Pensions the new tax regime

The Finance Bill 2004 contains legislation that will lead to major changes in the taxation of pensions. The measures in the Bill, which are to be supplemented by a raft of regulations, are due to take effect from 6 April 2006 (christened A-Day), two years later than originally proposed. The changes have been subject to an extensive consultation process which started in December 2002. Along the way there have been many subtle revisions to the Inland Revenue's first proposals. The reforms now due to be implemented will affect both new and existing pension arrangements in a number of very important ways.

Whether you are within two years of collecting your pension or have several decades to go before your working life ends, you need to be aware of the changes as they could alter the way you plan for retirement. Indeed, if you are due to retire before A-Day, the reforms might even prompt you to defer retirement until after A-Day.

The key to the Inland Revenue's approach is the introduction of a single new pension tax regime to replace all the existing approved regimes, including retirement annuities and unapproved pension schemes. While there will be many transitional arrangements, the existing pension regimes will disappear. The Revenue says that the result will be to reduce eight sets of pension rules to just one.

For the vast majority of pension scheme members, the changes will make pensions much simpler and easier to understand. A small minority, estimated initially at 10,000, will be affected by the proposed lifetime allowance.

Probably the easiest way to understand the proposed new structure is to examine its key components and then consider the transitional arrangements that will apply.

In place of the existing earnings cap (£102,000 in 2004/05) you will be entitled to accumulate a maximum total amount of £1.5 million in tax-favoured pension funds. The Inland Revenue claims that the £1.5 million is broadly equal to the cost of providing maximum occupational scheme benefits for a 60 year old with earnings equal to the earnings cap. However, this is only on the basis adopted by the Inland Revenue, which has chosen a 20:1 factor for converting cash to pensions (£1.5 million = £75,000 x 20). If you were to buy the corresponding £75,000 annuity from an insurance company, you could expect to pay around £2 million at current rates.

If you are in a DC pension arrangement, the lifetime allowance will simply apply to your total pension fund. If you are in a DB scheme, your final pension will be converted to a fund, for the purpose of checking against the limits using the 20:1 conversion factor.

The lifetime allowance (LTA) will rise in stages to £1.8m in 2010/11. Thereafter increases will be determined by the Treasury, probably for five yearly periods. The fact that the allowance will initially increase at a rate faster than expected inflation will limit the increase in the number of people affected by it. However, if after 2010 the allowance only rises in line with prices, it could hit a growing proportion of the workforce. There are two reasons for this:

• Earnings rise faster than prices over time, and
• The cost of providing pensions will rise as people live longer.

If you have a fund of more than the LTA when you take your benefits, the excess will be subject to a 'lifetime allowance charge'. If you take the excess as cash, the charge will be 55%.

The lifetime allowance charge is be reduced to 25% if you use the excess to provide additional retirement income. However, since this income would itself be subject to income tax (probably at 40%), the likely overall effective tax rate would remain at 55% - 25% plus 40% of (100 less 25).

The lifetime allowance charge makes overfunding pensions a tax-inefficient option - although it is less than the 60% proposed in the first round of consultation. However, it could be difficult to avoid overfunding. For example, if your pension fund were to grow rapidly in the last year before you drew benefits, you could find that the Inland Revenue might take 55% of much of the growth.

Your pension arrangements will be subject to a total annual tax-relieved contribution limit of £215,000 in addition to the lifetime allowance. This contribution ceiling will rise by £10,000 a year to £255,000 by 2010/2011. Thereafter increases will be determined by the Treasury, like the lifetime allowance.

The £215,000 annual allowance (AA) is the combined amount that you and any employer can contribute to your pension during a year. As an employee or self-employed person, you can contribute the greater of £3,600 or 100% of your earnings (up to the annual allowance), with tax relief. Your employer can make up the balance to £215,000 and will gain automatic tax relief, subject to the normal Taxes Act rules on allowable expenditure.

For active members of final salary (defined benefit) pension schemes, the contribution will be calculated as the increase in value of the employees' pension benefits during the course of the year. The Inland Revenue will value accruing benefits on a 10:1 basis in place of the 20:1 ratio used at retirement.

For deferred members - ie those who have benefits in a scheme that they have left - it is only the increase over and above inflation-proofing (or 5%, if greater) that counts as a 'contribution' for these purposes. So deferred scheme members will not be caught by the annual limit unless their prospective pension benefits (after inflation adjustment) increase by more than £21,500 in 2006/07 (£21,500 x 10 = £215,000).

For members of money purchase pension arrangements (including personal and stakeholder pensions), only the contributions made by the employer or employee in the scheme year will count. Any investment growth (or loss) in the value of the fund will be ignored.

If the total contributions to your pension exceed the annual allowance, you will be subject to an annual allowance charge of 40% under self-assessment on any excess contribution from your employer. If you make a contribution that exceeds your personal limit, any tax relief granted on the excess (eg by paying contributions net of basic rate tax) will be clawed back.

In either case, the contributions will remain within the pension arrangement and so you could face a further tax charge when they came to be used to provide benefits. Exceeding the AA - whether personal or total - is therefore tax-inefficient and best avoided.

There is one occasion when the annual allowance will not apply. That will be any year when you take benefits in full from a pension arrangement. This relaxation prevents the limit from biting if the value of your benefits were to jump because you retired early on favourable terms or took early retirement because of ill-health.

In practice, the annual allowance is much more generous than the current contribution limits for all but the highest earning members of occupational pension schemes. For example, the maximum annual contribution to a personal pension (if you were born before 7 April 1943) is currently £40,800 (ie 40% of the £102,000 earnings cap).

The concept of a normal retirement age will disappear, as will the current constraints on drawing occupational benefits while still remaining employed. However, from 6 April 2010, there will be an increase from 50 to 55 in the minimum age at which you can draw benefits. Occupational scheme members who have a contractual right to retire before age 55 that was in existence before 10 December 2003 will retain their rights. Members of pension schemes with low retirement ages (eg sportspeople) will also keep their right to retire early in respect of existing benefit, subject to certain conditions.

The general limit for tax-free cash when benefits are drawn will simply be 25% of your accumulated fund for any pension arrangement, including Protected Rights - ie funds built up from contracting out of SERPS and/or S2P. Additional voluntary contributions (AVCs) and free-standing AVCs will provide tax-free cash directly, which is not normally permitted under the current rules.

There will be no cash ceiling on the amount of tax-free cash, other than the initial £375,000 stemming from the maximum 25% of the £1.5m lifetime limit. This will be a large increase over the occupational pension regimes introduced since 17 March 1987, that currently restrict the maximum tax-free cash to around £150,000.

If you have joined an occupational pension scheme since 17 March 1987, you should gain from the 25% of fund proposal, unless the total contributions made to the scheme are relatively low. In contrast, under the current rules, the tax-free lump sum will be the equivalent of only 15%-20% of the accumulated fund for a member of a typical final salary scheme, building up pension at a rate of 1/60th for each year of service, according to one estimate. Similarly, in virtually every case, there will be an increase in the maximum cash you could draw from a retirement annuity (the predecessors of personal pensions). However, pension schemes and providers will not be obliged to pay the new maximum tax-free cash sums and it is possible that some will retain their old basis within their specific scheme rules, provided it does not breach the new 25% limit.

The downside of the change is that it will mark an end to the scope for occupational schemes to fund mainly or solely for cash. In addition, many of the defined contribution schemes recently established to replace final salary arrangements will pay out less cash, because their average employer contribution levels are only about 6%. At such modest contribution levels, the current tax rules can allow more than 25% of the fund to be drawn as cash.

The maximum death benefit payable before retirement benefits are drawn will be a lump sum equal to the lifetime allowance. All the complex salary-related constraints that currently apply to occupational schemes will disappear. If, at death, the total amount available turns out to exceed the lifetime limit:

• Any excess paid as a lump sum will be subject to the 55% lifetime allowance charge, payable by the recipient(s) of the monies.
• But any excess used to provide dependants' benefits (eg annuities) will not be subject to a lifetime allowance charge.

In theory, survivors' pensions can be provided instead of any lump sum under the lifetime limit, but it is hard to see why this option would be chosen below the lifetime allowance unless dependants' benefits were a requirement, eg under contracting-out rules or scheme rules. A tax-free lump sum will provide more flexibility and, if income were required, the capital can always be used to acquire a purchased life annuity, which has tax advantages over its pension counterpart.

At present many occupational schemes, particularly final salary schemes, offer dependants' pensions and a lump sum on death-in-service. Under the new regime, such schemes will be under pressure to pay only a (larger) lump sum.

There will be four different methods of drawing income from your pension arrangements:

• Scheme pension payments are pension payments made directly by occupational schemes with 50 or more members. Death benefits after retirement can either take the form of traditional guarantee periods of up to ten years or 'pension protection' (also called capital protection). Under pension protection, the maximum lump sum payment on death before age 75 would be the original annuity purchase price, less gross income payments made, less a 35% tax charge. Alternatively, final salary pension schemes will be able to offer a tax free lump sum as if the pensioner were still an employee. Lump sum payments will not be permitted on death after age 75 .
• For occupational schemes with less than 50 members, a scheme annuity cannot be paid directly from the fund, but can be paid by an insurance company.
• Lifetime annuity payments are pension payments made by authorised insurance companies. These are subject to the same death benefit options as scheme pension payments.
• Unsecured income, which is only available from money purchase schemes, includes withdrawals directly from a pension fund. Annual income under the unsecured option can be drawn from your accumulated fund at any level between:

- £1 a year, subject to any higher minimum imposed by the Department for Work and Pensions; and

- 120% of what you can obtain from buying an annuity on the open market. This is broadly equivalent to the maximum limit that currently applies under existing income withdrawal rules.

Pension fund withdrawal will still be subject to regular reviews, but reviews will only have to be five yearly rather than the current review period of every three years (although it might be prudent to have more frequent reviews). One rule that will not change is the requirement to stop fund withdrawals on this basis by age 75. At that age you will either have to buy a lifetime annuity or switch to alternatively secured income (see below).

As an alternative to fund withdrawals, part of the fund could be used to buy a fixed annuity for a maximum term of five years (but not beyond age 75). The maximum income would be the same 120% of what an open market annuity would provide.

Death benefits before age 75 would be the same as apply to pension fund withdrawals now, ie a return of the remaining fund on death, subject to a 35% tax charge. Alternatively, the whole fund could be used to provide dependants with pensions or continued withdrawals.

. Alternatively secured income (ASI), which is only available from money purchase arrangements, will be a new option. This will be a restricted form of pension fund withdrawal only available from age 75. ASI was originally proposed to meet the needs of certain religious groups that have ethical objections to annuities, but in practice it is likely to become regarded as a restricted means of extending income drawdown beyond age 75. The maximum ASI withdrawal will be only 70% of what an open market annuity can provide and reviews will be annual.

Funds remaining on death must in the first instance provide pensions for dependants. If there are no dependants, then the funds may be transferred to a nominated charity or pass to another nominated member of the pension scheme. In either case there would be no tax charge.

Investment

The new regime will remove most of the current restrictions on pension scheme investment. All schemes will be subject to the same investment rules and the special rules for small self-administered schemes (SSASs) and self-invested personal pensions (SIPPs) will disappear, as will the requirement to have a pensioneer trustee.

There will also be a tightening of the rules in some areas:

• The total holding of shares by a pension fund in a single sponsoring employer must not be 5% or more of fund value, compared to the current 50%.
• Loans to employers, other than in the form of bonds issued on the open market, will have to:

-Not exceed 50% of the value of the fund at the date the loan was granted.

- Be secured as a first charge on assets that will initially have a value at least equal to the loan. Subsequent falls in value are permitted, provided this is not the result of actions taken by the employer or connected persons.

- Charge a minimum interest rate to be set out in regulations (expected to be equal to the Corporation Tax Self-Assessment rate - currently base rate plus 1%).

- Normally last for no more than 5 years, during which time they will be repaid by equal annual instalments. However, it will be possible to roll over loans for a further five year period if the employer is having difficulties in meeting payments due.

. Loans to a pension scheme will be limited to 50% of the scheme assets at the date of drawing the loan.

The Inland Revenue has made it clear that residential property will be an eligible scheme investment. However, there will be new benefit in kind tax rules to deal with situations where you benefit from your pension scheme investment, eg by living rent-free in a house owned by your personal pension fund. Nevertheless, this could open up some interesting new planning opportunities.

Unapproved schemes (which will be renamed employer-financed retirement benefit schemes) will not receive any tax privileges under the new regime. For what are currently funded unapproved retirement benefit schemes (FURBS) this will mean:

• You will not be taxable or subject to NICs on employer contributions.
• Your employer will not receive any tax relief for their contributions until you have started to receive benefits.
• Investment income and capital gains within the fund will be liable at a rate of 40% (32.5% for dividends). Capital gains have been taxable at 40% since 6 April 2004 under general trust taxation reforms.
• All benefits will be liable to income tax, but will normally be NIC-free.
• Death benefits will be potentially subject to IHT.

If you are a member of an unfunded unapproved retirement benefit scheme (UURBS), the situation will be as now. Your employer will receive tax relief on benefit payments and you will pay income tax on them.

Unless any transitional reliefs are used, neither UURBS nor FURBS will count towards the lifetime or annual allowances, nor will they be subject to any lifetime allowance charge.

Not all vestiges of the old regimes will disappear immediately on 6 April 2006 (A-Day), although the Inland Revenue has said that its pensions reform will replace eight existing sets of tax rules with just one. There is a raft of transitional arrangements that will apply to people's rights and benefits acquired before A-Day. These include:

If the value of your benefits and rights on A-Day turn out to exceed the lifetime allowance, you will have three years from A-Day in which to register them with the Inland Revenue. Such rights can be protected in one of two ways:

• Primary protection The value of your A-Day rights will be revalued in line with the rise in the lifetime allowance. Any excess over this amount at the time of drawing your benefits will suffer a lifetime allowance charge.
• Enhanced protection You will have to cease active membership of all your pension arrangements before A-Day. All benefits (calculated on the pre A-Day basis) will then be free from a lifetime allowance charge. If you choose this option, you can switch to primary protection at any time after A-Day and before your 75th birthday.

Enhanced protection will also be available if your A-Day fund is less than the lifetime allowance. In practice, it may be hard to see why anyone would initially choose primary protection, but remember that enhanced protection is only an option if you accrue no further benefits from your pension arrangements before A-Day. For money purchase arrangements, this means no further contributions and for final salary schemes it means no further pensionable service, although increases as a result of salary rises are permitted, subject to certain restrictions.

If you were a member of an occupational scheme on 10 December 2003 and before that date you had a contractual right to retire under the age of 55 years (eg if you were made redundant), your right to early retirement will be unaffected by the move to a minimum retirement age of 55 in April 2010. This transitional relief only applies to occupational scheme members' benefits, so it provides no escape for those with personal pensions or stakeholder pensions, which currently permit retirement from age 50 onwards. The Finance Bill confirms that the right must be contractual and that if early retirement is at the trustees' discretion (as is often the case), then the age 55 minimum will apply.

The transitional reliefs for the tax-free cash sum are among the most complicated.

Assume that on A-Day you had accrued a tax-free lump sum benefit of more than 25% of the value of your fund. When you draw your benefits, the pension scheme will be able to provide you with:

• The lump sum accrued before A-Day increased in line with the increase in the standard lifetime allowance,
• Plus 25% of the fund accrued after A-Day.

This situation will generally only apply to occupational schemes and buy-out (s32) policies. Other pension arrangements, with the exception of a limited number of retirement annuities, cannot currently provide more than 25% of the fund.

Where you have the right on A-Day to take a tax-free lump sum benefit of not more than 25% of the value of your fund, but over 25% of the standard lifetime allowance (ie tax-free cash of at least £375,000 in 2006/07), then that amount would also be protected, provided it were registered no later than three years after A-Day. The method used will depend on which form of lifetime limit protection you chose:

• Primary protection The pre A-Day lump sum will be increased in line with the lifetime allowance up to when benefits were taken.
• Enhanced protection Your lump sum will be the same percentage of your fund at retirement as it was at A-Day.

If you had funds over the lifetime allowance at A-Day and at that time were entitled to over 25% of the fund as a lump sum, either of these options can apply. This could result in a lifetime allowance charge being levied, which you might be able to reclaim in whole or part.

Investment

Pre A-Day investments in SSASs and SIPPs will be subject to transitional protection.

This will mean that they could remain, even if they were outside the rules of the new regime. However, if there were to be a change after A-Day in the terms of a loan made by a scheme before A-Day, the whole loan will become subject to the new rules.

If you were a member of a FURBS and were taxed on your employer's contributions as they were made, then the lump sum benefit accrued before A-Day will be protected. The lump sum available at A-Day is increased in line with the RPI to the date that benefits are drawn. The IHT benefits will also be protected in respect of pre A-Day funds. However, the new higher rates of tax on investment income and gains will apply from 2006/07. Within three months of A-Day, UURBS can be consolidated into a registered (formerly approved) pension scheme without the value transferred counting towards the £215,000 annual allowance (although it would ultimately count against the lifetime allowance).

From a planning viewpoint, the delay in implementation of the reforms is welcome, as it provides some breathing space for necessary actions to be considered and put into effect. There are many points that need to be reviewed during that period. For example:

If you are due to retire before the new rules begin, it could pay you to defer your retirement. If you wait until after A-Day:

• The tax-free cash from your main scheme could turn out to be higher under the 25% of fund basis, if you are a member of an occupational scheme. You might also be able to draw tax-free cash from AVCs and FSAVCs.
• You might be able to enjoy more flexible benefits under the new rules. For example, the unsecured income route will allow you to take all your tax-free cash entitlement, but initially only draw a £1 a year income.
• If you decided to buy an annuity with your pension fund, you will be able to opt for pension protection.
• If you are a member of a final salary scheme, you may be able to receive higher post-retirement lump sum death benefits.

One difficulty is that many pension schemes are unlikely to allow their members to take advantage of all of the options permitted by the Inland Revenue's reform. For example, in some schemes unsecured income might not be available and final salary occupational schemes might not be prepared to offer 25% tax-free cash from 6 April 2006. Experience from previous legislative changes points to a reluctance among many pension scheme providers and trustees to incorporate changes that would add to their administrative burden. This is an area where regulations due to emerge later this year may force the more reluctant schemes to act.

If you are due to retire after the new rules come into force, some of the areas that you need to consider are:

. Is investment within pension plans the right retirement planning strategy for you now?

The annual allowance makes it possible to delay the start of pension contributions until much nearer retirement than is currently possible. This will be especially the case as there will be no annual allowance ceiling in the final year before drawing pension benefits in full .

Some experts have suggested that the right strategy now will be to use other savings vehicles initially - such as individual savings accounts (ISAs) - and then apply their value as fund contributions when retirement nears. This will provide greater flexibility because the funds would not be locked in a pension plan until a later date. However, outside an ISA, the strategy might be less tax-efficient and runs the risk that future changes in legislation or personal circumstances could limit the scope for last minute contributions.

. How should you top up the retirement benefits from your employer's pension scheme?

After A-Day, it will make no difference how you decided to top up your retirement benefits, because the same tax rules would apply to all pension arrangements. However, in practice not all top up arrangements are likely to offer all the flexibility that the new rules should make possible. For example, in-house AVCs would be unlikely to offer an unsecured income option or investment in residential property.

• Should you change your pension investment strategy? The more relaxed investment rules will allow you to change the investment structure of your fund, for example, by the fund borrowing to invest in residential property. In contrast, you might prefer to sacrifice potential investment growth in return for lower risk if your pension fund were close to the lifetime allowance, in order to avoid the lifetime allowance charge.
• If your fund is close to the lifetime allowance, should you opt for enhanced protection before A-Day?

Enhanced protection would mean that if your fund grew to over the lifetime allowance, you would not suffer any lifetime allowance charge. However, it would also mean that you would have to cease active membership of all schemes, although you can revoke the enhanced protection option at any time before age 75.

. Do you need to fill an income gap before age 55? If you want to retire before age 55, but this would be after 5 April 2010, you could not look to your pension arrangements to provide you with an immediate replacement income without any transitional protection. You might therefore need another retirement investment to bridge the gap before you could draw on your pension plans.

. How should you draw retirement benefits? Just because you will be able to draw 25% of your fund as a tax-free lump sum will not mean you should automatically do so. At present, the factors used by many final salary schemes to convert pension to cash fail to reflect the pension's true value. Strange though it may seem, a taxed pension can be better value than a tax-free lump sum.

There are some difficult choices to be made if the total value of your pension funds at A-Day are over the lifetime allowance.

• Should you or your employer make further contributions before A-Day? The immediate answer to this appears to be yes, provided your pension scheme will not be overfunded as a result. However, on closer examination you will need to take care, because the extra contributions can end up just buying extra taxable pension or a taxable lump sum, because of the way the transitional relief operates.
• What transitional protection should you opt for? Within three years of A-Day you must register your funds with the Inland Revenue and opt for either primary protection or enhanced protection. Enhanced protection will be the obvious choice, because it will protect all your funds from a lifetime allowance charge and still leave you the option to select primary protection at a later stage, should you want contributions to be resumed, for example because of a fall in fund values when you near retirement.
• What should you do about any funded unapproved schemes (FURBS)? The tax rate on gains and income within FURBS will rise from 6 April 2006 - the rate of tax on gains has already increased - so you should review the plan's investment approach. It could make sense either to withdraw funds and invest them personally.
• How should you and/or your employer fund for your retirement? Employer contributions to FURBS after A-Day will be less attractive than they are currently, because the employer will not benefit from immediate tax relief and then all the benefits will be taxable as income. You and your employer will need to consider alternative remuneration strategies, for example share incentive schemes or simply increased pay that can fund tax-efficient personal investment, eg via venture capital trusts (although, by coincidence or otherwise, the 40% tax relief now available will disappear on A-Day).

If you are an employer and have pension arrangements for your employees, the pension tax reforms could have a major impact on this aspect of your remuneration structure:

• How should you deal with those affected by the lifetime allowance? Some of your most senior, and longest serving, employees could find that it makes no sense for further pension contributions to be made on their behalf after A-Day. This will raise complicated issues of redesigning remuneration strategy, because shorter serving but equally senior employees may not be immediately affected by the lifetime allowance.
• What should happen to existing pension arrangements? In the new pensions world, the same tax rules will apply to all pension arrangements. This will not mean that all pensions schemes will have to provide the same benefits, but will raise awkward questions about how far the changes should - or must - be made in the light of the tax reforms. In some instances, the reforms might prompt a total review of retirement provision. The sooner you start to think about the impact of the reforms, the better.
• How should you communicate the changes to employees? Many employees will be largely unaffected by the reforms, particularly those who are members of group personal pension or stakeholder arrangements. Others will be winners, able to draw more tax-free cash, while some will be losers, with a reduction in their prospective tax-free cash. The message of the changes needs to be communicated clearly and early, because employees close to retirement might find they want to change their retirement date.

The reforms described above are still at Finance Bill stage and could alter by the time the legislation is passed and final regulations emerge. This possibility and the complexities of transition from eight pension regimes to one mean that you should get advice before taking any action. Even with the extra year's grace before A-Day, the timescales involved are relatively tight, so initial advice is best obtained as soon as possible.

This guide has been written for the general interest of our clients. It is therefore essential to take advice on specific issues. We believe the facts are correct as at April 2004 but there may be certain errors and omissions for which we cannot be held responsible.

ALAN NEDAS ASSOCIATES

MEMBERS OF NATIONAL REGISTER OF FEE BASED INDEPENDENT ADVISORS REGULATED BY THE FINANCIAL SERVICES AUTHORITY CONSUMER CREDIT LICENCE 471954