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Decisions – Pensions up in smoke

One of the great ironies of the Inland Revenue’s pensions ‘Simplification’ initiative, which kicks in on 6 April 2006 (universally known as A-Day), is that simple it ain’t.

The new rules sweep away boatloads of old rules but, in the process, create a significant number of additional wrinkles that will have pensions consultants, companies and individual employees at a range of salary levels scratching their heads for some time to come.

Jonathan Camfield, Inland Revenue Simplification specialist at actuaries Lane Clark & Peacock, warns that the change affects far more than just high-paid directors worrying about the transitional effects of Simplification. Finance directors in companies throughout the UK will have a number of technical issues to consider as far as their main employee-related schemes are concerned.

“It is really important to recognise that Simplification impacts on pensions schemes generally. FDs will need to review the rules and benefits of these schemes to see that they still make sense after A-Day,” he comments. An example of how matters could change would be middle to senior managers that are currently subject to the earnings cap of £102,000.

This cap relates to the fact that as things stand now (pre A-Day), for everyone joining pension schemes after 1 June 1989 only the first £102,000 of their salaries count as far as their pensions are concerned. In other words, if they retire today and their actual salary is £160,000, where they would expect to get two-thirds of their final salary, their salary would be deemed to be £102,000, not £160,000. Anyone in continuous employment with the same company from before 1 June 1989 is not subject to the cap and gets two-thirds of their actual final salary.

After Simplification, the £102,000 cap is abolished, since we are now working off the single lifetime pot of £1.5m. The cap or limiting factor has moved to the pensions pot, rather than focusing on the salary. The key point now is that since the cap has been in place for years, many companies will be collecting contributions from their high earners and making corporate contributions on their behalf that are based on the cap being in place; in other words, the company is contributing to an artificially lowered pension.

“When the cap goes, you may find yourself doubling or tripling the contribution the company makes to the pensions of your higher earners. Is this really something you want to do? Again, companies need to work through these decisions with their advisors,” says Camfield.

Another example he cites involves additional voluntary contributions (AVCs). At the moment, there is a limit of 15% of annual salary that an employee can pay as an AVC. Many companies like to encourage their employees to make AVC contributions. Therefore, they have a policy of matching pound for pound any AVC contribution an employee makes. After A-Day, the 15% rule is swept away. Instead, one has the new cap of £215,000 per annum, or the executive’s entire salary if it is less than this.

People can pay in more than this, but only £215,000 will attract tax relief, so this makes it a de facto limit. Do companies that have a rule of matching employee AVCs really want to throw open the doors in this kind of way? Matching £5,000 is one thing, matching an AVC of £215,000 is something else again.

There is, of course, a small risk that A-Day may never happen. We are due to have an election before April 2006, and if the Tories came to power they could choose to grab the policy levers and put the whole A-Day train into reverse. “This will not be an easy thing for any incoming government to do because the present government has already put much of the enabling legislation in place in the 2004 Finance Act. But if the Tories wanted to change things, they could rush through legislation to reverse the changes made already. It is not a likely situation, but it could happen,” he notes.

Any company occupational scheme must have at least one eye on the terms and conditions of the basic state pension since this, presumably, sets the low point which they have to improve on to make the occupational pension valuable to their employees. From this standpoint, it is interesting to see the National Association of Pension Funds (NAPF) arguing that the government should grant a single universal pension to all, irrespective of contributions, and that means testing should be swept away.

Andrew Sweeney, European partner at Mercer Human Resource Consulting, points out that there are sound market reasons for wanting to do away with means testing. “It is hugely distorting on the savings market to offer means tested relief,” he points out. This is because it acts as a disincentive to save for anyone at or near the margins. They will have some anxieties about their savings excluding them from the means tested benefit.

Whatever the government chooses to do as far as the basic pension is concerned, Alastair Lockhead, senior manager at accountants PricewaterhouseCoopers, argues that employees in occupational schemes will always need to have one eye on the risk he calls “concentration of investment”. Inevitably, a person’s occupational pension scheme is generally the biggest investment they will be associated with in their whole life. This creates a new set of risks.

“Part of the issue for the UK is that people are heavily dependent on company pensions. If something happens to the employer, they risk losing a large part of their retirement savings,” he points out. This is not an easy risk for a low or middle income earner to do an awful lot about, though the capital they have in their own homes is one potential alternative source of retirement income. For higher paid executives at senior management and director level, spreading the investment pot beyond the occupational pension scheme makes sense.

“This is one reason why we are seeing such a surge of interest in Self-Invested Pensions (SIPs),” he says. The new regulations that come into force after A-Day will allow directors to invest in residential property, including holiday properties abroad, though one has to be careful about attracting benefit-in-kind taxation, and the scheme needs to be properly set up with these issues in mind.

Deborah Cooper, senior research actuary at Lane Clark & Peacock, explains that even without the complexities of A-Day, there are some very complex questions facing employees at most levels of the earnings spectrum. “Take the issue of flat-rate versus index-linked pensions,” she says. On the face of it, people might think that an index-linked pension is better. However, if you take an economic environment of long-term, low inflation, a flat-rate pension delivers a bigger pension from day one of retirement, and it will take an index-linked pension a long time to overtake the flat-rate figure. Whether you will live long enough in an era of low inflation to be a net winner from your index-linked pension might be a moot point. That said, the poorest UK pensioners are the oldest, and they are poorest because they retired at a time when flat-rate pensions were the norm. “If you are planning to live to 95, a flat-rate pension is a bad idea. With index-linked, though, if inflation stays low, you have to spend more for a benefit that is largely illusory. It’s a tough choice to make, but this is how it is with many pension choices,” she says.

One of the real complexities with A-Day involves deciding how best to protect director pensions that are already in excess of the lifetime limit of £1.5m. There are provisions for two types of protection – primary protection and enhanced protection. Executives are not pressured to decide on one or the other of these now. They can register for both (if they meet certain conditions) and decide which way they want to go when the time comes to draw their pension. In fact, Jonathan Camfield, Inland Revenue Simplifications specialist at actuaries Lane Clarke & Peacock, explains that since enhanced protection is easy to lose, it is wise to register for both so the executive will be able to fall back on primary protection if necessary.

Primary protection enhances an individual’s lifetime allowance by a factor based on the amount by which the value of the pre A-Day pension rights exceeds £1.5m, expressed as a fraction of £1.5m. So, for example, an individual with pre A-Day pension rights of £2.25m who registers for primary protection will have a personal lifetime allowance of 150% of the standard lifetime allowance at any one time. Under primary protection, you can carry on earning further pension benefits after A-Day, though any amount in excess of your personal lifetime allowance will be subject to a tax charge.

What will also be welcomed by executives in this position is the fact that the 25% tax-free lump sum entitlement transfers to whatever their new lifetime allowance might be. Primary protection and the lifetime allowance applies to all the pensions an individual might have, aggregated into a lump sum.

Enhanced protection is rather different. Individuals can register for it regardless of whether their pre A-Day pensions rights exceed £1.5m. The main point here has reference to the likely accumulating value of your fund. If the fund is less than £1.5m but is clearly expected through natural investment growth to exceed that figure some time after A-Day, then enhanced protection could be the way to go. The key factor with enhanced protection is that the individual is not allowed to make any further direct pension contributions or this option falls away. In a money-purchase scheme, that means stop contributing. In a final salary scheme, Camfield says, the position is less clear. After A-Day, a final salary scheme can continue to increase at the lower of actual salary increases or 5% per annum. Interestingly, the salary cap, if that applied, will continue to set the maximum salary figure for use in this calculation. Enhanced protection also protects tax-free cash lump sum rights, with these rights increasing in line with increases in your overall benefit entitlement. There are complexities at almost every turn with these arrangements and individual directors are well advised to consult their advisors.

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