments: Virtually all the restrictions on permitted investments for pension funds will be removed. In particular residential property and personal chattels will be allowed [STOP PRESS: IMPORTANT CHANGES - please follow this link for details]. The only requirement will be that a market rental is paid for any personal use!

Unapproved Pension Schemes

Are unapproved pension schemes caught within the lifetime allowance?
No. Though there will be the option to fund an unfunded unapproved retirement benefit scheme (UURBS) promise within the 3 months after A Day, without this funding being counted against the annual allowance. Once this funding has occurred the benefit will be included within the lifetime allowance.

What is going to happen to unapproved schemes?
UURBS will be virtually unaffected by the reforms. There is provision for charges on assets and insurance against the insolvency of the employer, to attempt to improve the security of benefits. There is also provision for a National Insurance liability if a lump sum of more than 25% of the value of benefits is paid.

Funded unapproved retirement benefit schemes (FURBS) have been hit hard by the reforms. Prior to the reforms, they benefited from only incurring basic rate tax on investment returns. Contributions were taxed as a benefit in kind, but the resulting lump sum at retirement was tax free and, in the event of death, the fund would be paid out free of inheritance tax.

Under the reforms, FURBS investments are effectively taxed at the individual's marginal tax rate in respect of funds built up both before and after A Day. Funds built up before A Day will still be able to be paid out tax free. FURBS contributions after A Day will not be taxed when they are paid; instead the lump sum benefit paid out will be taxed in full. Unfortunately, the employer will not be able to claim corporation tax relief until the lump sum is paid out, possibly many years after the company paid the money in, and even then the relief will be against the lesser of the original contribution and the lump sum paid out - this is likely to be the nail in the coffin for FURBS contributions after A Day.

Planning Issues in the run up to A-Day

Should those people planning to retire soon after A Day bring their retirement forward?
With the facility to protect large pension and lump sum benefits at A Day, there will be no sudden loss of benefits for those planning to take benefits soon after A Day and, therefore, no reason to bring forward retirement to before A Day.

The only situation in which we envisage there being problems will be for those with money purchase benefits in a company scheme with a fund greater than £1.5 million at A Day and also greater than the maximum protectable amount of 20 times the current regime Inland Revenue maximum benefit. In such cases, possible solutions will include taking benefits or opting out of pensionable service before A Day, increasing remuneration, transferring to a personal pension or negotiation with the Revenue. The appropriate action will depend on the circumstances of each case.

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 who 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 up to a maximum of £375,000, 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 will be the generous annual contribution allowance post A Day which could be used to boost pension saving immediately before retirement. This could appeal to those whose pension benefits are below the lifetime allowance of £1.5 million.

Should pension savings be maximised before A Day to boost tax approved pension benefits?
Only if the value of pension benefits will be close to or over the lifetime allowance at A Day. This is likely to only be possible for members of company pension schemes with uncapped pension benefits (i.e. joined the scheme before 1 June 1989) or those funding retirement annuity pensions (i.e. pre 1 July 1988 personal pensions). The decision to pay further pre A Day contributions will also be influenced by whether primary or enhanced protection will be sought, and the expected term to retirement.

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. joined the scheme before 17 March 1987) and who would expect to have a certified lump sum well over £375,000 or 25% of the value of their pension benefits. Again, the appropriate action will be influenced by the protection being sought and the term to when benefits are expected to be taken.

Planning for Executive Pension Benefits that will exceed the Lifetime Allowance

The Revenue are clear that while benefits in excess of the lifetime allowance 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 allowance, 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 step in resolving this issue is for the terms of the pension commitment to be reviewed both within the scheme rules, the executive's employment contract and any other binding paperwork. The employer will also need to consider the principles that will underlie any restructuring of the pension package, such as:

  • cost impact for the employer
  • executive reward strategy
  • flexibility and options to be provided
  • communication/consultancy for executives

Proposed alternative compensation packages that could be negotiated are:

Salary supplement/alternative remuneration:

Where the employer would provide additional salary/alternative remuneration for 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:

Where the employer would grant additional pension scheme benefits to the executive (within current 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 claw back in other parts of the exit package would need to be considered to compensate for the advancement of pension benefits.

Maintain scheme benefits:

Where the executive will continue to be provided with normal benefit accrual after A Day. This will not be possible where enhanced protection is taken.

Where benefits are provided on a money purchase basis, the excess benefits above the lifetime allowance, or primary protected allowance, would incur the 55% lifetime allowance tax charge. This is a simple solution and may well be reasonably tax efficient for investments over the longer term.

Where benefits are provided on a defined benefits basis and protection is taken, there may be scope to provide some further accrual of pension after A Day while still avoiding any 55% tax charge. The exact position would depend on the executive's retirement plans and the scheme early retirement factors.

Funded Unapproved Retirement Benefit Schemes (FURBS):

With the unattractive tax treatment of  FURBS contributions after A Day, FURBS contributions are not expected to be included as part of an executive's remuneration package post A Day.

Unfunded Unapproved Retirement Benefit Schemes (UURBS):

The employer would give a commitment to the executive to meet directly the balance of the pension promise beyond the value of the lifetime allowance. When the earnings cap was introduced in 1989, UURBS were initially thought to be a simple and effective way to compensate new executives at the time for the capping of their tax approved pension benefits. However, problems relating 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. With the demise of FURBS and possible improvements in security, UURBS may see their popularity rise.

Partner 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 allowance) 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.

The appropriate approach will depend upon whether the employer is seeking a one size fits all solution or is willing to provide bespoke solutions for each executive. In any event, comprehensive information on each potentially affected executive's past pension arrangements will need to be collated, with consideration of each executive's circumstances, prior to agreement of a final restructured package. There is much to be done!

Barnett Waddingham LLP, December 2004.