Scheme Audits: part 1 - scheme benefits and contributions
Changes to scheme benefits and contributions
Pension scheme benefits at the moment are limited by the existing legislation in a number of ways and many schemes have effectively built their pension promise around the current limits allowed by the Inland Revenue. This is particularly so for final-salary schemes, but applies to all employer-based schemes to some extent. As an example, the Earnings Cap is likely to be used as a benefit and contribution limit on all types of existing schemes established since 1989 (or all members who have joined existing schemes after that date). The thing about these changes is that all of the existing legislation is disappearing in April 2006 and terms like ‘the Earnings Cap’ will cease to have any real meaning, so it’s not just the underlying structure of scheme benefits and contributions that’s about to change, but the way we describe and talk about them too.
At the moment, pension benefits are limited by reference to members’ earnings and length of service with an employer. This is usually quite obvious in the case of a final-salary scheme, but also applies to employer sponsored money-purchase schemes where, even though a fixed pension benefit is not being provided, the funds accumulated cannot be used to buy more than would have been allowed for someone with the same salary and service history in a final-salary scheme. Well, all that’s being blown away by these changes. Final-salary schemes will no longer need to make people accumulate pensions in chunks of sixtieths or eightieths to demonstrate a fit with legislative maxima. They’ll be able to provide twenty ninths, or thirty three and a thirds, or sevenths, or anything else they like. The only restriction will be that people won’t be able to overdo the overall lifetime allowance when their eventual pension benefit is valued at retirement, unless they want to be taxed on the excess. For money-purchase schemes this means a potential reduction in red tape I should think, as they will no longer have to keep checking that Revenue maxima have not been exceeded, but only if they choose to change their schemes. The thing is, it will be perfectly possible for schemes to carry on just as they are now after A-Day if they choose to. There is no reason why a scheme can’t continue to use the same benefit formulae as they use now to determine pension benefits. They won’t be able to refer to definitions like the Earnings Cap or the maximum benefit of two thirds of remuneration as coming from any legislative requirement, but the scheme itself could define these terms for its own purposes if it wants to. All of which, perversely, means that schemes will need to make changes if they decide not to change. I doubt many will stay as they are for long though, but it is exactly this that employers and trustees need to consider now, perhaps as part of their ongoing dialogue with their employees about the provision of more flexible retirement benefits. Indeed, I would think that many employers will find that this is a chance for them to get in their employees’ good books by tailoring their pension arrangements to better suit their requirements. That’s an opportunity in itself.
Under the new rules the maximum amount of cash that can be paid out is changing. The maximum tax-free cash at retirement will no longer be limited by salary and service as it is for occupational schemes today (both final-salary and money-purchase), but will be 25% of the lifetime allowance instead. The lifetime allowance is going to be £1.5 million to start off with (as you’ll know unless you’ve been on Mars or somewhere for the last six months), so the maximum aggregate tax-free cash you can get from all of your pension savings will kick off at £375,000 from 2006. Schemes will usually be able to provide up to 25% of pension savings. For most people this means there will be potential for an increase, but pension scheme rules will need to be changed to allow this greater flexibility if the employer decides to offer it. That’s important, an employer doesn’t have to offer the maximum benefits the Revenue is prepared to allow. Like now where the various maxima are defined by the tax laws, but what any particular scheme allows is decided by the employer and the trustees within the permitted limit. So employers could decide to leave their scheme benefits just where they are, limited by legislation that will no longer exist, or they can change their scheme benefits to offer a more tailored package for their particular workforce. It could, for example, be a highly popular move for an employer to increase the tax-free cash on offer from his or her scheme and it could prove quite motivational from a staff relations point of view. Indeed, there will no longer be the direct link that exists now between the amount of pension a scheme provides and the amount of tax-free cash that can be taken.
A number of factors will have to be taken into account before deciding whether to offer greater flexibility – for example
- the cost of allowing more pension to be commuted for cash (if that is how cash is provided), or
- the overall impact it could have on the benefits provided by the scheme – for example lower pension income, or
- the interaction with any restrictions on taking contracted-out benefits as cash
(Remember that we have not seen the detail yet as that will be in the Pensions Bill even though we expect contracted-out funds to be allowed to generate extra tax-free cash. So it’s still something we have to keep in the ‘not sure yet’ box.)
Some schemes may not be able to offer the higher tax-free cash amount without a fundamental change in the structure of benefits, for example schemes that provide a defined lump sum. In addition, schemes that provide cash-only benefits at retirement will need to review the overall benefit structure as this will not be allowed after the 5th of April 2006.
The new tax regime provides much greater flexibility over the amount and mix of benefits that can be provided particularly on death-in-service. For example, lump sum benefits on death-in-service will no longer have to be limited to four times salary for members of occupational pension schemes. Indeed, they will be able to be as high as the value of the lifetime allowance (£1.5 million in 2006). In addition, dependants’ pensions will not count towards the lifetime allowance (either the member’s or the dependant’s). Once again, employers will need to decide whether they want to change the level of benefits currently provided.
It is not clear yet whether in the new regime employees will be able to be members of a scheme for death-in-service benefits only. If it turns out that it’s no longer possible then any policy of providing these benefits separately or before an employee joins the scheme for pension benefits will need to be reviewed.
The rules for people who leave schemes with fewer than 2 years service are changing. Members who leave with more than 3 months but less than 2 years service will have to be offered a transfer payment to another registered pension scheme as an alternative choice to a refund of contributions. This again will need to be considered by the employer.
Increases to Pensions in Payment
The Pensions Bill allows final-salary schemes to reduce the rate at which pensions in payment are increased from the current requirement of 5% p.a. to just 2.5% p.a. (or RPI if less etc etc) in respect of benefits built up after a certain date (which may be as early as 6 April 2005). But it’ll be a choice, it’s not automatic. The question of the mandatory provision of pension increases in retirement has been one of the thorny issues in this round of so-called reform. If you remember, back in the pre-Green Paper days the Pickering report suggested that mandatory increases to pensions should be dropped as they were just too big a cost for employers to underwrite. A kind of pensions bridge too far scenario if you like. Well, the watering down of the requirement for final-salary schemes has been complicated a bit by the fairly recent announcement from the DWP saying that compulsory increases (that are referred to as Limited Price Indexation, or LPI, by the way) will be removed entirely from money-purchase occupational schemes and personal pension schemes. This will be done by amendments yet to be made to the Pensions Bill as it goes through the parliamentary process later this year. At the moment occupational money-purchase schemes have to apply indexation to the contracted-out rights accrued between 1988 and 1997 and to all pension rights accrued since 1997. Whereas, for personal pensions (grouped personal pensions and grouped stakeholder pensions) indexation currently only applies to contracted-out benefits accrued since 1988. For people retiring from occupational money-purchase schemes and all personal pension schemes, after the law changes, there will be no requirement to index benefits at all (providing the scheme changes their rules). So, to recap a bit, some final-salary schemes will continue to provide LPI increases to pensions in payment at the current level of 5% p.a. or RPI (whichever happens to be the lower at any given time), whereas others will choose to limit the increases to the lower of RPI or 2.5% p.a. But for all money-purchase arrangements including personal pensions there will be no requirement to provide LPI increases at all. As I understand it that’s what a single tax regime is all about. Everyone’s treated the same and subject to the same rules, except where there are exceptions, obviously.
But, and as an aside really, employers and scheme trustees should be aware that some discretionary increases to pensions in payment after A-Day might fall within the definition of a “benefit crystallisation” event (something we used to refer to as ‘retirement’) and they will need to keep their wits about them to ensure such payments are properly described to pensioners. More on this subject later on when I’m going through the ‘provision of information’ stuff. No point going into all that at this stage, and anyway my head’s beginning to hurt.
As the rules on trivial commutation are changing schemes will need to decide whether to continue to offer trivial commutation. What’s going to happen is that pensions can only be ‘trivialised’ (if there’s such a word in this context) if the total value of all the pension savings a person (whether in payment or not) has is below the limit of 1% of the lifetime allowance at any time. In 2006 the triviality limit will therefore be £15,000 (1% of £1.5 million – keep awake at the back there!). Now, you’ll probably remember I wrote a Beeline about this a while ago pointing out that the Revenue guys had changed their minds on how this would work in practice so as to stop people setting up loads of little pensions and cashing them all in under the triviality rules. Well, where it’s ended up is that schemes will only be able to pay out cash for a trivial pension once they’ve ascertained what an individual’s overall pension holdings are. That doesn’t sound too easy to do in practice and may not seem as compelling to employers and trustees as simply saying “we don’t do trivial”, if you know what I mean.
Final-salary schemes with fewer than 50 members will not be allowed to pay pensions out of the scheme assets. Instead the trustees will need to secure benefits by buying annuities.
Also, on the payment of benefits front, trustees will have to be careful in future when they pay out death benefits from pension schemes. At present payments need to be made within two years of trustees being informed of a member’s death, but after A-Day this will change so that payments must be made within two years of the death occurring. Payments made after the two year deadline (no pun intended, really, even though I’ve been typing this thing for hours and it’s making my finger hurt) will be deemed to be ‘unauthorised payments’ and will be subject to a new tax of 40%. ‘Members’, of course, in this context includes people with deferred pensions in the scheme and keeping track of when they die is never going to be easy for trustees. I suppose if they don’t turn up for the annual pension scheme Christmas bash for a couple of years that could be a bit of a giveaway, but it’s a bit of a long shot if you’re relying on it. Trustees might want to put mechanisms in place to get things on a better footing - perhaps an individual pension audit carried out by a financial adviser to help members keep track of all their bits and pieces of pensions? Anyway, I wrote a BeeLine about this whole thing once called 'Taxing the Dead', or something silly like that. You could look that up if you need a bit more background.
From 6th April 2006 employers will be able to offer employees the flexibility to continue working after retirement age while taking part or all of their pension benefits at the same time. At present this is not allowed under the rules. It will be up to the employer to decide whether, and on what basis, this is offered. Once again, it’s not a right for the employee and scheme rules will need to be amended if the employer wants to offer it.
The decision to offer and implement a flexible retirement policy should be part of the wider process of preparing for the introduction of age discrimination legislation anyway. Over the coming months employers will have to review a number of employment policies – retirement being just one of them. At the same time employers and scheme trustees should make sure that any changes to the benefit structure of their schemes will be compliant with age discrimination legislation. This is due to come in from Europe in October 2006 as a kind of double whammy with the pension changes to keep HR directors busy. With two major pieces of legislation coming in within a few months of each other, retrospective pension laws and the enforced implementation of anti-ageist policies in the workplace, don’t ask me why but I’m reminded suddenly of the sergeant at the beginning of each episode of Hill Street Blues. It’s a jungle out there, that’s for sure.
Occupational money-purchase schemes will also be able to let members get involved in ‘income drawdown’ (on the same footing as personal pensions and stakeholder pensions) whereby they can draw a pension directly from the scheme’s assets rather than by buying an annuity. Previously people have been able to achieve this, but only by changing from the occupational regime to the individual regime first. I doubt you’ll be surprised to hear me say, though, that this also is not an automatic right for occupational money-purchase scheme members, but only becomes available if the employer changes the pension scheme to accommodate it.
From April 2010 the earliest age at which benefits can be paid out of pension schemes will increase to 55 from 50. It will be up to schemes themselves to decide how best to deal with this increase in the minimum age. It does mean
- A review of early retirement policy, and
- Setting a transitional policy designed to deal with the increase in the minimum age at which benefits can be taken.
This isn’t as easy as it first seems as companies will obviously have some people who may ‘just lose out’ on early retirement at 50, but planned well ahead it could be an issue employers will want to use to help their scheme members plan their retirement strategies.
Contributions to pension arrangements after A-Day, like scheme benefit structures themselves, will no longer bear any relation to existing legislation or the restrictions currently imposed. But again it will be for employers, trustees and scheme administrators to make the changes if they want pension scheme members to take advantage of them. For grouped personal pensions (GPPs) or the stakeholder pension subset of personal pensions (GSPs) this will mean that the age-related restrictions on annual contributions will be lifted. So, gone will be the concept of 17.5% of earnings up to the age of 35 or whatever, with carry-back sweep-ups possible, but only for MENSA members, and all that dumb stuff. Instead people will be able to pay up to £3,600 or 100% of their earnings (if that’s more) into their pension scheme every year if that’s what turns them on. Not only that but the 15% limit on member contributions to occupational pension schemes that’s been with us since the year dot is also going out of the window. There’s no reason why members of occupational pension schemes can’t pay 100% of salary to those schemes too, but once again, only if the rules are changed to allow them to do so.
Employers may also be able to pay up to £215,000 (depending on individual circumstances) into a pension scheme for an employee irrespective of what the employee is paid, with no tax liability on either the employer or the employee. To put that in Plain English, an employee on £7,000 a year could get a contribution of £215,000 paid into their pension pot by their employer in 2006, no questions asked. Woof! Now there’s something sexy to talk to people about.
Additional Voluntary Contributions
It’s no longer going to be compulsory for employers to offer occupational scheme members the facility to pay Additional Voluntary Contributions (AVCs). Employers, in conjunction with their advisers, will need to decide whether to continue offering members the flexibility to pay top-up contributions to the scheme or to some other type of employer-sponsored arrangement. But don’t forget that any changes in the arrangements for the future will mean a review of what happens to the existing arrangements too.
It’s worth saying, I think, that the new rules do offer greater flexibility in terms of overall scheme design and it may be that employers will wish to review the whole benefit structure of their schemes to take account of this. However trustees and employers will need to consider the impact of the (potentially) amended Section 67 of the Pensions Act 1995 when we finally see the Pensions Act 2004 later in the year. Section 67 is the bit that governs the restructuring of previously accrued benefits within schemes and has got caught up in the ‘far too tricky’ box at the moment. There’ll be plenty of BeeLines about this aspect of the changes later in the year as things get clearer, but for now you’ll need to be aware that not all scheme changes will be easy.
And now on to the next part …….
Scheme Audits: parts 2 & 3 - administration and communication
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.