Scheme Audits: parts 4, 5 & 6 - transitional protection
The need to inform members who are likely to be at risk of being subject to a retrospective tax on their pensions
Basically I suppose it’s nice of the people in the Inland Revenue to introduce a new tax and recovery charge for people who overdo their pension saving, but at the same time allow people who will have already overdone it on day one of the new regime to protect themselves from that tax. The trouble is, there is no plan in place to inform all of the people in UK plc affected by this retrospective tax and nor will there be. In fact, no-one even knows for sure how many people are actually going to be affected. So it’s all a bit of a leap in the dark really.
The tax and recovery charge, as you probably know, is a nasty 55% - so it’s well worth avoiding if you get the chance! But as with everything in pensions, knowing how to protect oneself from the tax isn’t exactly straightforward. Put it this way, I’ve read through the whole of the Finance Act and, quite frankly, it just doesn’t jump off the page at you. Anyway, if you think there are only two ways for people to protect themselves from this new tax, you’re wrong. I reckon there are four.
So, first things first, a few facts to get you going and to make sure we all understand what’s what with all this protection from tax stuff. People are only going to be given the opportunity to protect themselves from this tax for a short period of time around A-Day. The best way to think about A-Day is to imagine it as a sort of D-Day for pensions. Unlike the real D-Day, though, everyone affected by A-Day is supposed to know in advance so they can prepare for it. Ignoring the whole thing just doesn’t seem a sensible option, although I’m not too sure how 25 million people in the workforce are supposed to find out about it either, but for the lucky ones that’s where financial advisers come in I guess. Employers and trustees, once properly informed about all this stuff by financial advisers, will presumably pass the information on to those employees in their pension schemes who may be the ones likely to be affected badly by it all. With that information, those people can then go on and find out for sure if they are the people in the frame tax-wise and to get advice on what they ought to do about it. But getting the information to people is the start of that process, and that’s what this BeeLine is all about.
Protection is being granted as a sort of concession for people who are affected on A-Day when the new rules come in and we all become subject to a lifetime allowance - a kind of maximum amount we will be allowed to have in our pension pots. The lifetime allowance starts off at £1.5 million in 2006 and is set to go up over time at an unspecified rate (although Government has already said that in the first five years or so it will go up to £1.8 million - that was part of the climb down or U-Turn or whatever you call it following the stormy consultation process).
The four forms of protection are ‘primary protection’, ‘enhanced protection’, both ‘primary’ and ‘enhanced’ protection together and, for people who don’t spot what’s going on in time, ‘no protection’ whatsoever. The last option, of no protection, is the one most people will end up with I think if they’re not lucky enough to have a financial adviser who’s up to speed with this stuff. What follows is a brief overview of the four options:
This is only available to people who have more than £1.5 million in their pension pot before A-Day and it ‘protects’ the value of their pension already accrued up to 5th April 2006 and allows it to continue to grow modestly in line with whatever the Government prescribe without triggering off any tax charge. It kind of ring-fences the past savings really. That’s the way I look at it anyway. Going for ‘primary protection’ doesn’t stop people carrying on with their pension savings after A-Day if they want to, but of course they could be deep into tax territory if they do. People need to apply for ‘primary protection’ on A-Day or within three years after A-Day. After that the option simply isn’t available. The last bus leaves on 5th April 2009 if you like. That sort of thing, anyway.
This is a bit different in that it allows people to protect not only the current value of their pension savings at A-Day, but to get the full value of future investment returns or salary increases as well without incurring a tax penalty. So, people with money-purchase pensions can keep everything they have accrued up to A-Day and, by applying for ‘enhanced protection’, can continue to get the value of future investment returns without paying tax on them as well. This is better than the ‘primary’ approach where people are only protected up to the level of prescribed Government increases. For people in final-salary pension schemes, applying for ‘enhanced protection’ allows them to have their pre-A-Day years of pensionable service based on their salary at retirement (albeit with some restrictions to make sure they don’t take the mickey and whack their salaries up just before they retire), rather than their salary on 5th April 2006. So, again, very generous and better than valuing the benefits before A-Day and protecting only up to the level of prescribed Government increases for the future. The big downside to ‘enhanced protection’, though, is that part of the deal is people applying for it must agree not to make any more pension savings for the rest of their lives. So they have to voluntarily jump ship pension-wise and give up on pension saving altogether. The other funny thing about ‘enhanced protection’ is that you don’t have to be over the lifetime allowance of £1.5 million to apply for it. Anyone can go for ‘enhanced protection’ if they like. As with ‘primary protection’ you need to apply for it on A-Day or three years after, but as you need to have left your pension scheme for good by A-Day at the very latest, the three-year concession looks a bit useless to me.
Both Primary and Enhanced Protection
This option came to our attention when we were trawling through the legislation and it looks to me to be pretty important. People will be allowed to apply for both ‘primary’ and ‘enhanced’ protection at the same time. As far as I can see, the point of doing this will be that people who go for ‘enhanced’ protection (and are already over the lifetime allowance at 5th April 2006) may want to give up on ‘enhanced protection’ one day and not want to drop back to ‘no protection’. By applying for both ‘primary’ and ‘enhanced’ on A-Day they will be able to drop back to ‘primary’ protection if they ever need to. A sort of fall back position if you like, but only available to people who are well-informed enough on A-Day to apply for both ‘primary’ and ‘enhanced’ even though they only really want ‘enhanced’ protection to start with. Obviously this all comes under the generic description of ‘very fiddly’ and really does mean people with financial advisers will have a real edge on the DIY merchants who just have a stab at understanding all this gobbledegook themselves. Incidentally, undoing ‘enhanced protection’ can be a bit tricky too and if it’s not done properly can lead to a £3,000 fine. I’ve written a BeeLine about that too (am I prolific or what?) and you can get to see it here if that’s what turns you on.
Just to complete the set and to sort of tie things up I’ll mention again that people who just don’t see this train coming will be likely to miss it and only afterwards find out that it was not only the first train, but also the last one. Now we know the Government isn’t going to mount an awareness campaign to ensure that people affected by this retrospective legislation are aware that they may need to take urgent action by A-Day (even to the extent of doing something as drastic as leaving their pension scheme), I think it’s up to those of us who do know about these things to get to tell as many people as possible. Another reason why pension advice will be more important than ever in our ‘simplified’ future!
The provision of information on transitional protection to those members affected
Now, employers and trustees will need some help in working out who if anyone among their workforce is actually going to want to take advantage of any of the various forms of protection available on A-Day. The easiest ones to spot, on the face of it, would seem to be those with pension holdings on A-Day valued at over the lifetime allowance of £1.5 million. But even that’s not as straightforward as it seems as it will depend on the type of benefits that the scheme provides.
Strange as it will seem, it will be easier for people in final-salary schemes to spot if they are in tax territory than for people in money-purchase schemes. Basically, if your salary and service so far will provide you with more than £75,000 a year as a pension then you can safely assume you could well be in a bit of bother with all this and it would probably be a good idea to get someone to have a close look at things for you. A £75,000 pension ‘valued’ at 20:1 will take you to the £1.5 million limit.
But for people who have not reached that limit by A-Day, but who think their pension earned at that date may one day be worth more than a future lifetime allowance (because of good investment returns for money-purchase scheme members, or higher salaries in future raising the value of past service final-salary entitlements) they too can opt for enhanced protection. This is something I have referred to in previous BeeLines as ‘pension momentum’ and you can read that again here if you like. But, in a nutshell it means that employers and trustees will need to understand a fair bit about the way this stuff will work before they will be able to explain it to their employees. I think that’s in the ‘difficult, but possible, box’ and employers and trustees will value, I’m sure, all the help that financial advisers can give them in this area.
It might help, when explaining it to others, if I go through some of the background to how we actually ended up here in the first place. Things always make more sense when you know how they came about, even if no-one can work out why they came about. The Government decided long ago to rip up our current complex benefit-limited pension laws and replace them with a simpler system based on all of us having the same maximum pot we can put aside over our lives to buy our pensions with. We’ve had loads of consultation and literally millions of words published by the Government over the last few years to make sure retrospective legislation of this sort can be implemented in an orderly and sensible way.
The upshot of it all was that we would all be subject to a maximum pot of £1.5 million of tax-relieved pension savings after the implementation date on 6 April 2006. The maximum pot is designed to go up over time and we already know the Government intends to raise it to £1.8 million by 2010, although they’ve been a bit coy about where it’s going to go after that. They have called the maximum pot the lifetime allowance.
Anyone saving more than the lifetime allowance will be able to do so, but will get taxed at a whopping 55% if they do. My view is that this will be something of a deterrent and will stop people overdoing their pension savings in the future. Some people, though, will already be over the limit on A-Day. Their case has been successfully put and transitional arrangements will be in place so that they can avoid being hit by tax on the pension savings they have already accrued. They’ll only be able to do that if they find out about this stuff in time, but anyone still reading this at this stage knows all about that.
So, our benefit-limited pension system is going to be replaced by a simpler system based on a maximum lifetime allowance which will apply to our pension savings. Goodbye to all the complicated and complex pension benefit limits.
Well, not quite. First we heard that people in final-salary pension schemes would be subject to a system based on a maximum pension benefit rather than a maximum pot to buy a pension with. This happened because the Government decided that final-salary pensions could be ‘valued’ to test them against the lifetime allowance using a factor of 20:1. Furthermore, that factor is able to be applied at any age. The end result is that instead of a lifetime allowance of £1.5 million applying, a maximum pension of £75,000 will. £75,000 is one twentieth of £1.5 million. So, in plain English the lifetime allowance will only be used by final-salary schemes as a way of determining the maximum allowable pension. The actual allowance will be meaningless with pensions being allowed to cost whatever they cost as long as the pension amount isn’t exceeded.
Well, that blew the idea of one regime as final-salary schemes were to be subject to a maximum pension, whereas money-purchase schemes would be the only ones saddled with the idea of a maximum lifetime fund allowance. But a little later on we found out that we hadn’t understood the Finance Bill (as it was then) when we first read it and that money purchase schemes (including personal pensions and stakeholder pensions) could also use the 20:1 factor to ‘value’ such pensions at any age too. I wrote about this at the time and you can re-read that if you like by clicking here. This could leave only people in income drawdown actually subject to the lifetime allowance.
Now, if like me, your head’s beginning to hurt thinking about all this then just consider what it could all mean. It looks like we are getting rid of a system based on maximum emerging pension benefits and replacing it with a system based on maximum emerging pension benefits, while at the same time we’ll be claiming to have replaced it with a system based on the concept of fund values and a maximum lifetime allowance.
The need to renegotiate future remuneration packages for those who choose to leave pension schemes to protect the value of their existing pension holdings
Always assuming that people will be able to get their heads around the stuff I struggled to write in that last section, there will be a number of senior people in the workforce who will opt for ‘enhanced protection’ on A-Day. They may be people who are already over the lifetime allowance, or they may be of the view that their ‘pension momentum’ is such that the pension entitlements they have already accrued will one day be taxed in part at 55%. They will also be people who have discounted the option of staying in their employer’s scheme for future service after A-Day as that is the only way they will be able to protect the full value of the pension they have accrued so far at that date.
This is where everything gets extremely difficult, I think. In order to comply with the terms set down for being granted ‘enhanced protection’ by the Inland Revenue, such people will have to cease being active members of any form of UK pension provision for the rest of their lives. Essentially, they will need to get out of pensions and stay out if they want to keep the protection they are granted at A-Day.
So the deal will be that to get the benefits of 'enhanced protection' people will have to leave active membership of their employers' pension schemes. Woo! Now that leads us into all sorts of issues as far as advising people to do this is concerned and I think everyone involved in the giving of information on this subject will need to be very careful indeed not to accidentally 'advise' people at the same time. It's all very well, of course, for the Revenue to give people a good reason why leaving active membership of an occupational pension scheme might be a good idea, but another entirely to actually advise any individual to do so.
I’m not sure how this will work out in practice, but I am fairly sure that many people will opt for ‘enhanced protection’ once they understand what is going on around them. By doing so they will be placing themselves outside of their employers’ schemes, but that doesn’t necessarily mean they will want their employer to profit from that. Quite the opposite I should think.
A typical final-salary scheme today providing sixtieths of salary is probably costing around 20% of payroll year on year to fund. So someone opting out of such a scheme may well claim that they will have foregone 20% of their salary by doing so. Given that the people most likely to opt for ‘enhanced’ protection’ will probably be the most senior employees in the companies concerned, it seems more than likely to me that they will ask if they can have that money in some other way. They would argue, I guess, that it’s not their fault that the Government has made it necessary for them to leave the scheme and to forego any future pension accrual and that if that hadn’t happened they would have been content to stay in the pension scheme. However, as it’s no longer sensible to do that they’ll now have to find other things to invest the employer’s 20% of salary in instead. This will be the gist of probably hundreds of thousands of conversations going on all over UK plc between companies and their most senior people before A-Day I should think. But only if the people and employers concerned find out about it before then. For those that don’t a different type of conversation will take place I suppose at some point after A-Day when people find out their pensions are being taxed to bits and there’s nothing they can do about it at that late stage. If that hasn’t got “Ooh-err!” written all over it I don’t know what has.
1 September 2004
This is based on Scottish Life’s understanding of the relevant legislation and regulations (some of which are draft). It may be subject to change as a result of changes in legislation and regulations. Independent advice must be sought regarding the effect on a specific scheme.