Scheme Audits: parts 2 & 3 - administration and communication
Changes to the way pension schemes will be administered
A number of new requirements will come into force on 6th April 2006 regarding the way that records will need to be kept and affecting the timing of payments out of pension schemes. I mentioned one of the latter in Part 1 when I was explaining the way that death benefits will need to be paid out within two years of the date of a pension scheme member’s death if the payment is to count as an ‘authorised’ payment. As I’ve said before the penalty for making an ‘unauthorised’ payment is that such payments will become subject to a new tax at the rate of 40%. Or to put that another way – Ouch!
Well, it’s not just the payment of death benefits that will be treated this way I’m afraid. Something similar will also apply to the payment of tax-free lump-sum benefits on retirement. It looks like any payments that are not made within three months of the date that the pension becomes payable (the ‘retirement date’ in today’s jargon) will be treated as unauthorised payments too and the cash sum will lose its tax-free status! Not only that, but such late and unauthorised payments will be subject to 40% tax even if the pensioner is not a 40% taxpayer. In case this is the first time you’ve heard about that I’ll leave it for a second while it sinks in. OK? Right, so late payments of tax-free cash after A-Day won’t be remedied in the time honoured fashion of saying “sorry about that!” and adding a bit of interest. Oh no. It’ll take a bit more than that I think. It will have to be someone’s fault for a start. But whose fault, the trustees, the employer, the pension provider, or maybe all of them? To me this and other aspects of this new stuff all points to the increasing importance of administration of pension schemes after A-Day.
So, by now I hope I’ve said enough to get you to see why I’ve been going on about how crucial administration issues will be in our future pension environment. There are other new ‘record keeping’ requirements too that will need to be understood and implemented from day one of the new regime if individuals, employers and scheme administrators are to have a hope in hell of getting things right over the longer term.
The two main issues relate to new record-keeping requirements for all registered pension schemes regarding the ‘lifetime allowance’, particularly as people ‘crystallise’ their benefits. Basically what all this nonsense means is that every time someone uses up some of their various pension funds to buy a pension or provide some kind of income the administrators of that pension arrangement need to tell them what percentage of their ‘lifetime allowance’ they’ve used up while doing it. That then hangs around their neck for the rest of their time on Earth so that others can check that they’re not going over the lifetime allowance when they ‘crystallise’ other benefits later on. This all comes down to a number of things I’ve said before, it’s all leading to much of the responsibility being placed on the individuals themselves.
A silly example might help. Say someone retires by getting a pension from their personal pension savings, but doesn’t bother to retire from the company pension scheme they’re in at the same time, neither do they choose to retire from the deferred bits and pieces of company scheme pensions they’ve got hanging around either. Let’s say this happens in 2006 while the lifetime allowance is £1.5 million and the amount of money in the personal pension fund used to buy the pension is £300,000. The administrator of the personal pension scheme would then need to record that 20% of that person’s lifetime allowance had been used up by that ‘crystallisation event’ (with a copy to the person crystallising), so that future crystallisations could take that into account. Let’s say this person then crystallises again in 2010 when the lifetime allowance has gone up to £1.8 million. At that stage, with the 20% knocked off for the previous crystallisation event, the amount of leeway left for other tax-free crystallisations would be 80% of £1.8 million, namely £1.44 million. So if the next crystallisation uses up less than £1.44 million then that relevant percentage is clocked up on the permanent record, but if it goes over the £1.44 million figure the crystalliser gets hit for tax on any excess. This tax is called the ‘lifetime allowance charge’ just in case you’re interested (or even still reading). Well, there you have it, all explained in just one paragraph. Lord knows why the Government guys needed to write so many pages about it. Should’ve spoken to me first really, would have saved a lot of time and effort.
Many have been saying that this whole idea of recording crystallisation events against a lifetime allowance that increases in value over time is going to be more than a little fiddly. It’s in mega-fiddly territory really, particularly compared to where we are now, particularly as it presumes some impressively homogenous approach will be adopted by all those involved in pensions in the UK that will make it possible for the wall of new information to flow freely around the place. It’s also going to be confused more than a tad depending on whether people ‘buy’ annuities, or if ‘scheme pensions’ are provided for them. If people purchase an annuity or go into income drawdown, then the amount of their pension funds used doing that will be related directly to the lifetime allowance at the time (as in my little example above). But if a ‘scheme pension’ is provided for them then the ‘value’ of the benefits being provided will be ‘calculated’ using a conversion factor of twenty to one irrespective of the age of the person the pension is being provided for (so a pension of £10,000 a year would be valued at £200,000 for the purposes of knocking it off the lifetime allowance even if it actually cost more than that for the scheme to provide the pension). Now if all of this works like clockwork it’ll be brilliant, but I’d say that level of co-operation from the various interested parties on the UK pension scene would be pretty much against the run of play. Hopefully I’m wrong on that, but the sharing of information won’t be helped I think by the fact that the whole concept of what’s going on is so very very hard for normal people to get their heads round. I mean for a ‘simplified’ regime this looks more than a bit on the complex side to me and maintaining a record of crystallisation events probably doesn’t have that kind of feel about it that makes me confident it will come near the top of most peoples’ priorities. It’s got ‘get a life’ written all over it really, hasn’t it?
Anyway, that’s not even the half of it. Administrators will also have the new idea of an ‘annual allowance’ to get to grips with. The annual allowance is the maximum amount of tax relievable pension saving in any single year, and exceeding it (I know, you’ve guessed it already) puts you into tax territory. The annual allowance in 2006 will be £215,000 and it, like the lifetime allowance, will increase over time. Pension schemes will need to record each year how much of the annual allowance has been used up during the tax year for every single member.
Now, for a money-purchase scheme this is pretty straightforward, it is basically the amount of contribution that has been put in by the employee and the employer between them. Interestingly it doesn’t include any increase to the money-purchase fund because of positive increases in the investment return, which is nice. People won’t find they’re being taxed on their contributions because their investments have had a good year.
For final-salary schemes it’s not quite so straightforward. What will happen with them will be that the increase inthe ‘value’ of an individual’s pension benefit will be calculated (in this case using a factor of ten to one, rather than twenty to one) and that increase in value will be compared to the annual allowance to see if it’s over the top or not.
Again, just like the recording of crystallisation events, the percentage of the annual allowance used up for individuals will have to be tracked and recorded so that people can’t get away with it by simply joining masses of schemes. Fair play, but a toughie I think for those involved in administration and managing the flow of information. Once again this is information that individuals will require for their self-assessment tax forms.
Now there are many other bits and pieces I could include under this header, including the recent suggestion from the Revenue that special administrative requirements should be in place for anyone over half way to the lifetime allowance, but I’ll call it a day here and get on with writing about some of the new communication stuff that’s about to hit on A-Day if you don’t mind.
Changes to the way pension schemes will need to communicate with their members
Now, apart from all the usual communication issues that pension schemes are involved in already (such as annual benefit statements and the like), the new tax regime after A-Day will give rise to a whole load of other information requirements that will need to be provided by schemes. You will, I hope, have got the idea by now that the chances are many schemes will change the way they provide pension benefits. Even if they don’t change, I think schemes will probably have to change the way benefits are designed anyway as the legislation providing the rationale for the current way of configuring benefits will no longer exist. So, in a nutshell, the chances are things will change in all schemes and these changes will need to be communicated to members in good time.
In practical terms there’s more to all this for employers and trustees than just talking things through and getting their heads around the new options. At the same time all documents relating to the scheme – or anything that defines the pension promise – should be examined – for example
- Scheme Booklets
- Announcement Letters
- Contracts of Employment
- Service Agreements.
It is important to understand what has been promised in the past and to consider the impact of the new regime on benefits going forward, particularly I think where such promises have been made to individuals by personal letter or as part of their contracts of employment.
It is important too, as I’ve said before, that every piece of pension saving that is used to provide a pension income (a so-called crystallisation event) is described properly to members in relation to the amount of their lifetime allowance it has burned up. This seems too obvious to mention where people are retiring and all their benefits are being purchased at once, but it is worth noting that discretionary increases to pensions made by trustees from time to time could also be classed as ‘crystallisation events’ and will need to be both recorded and communicated to pensioners too. It’s not too hard to see that the change in the rules that knocks out in-built pension increases (the LPI stuff I was going on about earlier) could give rise to an increase in the use of discretionary increases. The point I’m making here is that such discretionary increases after A-Day will come with their own baggage on the reporting and communication fronts.
Also, the changes to the records that schemes will be required to keep that I went through in section 2 of this BeeLine will probably have to be made available to scheme members too. It will be important for individual members to know where they stand from time to time in relation to the contribution and lifetime allowances. Employers may want to look at the whole way they communicate ongoing information with scheme members after A-Day and it would probably be better if they start thinking about that sooner rather than later.
Communicating information to employees, though, may be one of the key areas that employers and trustees might want to focus on at this stage. One obvious area where this would appear to be crucial is the communication of details of how the new tax of 55% will apply to the existing pension pots of highly-paid employees. That’s not to say that employers or trustees should venture into the realms of giving advice to individuals, far from it. But the provision of information about the effect of the impending changes seems a good first step to individuals being enabled to protect themselves from this new tax should they choose to do so.
To hammer home the point one more time there really needs to be effective communication between employers and trustees and with scheme members to ensure a smooth transition to the new regime. Again, there is also a requirement for employers to review all current communication materials.
And now on to the next part …….
Scheme Audits: parts 4, 5 & 6 - transitional protection
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.