Article by Richard Birch, Senior Manager with Ernst & Young Financial Management Ltd. This article appeared in the February 2003 issue of Tax Adviser.Summary
- The massively over-complex structure of UK pensions, struggling to operate within eight different tax regimes, has long been overdue for a major overhaul.
- Many of the proposals now on the table are truly radical to say the least and represent a brave attempt to build a simpler, more flexible pension regime aligned to the modern, more mobile working environment. Simplification is at the heart of the new proposals, which attempts to provide a ‘one size fits all’ approach that will adopt one overall tax regime, and allow individuals to belong to different pension schemes simultaneously.
- There are however some big issues that the proposals fail to address. Arguably, the single biggest challenge facing the government is that essentially the average individual is either not contributing to a pension at all, or contributing too little too late.
The concept of a pension is simple and sensible – put away some of your earnings today so that you can receive an income when you stop working, and retire with dignity. To encourage people to provide for their retirement, the government even offers tax relief on savings – after all, it doesn’t want you to become a financial burden on society. Now, what could be simpler!
Regrettably pension provision in the United Kingdom (UK) is far from simple. The plethora of rules and regulations surrounding the multitude of approved pension arrangements is mind-boggling. The legislation and taxation were complex to begin with, but with every change and new development the complexity has expanded exponentially. Legislation has been bolted on to an existing framework that was never designed to support such a complex infrastructure and that now encompasses no less than eight separate tax regimes. Even seasoned tax and pensions professionals can struggle with the minutiae within s. 590, s. 591 and s. 592 of Income and Corporations Taxes Act 1988 (ICTA 1988), the guidance in IR12 (2001) Practice Notes on Approval of Occupational Pension Schemes or IR76 Pension Schemes Office guidance, or battle with the rules relating to transfers and retained benefits. And that’s to say nothing of Stakeholder, or the differences between pre-1987, 1987–1989, and post-1989 regimes, self-investment rules, additional voluntary contributions (AVCs), FSAVCs, s. 32 buy out plans, and of course personal pensions.
Pensions have therefore been long overdue for a fundamental overhaul of the prevailing tax regulation, and it is against this background that on 17 December 2002 the government published its long awaited Green Paper, setting out its proposals for simplifying and harmonising approved pensions in the UK. On the same day, the Inland Revenue published its Consultation Paper Simplifying the taxation of pensions: increasing choice and flexibility for all. It must be stressed that these are currently only proposal documents, and that any detailed analysis will also need to consider the Department for Work and Pensions (DWP) document Simplicity security and choice and its accompanying technical paper, both also released on 17 December.
However, many of the proposals in these documents are truly radical to say the least and represent a brave attempt to build a simpler, more flexible and better pension regime aligned to the modern, more mobile working environment.
The new regime
At the heart of the government’s proposals is a frontal assault on the existing tax regime. The government has taken on board from Pickering (A simpler way to better pensions – the independent report by Alan Pickering published in July 2002) that if ‘a rose, is a rose, is a rose’ then ‘a pension, is a pension, is a pension’. It has always long been mystifying and inequitable that pension benefit and tax concessions differ considerably from one pension regime to another. This complexity has made effective pension planning more difficult and costly, favouring wealthier individuals, while confusing and deterring most ordinary people from making adequate provision for their retirement.
(1) To address this position, the government proposes abolishing the existing eight tax regimes and replacing them with a single tax regime that will apply to all approved pensions. The intention is to introduce the new tax regime as a clean break. There will be no concessions for the grand-fathering of existing regimes, and after the introduction of a set ‘A-day’ (possibly April 2004) the new tax rules will apply to all future accruals.(2)Individuals will benefit from full concurrency i.e. the ability to contribute to different types of scheme simultaneously.
(2) Individuals will benefit from full concurrency, i.e. the ability to contribute to different types of scheme simultaneously.
(3) The self-employed will now have the option to opt into the State Second Pension.
(4) With effect from ‘A-day’ tax relief will be restricted by reference to a lifetime limit based on the total pension fund built up, tested at the point when benefits are drawn. It is envisaged that the starting point will be £1.4m and this will then be subject to future indexation. If the lifetime limit is exceeded, then a 33 per cent ‘recovery charge’ will be applied on the excess proportion. Additionally the benefits taken from that excess proportion will be subject to income tax, regardless as to whether this is taken as a lump sum or an income.
It is worth noting that indexation is only to be linked to the retail price index (RPI), rather than the historically higher and arguably more relevant average earnings index. It seems somewhat inequitable that the government is not prepared to allow full investment growth over the lifetime limit, whereas – particularly in a defined contribution scheme – the individual will usually have to take the full brunt of any downward investment returns on the chin. If an individual has benefits accrued from earlier regimes that exceed the lifetime limit at the time of the ‘A-day valuation’; these will be honoured or, in the words of the document, ‘respected’. Individuals will have up to three years to register the value of these benefits, which can then be taken in addition to the benefits accrued after ‘A-day’. However, benefits from the ‘respected’ fund will still be subject to the relevant pre-A-day Revenue limits. Currently, the Revenue has not explained how they will view growth on these benefits if this exceeds RPI.
(5) Personal contributions will be restricted to the highest of £3,600 or 100 per cent of annual earnings. In addition, there will be an annual limit imposed on the total contributions (or ‘inflows’) that can be paid into a pension, from both individuals and employers. The limit will be £200,000 in 2004, but again this should be subject to indexation. For a defined contribution arrangement, ‘inflows’ is simply the total of all employer and employee contributions. However, the position is more complex for a defined benefit scheme as these will need to be assessed by applying a standard actuarial factor to the level of benefit increase. Schemes will be required to provide members with an annual statement, which will provide details of any required information to add to an individual’s Self Assessment Tax Return (SATR)so that the resultant Income Tax (IT)charge can be calculated.
(6) Providing the scheme rules allow, individuals will be able to draw benefits while they remain in the same employment. This will allow a more flexible and gradual approach to retirement, and means that there will no longer be a requirement for occupational schemes to incorporate a ‘normal retirement age’. However, the minimum age at which benefits can be taken from a pension will be raised from 50 to 55 by 2010. This will even apply to those in special occupations such as professional footballers, although it is envisaged that early retirement before age 50–55 on the grounds of ill health, will still be permitted. In the event of serious ill health, the Revenue had previously allowed full commutation with no tax charge being levied, but this did not extend to certain arrangements such as personal pensions. The new regime will extend this dispensation to all schemes.
(7) The maximum tax free lump sum will be 25 per cent of the fund accrued, subject to an initial limit of £350,000 i.e. 25 per cent of the £1.4m lifetime limit. A welcome point is that trivial commutation will be allowed where total funds do not exceed £10,000. This is significantly higher than current levels, although such commutation will only be permitted once and the calculation must take into account both protected rights and non-protected rights benefits. A further aspect is that the proposals will allow individuals to effectively take all of their tax-free cash at outset and defer pension income as they will only need to draw an income of £1 gross per annum.
(8) Death before drawing benefits – any benefits that exceed the lifetime limit (the proposed £1.4m) will be subject to the 33 per cent recovery charge. However, there will be no cap on the total lump sum benefits or the level of dependants’ pension that can be provided. No further tax will be applied to the lump sum after the recovery charge has been applied although dependants’ pensions will remain taxable as income.
(9) A more flexible approach to annuity design is being permitted, that for example, will allow for a series of limited period annuities to be purchased.
(10) Self-invested personal pension scheme (SIPP) and small self administered scheme (SSAS) investment rules will be brought in line with those applying to normal occupational schemes – this could therefore see the end of SSAS as a favoured tax-planning vehicle for smaller businesses, where currently there are favourable self-investment and ‘loan-back’ rules. All existing investments held at ‘A-Day’ would be allowed to run their course, even if these would not be permitted as a new investment after ‘A-Day’.
The complexity of the proposals means, not surprisingly, that some wording and sections are unclear and/or undefined. As an example, the wording relating to the lifetime limit and the treatment of ‘respected’ funds is somewhat ambiguous. At this juncture, it would appear that the Revenue has yet to decide whether the ‘A-Day’ value for the respected funds is to be linked to RPI, or another index, or whether such funds will be allowed to benefit from full fund growth without any additional tax charge.
- The lifetime limit of £1.4m, which also takes into account the value of protected rights, is broadly based on the fund necessary to provide a man of 60 with an indexed pension equivalent to two thirds of the current earnings cap, plus a 50 per cent spouse’s pension. On this basis, high earners (ie, those either earning over the earnings cap now or at retirement) will be penalised. Those individuals who expect to have benefits approaching the lifetime limit may need to think seriously about taking benefits early Otherwise any growth over-and-above inflation will suffer the tax charges outlined above.
- The proposed tax treatment of death benefits raises an interesting question as to whether there might be greater advantage to receiving larger lump sum benefits rather than a smaller lump sum plus a dependants’ pension.
- For the first time, personal pension plans (PPP) and retirement annuity plans (RAP) will now essentially be treated in the same way with regards to contributions and benefits. ‘Leap-frog’ techniques to combat the potential taxation problems of contributing to both in the same tax year will no longer be required. Additionally, carry forward (for RAP) and carry back (for PPP and RAP) will be discontinued. Those familiar with RAP will know that there was possible scope to make contributions, within reason, that exceeded the Revenue limits, but which the Revenue allowed to remain invested subject to receiving no tax relief, but still allowing largely tax-free growth on investments. This is something not possible under PPP rules that utilised new rules incorporating ‘Pension Relief at Source’. The new regime now suggests that a similar strategy could be adopted across all pension schemes.
- An interesting consideration for Occupational Schemes is that currently where an employee leaves service within two years, employers may be permitted under preservation rules to reclaim employer contributions and re-direct them to support the scheme. Under the new proposals, all occupational schemes will become ‘immediate vesting’, and this could impact on actuarial calculations and future funding costs where staff retention has been a factor.
- As identified earlier, if funds exceed the lifetime limit, individuals will suffer a penal tax charge and this means that individuals will be taxed on growth of their pension funds over and above inflation. For those in defined benefit schemes any pay rise that increases their pension benefits would effectively give rise to a P11D tax charge. This means that individuals will then be dissuaded from investing in potentially higher returning investments such as equities, whereby they would be taking a higher risk for which they cannot gain any significant benefit, unless the additional growth exceeds the tax charges. If (as is likely), larger numbers of people find themselves in this position, will lower equity investment have a knock-on impact on the UK economy? There is also a danger that if UK pensions are less attractive for high earners as compared with European Union (EU) pension schemes, will it drive talent from the UK elsewhere?
- The position on Funded Unapproved Retirement Benefit Schemes (FURBS) is somewhat unclear. Some commentators have implied that existing FURBS could be included in the £1.4m lifetime limit, but when asked the Revenue declined to comment other than to say that FURBS would be covered in the next round of consultation. FURBS are one of the regimes that the Revenue may wish to radically review or even possibly withdraw, and this could therefore be a worrying development for some.
Although I feel sure the government will argue to the contrary, the reality is that the proposals are effectively retrospective legislation. If these come into force in their present form, the earnings cap in the guise of the new lifetime limit will effectively apply to everyone, and it will no longer be possible to utilise two or more caps in pension planning strategy. Thousands of individuals are therefore likely to suffer tax charges that they would not otherwise have incurred, and many who have already retired will enjoy lower lump sum death benefits than they do now.
As always the devil will be in the detail and much will depend upon responses to the consultation. Based on previous experience of such processes, the earliest envisaged implementation date of April 2004 would appear challenging to achieve, and possibly over optimistic. Realistically April 2005 (or even later?) is a more likely proposition for such a major overhaul to the UK approved pension regime.
Overall we have some 330 pages of proposals and associated information to consider, and considerable refinement is therefore likely to be needed. The practical and logistical issues alone are immense, and both the pensions industry and the Revenue will need to ensure that the timing and transitional periods are handled sensibly, particularly bearing in mind that pension providers are still reeling from the aftermath of stakeholder and the ‘1% world’. Indeed, the Government readily acknowledges that the proposals will impose considerable additional work for schemes. It has therefore proposed a three-year time-scale, from the date when the new regime is introduced, for existing schemes to meet the new requirements.
The important question
Fundamentally the government wants to simplify pension provision in the UK thereby encouraging more people to make better provision for their retirement. Although a laudable goal there are some big issues that the proposals fail to address. Market confidence continues to be impacted by one ‘scandal’ or another such as the pension transfer reviews, the Equitable Life debacle, and even the current endowment issue that, although not directly pension related, is again impacting on the financial sector. Investment returns and annuity rates have dropped substantially over recent years and remain low, and with the growing demise of defined benefit schemes, there is no doubt that the whole subject of pensions is an immense problem for the government.
The single biggest challenge facing the government is that essentially the average individual is either not contributing to a pension at all, or contributing too little too late. The government’s efforts to simplify the face of UK pensions should definitely be applauded, but it appears to have missed the important opportunity of introducing compulsion. I fear that without this, although the new regime will make the gift packaging look a great deal neater, it is unlikely to significantly improve the size of the pension prize inside.
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