UK: Family Wealth Management - Personal Financial Planning, Tax And Investment

Last Updated: 20 September 2010
Article by Paul Garwood

Foreword

Plotting your way around the austerity measures

The Coalition has clearly not wasted any time in its attempt to get a hold on the burden of debt left behind by the previous Government, with taxation increases and plans for swingeing cuts to public sector budgets.

The June Emergency Budget heralded a 20% VAT rate from January 2011. Plus there was the unprecedented decision to increase the capital gains tax rate for high earners mid-year, which will prove to be an administrative headache.

But it wasn't bad news for everyone. The increase in entrepreneurs' relief from the first £2m of lifetime gains to £5m will be a welcome boost for entrepreneurial activities. And in a popular move, the Coalition overturned the previous Government's plans to ditch the tax breaks on furnished holiday lettings.

As promised in the Conservative election manifesto, the Coalition has announced its intention to end the effective requirement to use a pension fund to buy an annuity by age 75. This new measure will be introduced from 2011/12. In the interim, those reaching 75 on or after 22 June will be allowed some breathing space enabling them to take advantage of the new legislation when it comes in.

We are now well into our first year of the 50% tax rate for those with income of more than £150,000. In this summer 2010 edition of Family Wealth Management we look at some tax efficient investment options for those looking to mitigate higher rates.

With the Conservatives' plans to increase the inheritance tax threshold now on the backburner, we look at ways to help you reduce liabilities.

The trend for investing in gold looks set to continue. We also look at short-dated bonds as an option for those looking to bridge the gap between income needs and low cash deposit rates.

Award recognition across the firm

Smith & Williamson Investment Management was named Best Growth Wealth Manager and Best Wealth Manager for Inheritance Tax and Succession Planning at the Investors Chronicle and FT Wealth Management Awards, 2010.

Eight people from Smith & Williamson were named among the leading accountants in the wealth management sector by Citywealth.

Our Private Client Tax department won the accolade Best High Net Worth Team at the Taxation Awards 2010.

Smith & Williamson has also been shortlisted for three STEP (Society of Trust and Estate Practitioners) Awards, including Investment House of the Year, Multi Family Office team of the year, and Independent Financial Adviser of the Year. The winners will be announced on 19 October 2010.

The Government announced in its Emergency Budget that from April 2011, the obligation to buy an annuity by the age of 75 will end.

Radical changes have been proposed to the rules requiring members of defined contribution pension schemes to purchase an annuity on reaching 75 on or after 6 April 2011. A consultation document has been published on the proposals to abolish the requirement entirely. But in the interim, transitional rules have been introduced, allowing members of registered schemes who reach 75 on or after 22 June 2010 to avoid buying an annuity until they reach 77. They will be able to take advantage of the new rules in due course, if they wish.

Transitional rules to 5 April 2011

The transitional rules affect individuals with a defined contribution pension scheme whose 75th birthday falls on or after 22 June 2010 and who, immediately before that birthday, have either:

a. an unsecured pension (USP) – also known as income drawdown

b. funds held in a pension that they have not yet drawn on.

PENSIONS AT - AGE 75 - GOODBYE TO OBLIGATORY ANNUITIES

Main impact of the changes

  • There is still a requirement for benefits to be drawn at age 75. The funds of individuals who do not take any action will be transferred into a USP, as opposed to an alternatively secured pension (ASP), the income limits and death benefits rules of which will apply to age 77.
  • The fund will still be measured against the lifetime allowance at age 75 and, if its value exceeds the lifetime allowance, a 55% tax charge will still apply on the excess.
  • The pension commencement lump sum must be taken within 12 months of reaching 75, subject to the discretion of the provider, and if it is not taken within that period it is lost.
  • Those reaching 75 in a USP can stay in it until age 77, subject to the discretion of the pension provider. As a result, should they die in the meantime, a lump sum death benefit will be available, subject to a 35% income tax charge.

Who benefits most from the changes?

The main beneficiaries of these changes are individuals reaching 75 on or after 22 June 2010 who are either already in a USP or who have not drawn down their pension benefits. The underlying fund will be protected for the next generation until age 77 and potentially until they die. However, those with smaller pension funds are still likely to purchase an annuity as this will be the only practical and cost effective option for them.

Pension providers

Although the new rules can override existing rules, it is important to note that pension providers only have to introduce them at their discretion, so don't assume they will do so.

What hasn't changed?

Rules relating to pension contributions and tax relief have not changed. In particular, as there is still a requirement for benefits to be taken at 75, relief would not be given on any contributions after an individual's 75th birthday.

The lifetime allowance remains in place and there are no changes to the rules dictating when pension funds must be tested against the allowance.

Further consultation

A consultation document was issued on 15 July 2010 proposing long-term changes to the annuity regime. It proposes that USP (income drawdown) continues beyond age 75, with any residual fund on death of the member being available as a lump sum subject to a tax charge of around 55%. This would not be liable to inheritance tax (IHT), although it has been made clear that new rules will not provide incentives for pensions to be used as IHT planning vehicles. At present, the tax charge on death before 75 is 35%, and after 75 it is between 70% and 82%.

Under the new rules it is proposed that the uncrystallised pension funds of those that die before 75 will not be liable to a tax charge, while there will be a 55% tax charge on death benefits in all other circumstances.

The level of income that can be withdrawn will still be capped but it has also been proposed that, if a minimum level of income has been secured to prevent individuals falling back on the state, this cap could be exceeded. The minimum level of secured income has not been specified at this stage.

The interim measures will provide some additional flexibility for certain individuals, but these are only temporary. There is still some way to go with the consultation process before the new rules are finalised and while, overall, they are welcome, there are practical and fairness issues which need to be clarified.

REFLECTIONS ON THE EMERGENCY BUDGET

A look back at what the Chancellor described as "the unavoidable Budget".

Much of George Osborne's first Budget was aimed at convincing the credit ratings agencies and the bond market that it was a credible fiscal deficit reduction programme that would stand up to global comparison. However, there were a number of practical measures to consider.

VAT to increase to 20%

The biggest Budget headline was the decision to increase VAT to 20% from January 2011. VAT has a number of advantages for the Treasury – it brings in large amounts of money quickly and it is collected at source by businesses who essentially do all the hard work. Although the postponement of the increase until the New Year provides time for inflation to drop from its current above-target level, the higher rate may make it difficult for the Bank of England to keep inflation within its 2% target.

Corporation tax

Mr Osborne announced a five-year roadmap for corporation tax aiming to improve the country's competitiveness globally to show the UK is "open for business". The reduction in headline corporation tax rates will be paid for by changes to the capital allowances regime, which will come in over the next couple of years. It means that relief can still be obtained but more slowly than before.

There will be a levy on banks' balance sheets from next January, with further consultation to come on a financial activities tax.

Income tax

The income tax personal allowance has been increased by £1,000 to £7,475, with the promise that it will rise to £10,000 over time. This is good news for many taxpayers, but of no interest to those with higher incomes whose personal allowances have been withdrawn.

Capital gains tax and entrepreneurs' relief

There was no precedent for changing capital gains tax (CGT) rates part way through a tax year, so it was a surprise that the increase for higher rate taxpayers from 18% to 28% took place from midnight on Budget day. Some gains attach to tax years rather than a date of disposal and special rules were needed to cope with those. It was a relief to see that there was no change in the CGT annual exemption for 2010/11 and the Budget Report indicated that this will be index-linked going forward. However, the FAQs posted on Budget day on the HMRC website suggested that there are no guarantees about CGT rates for future years.

The increase in the limit of lifetime gains on which entrepreneurs' relief is available, from the first £2m to £5m, will be a welcome boost to entrepreneurial activities. However it was disappointing that the scope of the relief was not widened. At present it is necessary to be an officer or employee and own 5% of the shares for the year up to disposal. The officer/employee test can catch out those who are planning their exit from the company in stages and the second test excludes many employees, particularly where an outside investor is brought in to the company.

Tax policy-making reform

For many years there have been concerns about the process for introducing new tax legislation and many examples of poorly targeted, badly drafted legislation rushed through the House of Commons without any real scrutiny. With that background it was pleasing to see that there is to be a consultation on a new approach to tax policy-making.

General anti-avoidance rule?

The introduction of a general antiavoidance rule (GAAR) is a possibility. We got close to having a GAAR in 1999, but the proposal foundered at the last minute due to the inability of the Revenue to resource a clearance system. Today, HMRC has even fewer staff, so it remains to be seen whether the GAAR will happen this time around.

THE FUTURE FOR TAX RELIEF ON PENSION CONTRIBUTIONS

Four years on from the 'pension simplification' reforms; rules of the game have changed.

For three years following its launch pension simplification ran smoothly. But then the Government realised it could not continue to give tax relief on sizeable pension contributions while tax receipts were falling.

In the spring of 2009 it was announced that there would be some radical changes to tax relief on pension contributions from 2011/12. Although, it was not until the March Budget of 2010 that the mechanics of these changes were announced and we realised that simplification was over.

For 2009/10 and 2010/11 we were given transitional rules which limit pension contributions for those earning £150,000 or more (including pension contributions) to the same level of regular (at least quarterly) contributions that they were paying as at April 2009; or £20,000; or £30,000 if their average pension contributions in the previous three tax years had been at least this amount.

These rules are complex and were tinkered with in December 2009 when the income limit was reduced from £170,000 to £150,000 (including pension contributions of at least £20,000). However, the rules proposed for 2011/12 looked totally unworkable for pension advisers.

New rules under discussion

Unsurprisingly, it was announced in the June Emergency Budget that the new rules planned for 2011/12 would be "simplified". This was closely followed by the publication of a discussion document on 27 July.

This document makes it clear that if the Government decides that its alternative approach meets its objective of reducing the tax relief given on pension contributions, it will replace the complex legislation that was enacted at the end of the last Parliament.

The document focuses on reducing the annual allowance (currently £255,000), the valuation of pension accrual within defined benefit schemes, limiting tax relief to a maximum of 40% and reducing the lifetime allowance, currently £1.8m.

It advocates a flat rate annual allowance for all of between £30,000 and £45,000 and a simple non-age adjusted flat factor of between 15 and 20 to convert defined benefit pension accrual into a contribution which can be measured against the annual allowance. Steps will also be taken to stop employers from granting extra deferred benefits which fall outside of this equation.

If the annual allowance is breached it is proposed that there would be a 'stepped' tax charge to recoup tax relief. This would depend on the quantum of the excess contributions over the annual allowance.

Proposed reduction in the lifetime allowance

Following a reduction in the annual allowance, it is suggested that the lifetime allowance also be reduced to £1.5m. This would be accompanied by the right to make an election, to protect those with funds exceeding the lifetime allowance when the change is introduced, although only up to the level of the value of the fund when the changes are made.

Finally, the proposal that higher rate tax relief on contributions be limited to 40% rather than 50% is also under review.

Less relief to high earners

The proposals are radical and will most definitely reduce the amount of higher rate tax relief given to high earners. They would also bring a large number of people with final salary schemes into charge to tax and it remains to be seen whether those affected will want to renegotiate their salary packages.

A lower lifetime allowance with another round of pension protection elections might be welcomed by advisers but will not benefit pension investors. Whatever comes out of the consultation, it is certain that high earners with final salary pensions will be lobbying hard against the proposals as they stand.

INVESTMENTS FOR A HIGHER TAX ENVIRONMENT

What can individuals do to avoid penal tax rates on their savings without resorting to outdated complex schemes?

We are now well into our first year of the 50% tax rate for those with income of more than £150,000, and the 60% tax rate for those with taxable income between £100,000 and £112,950, who have lost their personal tax allowance.

To avoid these rates, there are a number of tax efficient options open to most people, including tax reliefs and allowances, tax-free investments and tax shelter investments. Reliefs and allowances It is relatively unusual to find both husband and wife each with taxable income of more than £150,000. More often, one spouse does not have much taxable income at all.

A very simple and tax efficient way of reducing a family's tax rate is, therefore, to transfer taxable savings to the low or no income spouse. He/she can then use his/ her own personal tax allowances and basic rate tax bands to reduce their joint income tax rates.

Furthermore, both husband and wife have annual capital gains tax (CGT) allowances of £10,100 each for 2010/2011, which can also be used with simple planning.

Inter-spouse transfers of assets are not subject to CGT so assets can be transferred between spouses to ensure that each spouse's allowance is used. Before gains are realised, it's worth bearing in mind that capital gains are subject to tax at 18% in the hands of basic rate taxpayers.

Tax-free investments

Completely tax-free investments are limited now to Premium Bonds, National Savings Certificates (£15,000 per issue) and Children's Bonus Bonds (£3,000 per issue). Some collectors' items such as classic cars, coins and some personal chattels, depending on their value, are also exempt. Individual savings accounts (ISAs) are sometimes considered to be tax-free investments. However, withholding taxes on dividends cannot be recovered. For income tax purposes this means that ISAs are on an equal footing with other equity-based investments in the hands of individuals who pay tax at the basic rate. They are not subject to CGT when disposed of and the current annual ISA allowance of £10,200 should enable a couple to accumulate a fairly sizeable pot inside these vehicles over the years.

Tax shelter investments

Tax shelter investments tend to allow you to defer your tax liabilities until a later time as well as sometimes giving you a tax-free element. Typically, they roll-up free of all taxes until they are surrendered or encashed. The most typical are pension plans, insurance bonds and offshore maximum investment plans or endowments.

Insurance bonds

Like ISAs and pension plans, insurance bonds can grow free from all taxes if they are based in an offshore jurisdiction. However, UK-based insurance bonds will have their investment income and growth taxed as they go along at a rate of between 15% and 20% per annum.

'Tax-free' withdrawals of up to 5% of the original capital investment can be taken each year, and, to the extent that this allowance is not used in any one year, it can be carried forward.

They can be fully encashed at any time and have no fixed maturity date. Provided they are set up with multiple lives assured, investors can plan their encashments to coincide with lower tax rates.

Like pensions, offshore bonds can invest in the widest range of investment classes, generally through collective funds. It is a myth that they are expensive relative to other investments, although it is recommended that you do take proper advice on charging structures from someone who is fully conversant with them.

Pensions

Pensions are a good investment as they attract upfront tax relief, while the fund can grow almost entirely free of tax, and 25% can be withdrawn tax-free on vesting.

Maximum investment plans and endowments

Maximum investment plans and endowments are regular premium insurance policies. Provided premiums are paid for at least 75% of a ten-year term and they do not vary within specified limits, tax is limited to insurance company rates of between 15% and 20%. There is no further higher rate tax to pay on encashment.

Again, these investments provide access to a wide range of asset classes and expert advice should be obtained to ensure that you get the best terms available and the widest range of investment options.

Other tax efficient investments

Venture capital trusts, enterprise investment schemes, film partnerships, AIM stocks and timber are not considered to be part of a typical savings portfolio. They tend to be highly specialised investments used, in some cases, to take high risks on start-up companies or a basket of them, or to plan for inheritance tax. In future issues of Family Wealth Management we will take a detailed look at these types of investments. Also see the feature on commercial forestry later in this newsletter.

This is just a taste of some of the options available for avoiding the 50% tax rate. If you need more information about these or other tax efficient savings plans, get in touch with your usual Smith & Williamson contact or call one of the people listed on the back page. Some tax efficient investments carry a high risk that some or all of the capital invested could be lost. It is important to take appropriate advice before proceeding with such an investment.

GOLD SET TO SHINE OVER THE LONG TERM

Compared to previous cycles, gold has appreciated at a more measured and steady pace over the past nine years. Expect this to continue.

During the past few years we have seen a growing acceptance of gold as an asset class, driven by investment demand and central banks' net purchases. The recent change in central banks' attitudes can be viewed as confirmation that gold is being used as a hedge against currency risk and reserve management, which is key for its long-term valuation. For example, in late 2009, the Central Bank of India purchased 200 tonnes of the International Monetary Fund's gold. Central banks in China, South Korea and Taiwan are also considering increasing their gold reserves.

We anticipate demand from China to be another positive driver for gold in the years ahead. According to the World Gold Council, China accounted for approximately 11% of the world's gold demand in 2009 and this is expected to double in the next ten years. Recently, the Chinese Government relaxed the rules over its citizens owning physical precious metals. Furthermore, while China has been aggressively investing in its domestic gold mining industry, the country remains a net importer of gold.

In the past few months, there has been a heightened interest in gold from European investors who are seeking protection against the declining euro, caused by sovereign debt issues. In Germany and Austria, demand for gold coins has surged, as individuals flood local dealers to exchange their euros for bullion. In Abu Dhabi, demand is visible by the number of gold-dispensing ATMs that are appearing.

Despite the recent increase in demand, gold as a percentage of financial assets is at a fraction of previous levels when compared to previous peaks in 1969 and 1980.

Recently, gold has faced some volatility. This is due to the short-term strength of the US dollar compared to the euro, caused by Greece's sovereign debt concerns and anticipated instability in the rest of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The Greek saga and the recent downgrade of Spain have been the key causes of investors' concerns. These concerns can only be expected to increase if contagion spreads in the region, especially following the $1 trillion bailout in the eurozone to help support the euro.

Since the 1800s, the shortest gold bull cycle has been ten years. The current bull market for gold is only in its ninth year. We believe that, while it may be bumpy along the way, this will be an extended cycle because of heightened fiscal debt levels, conflicting stimulus easing measures and currency instability.

While we don't know the ramifications of current macroeconomic issues, one thing is certain: we haven't solved the major funding problems yet – we've just postponed them. As a result, volatility is likely to persist for some time. We believe the secular trend for gold remains positive, as concerns surrounding growing government debt levels, global geopolitical stability and currency debasement will translate into further investment demand.

SHORT-DATED BONDS STILL LOOKING ATTRACTIVE

Short-dated bonds can bridge the gap between income needs and low cash deposit rates for risk averse investors.

The UK base rate has been 0.5% since 5 March 2009. It could well remain at this level for some time because of the relatively subdued inflationary environment, and the possibility of more quantitative easing if the economy shows signs of further stuttering. Meanwhile the UK gilt yield curve remains in very similar shape to where it was this time last year.

Against this backdrop, one of the biggest investment challenges is to satisfy the demands of risk-averse investors looking to bridge the gap between their income requirements and cash deposit rates. Smith & Williamson first identified a possible solution to this in the spring of 2009 – investing in a portfolio of short-dated investment-grade corporate bonds. The yields available from these short-dated bonds are generally sufficiently greater than the base rate, and there is an opportunity, although not guaranteed, to potentially make modest capital appreciation via active management of the portfolio. A portfolio or fund of these bonds can, at the time of writing, achieve an income yield of around 3.5% after charges.

How it works

These corporate bonds are typically issued by companies as a means of raising capital. We focus our attentions on investmentgrade bonds, which are rated at BBB- and above by Standard & Poors, the ratings agency, where the quality of the company and its ability to pay the income (known as the coupon) is deemed to be relatively robust. The bonds also rank higher than the ordinary equity shares in the event that the company fails. Indeed, many investors would probably be very happy to hold the shares in household names who have issued short-dated bonds such as National Grid, Shell, France Telecom, BASF, Marks & Spencer, Nokia, Severn Trent, GlaxoSmithKline and First Group. There are also a number of companies that we consider for investment who choose not to have some of their bonds formally rated by credit ratings agencies, such as John Lewis, Carlsberg, Co-operative Group and Heineken. These issues from well-known companies will often offer higher yields because their bonds do not have an official rating.

Achieving a prudent level of diversification can be problematic for individual investors as many corporate bond issues require a minimum investment of £50,000 per issue. Investing in a fund ensures access to, and a sensible level of diversification across, numerous companies and sectors. Our fund currently holds some 60 separate issues.

So, in summary, investment grade corporate bonds are not a substitute for cash on deposit, and their capital values are not guaranteed, but they do represent an additional option for investors with income requirements as a possible complement to their cash deposits.

PENSION TRANSFERS IN AN UNCERTAIN WORLD

Should you consider transferring out of your defined benefits scheme?

Membership of a defined benefit (DB) pension scheme is still considered one of the most valuable benefits that an employer can offer. It is therefore not surprising that advisers, quite rightly, rarely recommend that employees either leave their current employer's DB scheme or transfer benefits that are preserved in a previous employer's scheme to a personal pension plan.

Benefits set up by an employer or former employer are calculated according to a formula that is detailed in the scheme rules, usually related to salary and length of service. As they are known in advance, members are not subject to either the annuity rate or investment risk inherent in defined contribution arrangements. Preserved pensions are also generally revalued between the date of leaving and retirement, giving some protection against inflation.

However, it would be wrong to make a blanket assumption that transferring these benefits to another pension plan would never be appropriate, without a detailed review of the individual scheme member's personal circumstances and the scheme.

DB schemes do not provide an absolute guarantee in terms of the amount of benefits they will pay, just a promise of future benefits. Therefore there could be reasons why some members might consider an alternative arrangement to be more suitable for them, especially those with higher remuneration and/or long service.

We review some of the factors that could have an impact on the decision to transfer existing defined benefits into a personal pension plan.

Pension Protection Fund

One of the factors that must be considered is the funding position of the scheme. Is it in surplus or, as is more likely in the current climate, is it running a deficit and, if so, what plans are there to make good this deficit? How likely is the scheme to remain open? Is it still accepting new members or imposing restrictions on accrual?

The promised benefits under a DB scheme are only really as robust as the sponsoring employer. Answers to these questions could give an indication of the likelihood that the benefits will actually be paid.

The previous Government established the Pension Protection Fund (PPF), which acts as a safety net for members of qualifying DB schemes. If there is a qualifying insolvency event in relation to the employer, and there are insufficient assets in the pension scheme, a level of compensation is paid to cover the promised benefits.

However, benefits under the PPF are set at only 90% of accrued benefits up to a maximum of £29,748.68 per annum. So, while a degree of legislative protection exists, members with higher pensions might find their pension benefits restricted if the sponsoring employer becomes insolvent.

Higher earners and tax on pension contributions

From April 2011, tax relief on pension contributions will be restricted, probably by a lower annual allowance. This change could present particular issues for DB scheme members receiving promotions or significant pay rises. Such changes may increase the value of their pension contributions to above the revised annual allowance, or subject them to tax charges to recoup excess tax relief. The resultant tax charge would then either have to be paid by the member via the self-assessment process or, possibly, out of the scheme, thereby reducing the members' benefits. The previous Government proposed that the current conversion ratio of 10:1 used to measure the annual allowance equivalent variable, age-related ratio. However, the discussion document published by the Treasury on 27 July says that such tables might be too complex to administer and proposes a non-age related conversion factor of between 15 and 20. This would bring a large number of DB schemes members into the scope of a charge to tax on excessive annual contributions, so it needs to be considered carefully.

Minimum revaluations in deferment

The Coalition Government has already announced that future minimum revaluations of both deferred benefits and pensions in payment will be based on the consumer prices index rather than the retail prices index. As this would reduce the cost of funding pension schemes, employers and trustees are likely to adopt it. This reduction in future revaluation might result in members with deferred benefits seeing a future reduction in their cash-equivalent transfer value.

Encouragement to transfer

Incentivised transfers are an option used by employers keen to encourage members to transfer away from DB schemes. While these 'incentives' appear to make such a transfer more attractive to the scheme members, a good financial adviser will still start from the premise that any transfer away from a DB scheme is unlikely to be in the members' interests. If you are offered such an incentive, it is important to obtain detailed personal advice from a suitably qualified adviser.

Death benefit considerations

In light of inheritance tax limits there is a case for members with larger estates to make use of trusts when dealing with the potential death benefits available from their pension plan. These can be considerably easier to arrange via an individual pension arrangement.

Increasing interest rates?

A member who has already decided to transfer away from his/her DB scheme may find it harder to do so in the future if interest rates increase. This is because it's likely to increase the 'critical yield' required to match the benefits on the transferred amount. Furthermore, increased critical yields will generally make them more difficult to justify. While critical yields are only one factor to take into account when considering a transfer of benefits, they are an important indicator of the additional level of risk that the scheme member will have to take in order to match the benefits foregone.

No more commission

The impending Retail Distribution Review will remove the ability for financial advisers to receive a commission payment from product providers when, for example, arranging the transfer of pension benefits. Advisers will have to agree their remuneration in advance with the client, thereby providing flexibility and transparency for the client, who can be certain that the advice to transfer benefits is being driven by what is most suitable for individual circumstances and not the level of commission the adviser might receive.

Single members

Members without beneficiaries might consider a transfer into an individual plan within 12 months or so before retirement as DB schemes' transfer values will generally make allowances for spouses or other dependants' pensions, even though such extras will be of no benefit to the single member.

It is still rare to advocate a transfer away from a DB scheme and a good adviser will always work from the premise that such a transfer would not be in the interests of a scheme member. However, where a member could be impacted by one or more of the above-mentioned factors, it is at least worth a discussion to see what they could gain or lose by transferring benefits elsewhere.

PENSIONS AND DIVORCE

Top ten points to consider about a pension for anyone getting divorced

For those going through a divorce, it's critical to seek proper financial and legal advice. Here's some food for thought.

1. Pensions will be part of the assets to be divided

After their house, pensions are usually the second most valuable asset a couple will have accumulated. They are taken into account with other assets when estates are divided.

2. Large contributions during separation can be included

Continuing to make contributions to a pension during the divorce can still be a valid financial planning strategy. However funds can't be hidden this way. As large pension contributions will create a moving target for the lawyers to settle on, consider delaying them until after the divorce.

3. Pensions cannot be treated in the same way as other more liquid assets

Pensions have their own rules and cannot be divided as easily as other financial assets, such as houses, share portfolios or ISAs.

4. Pension sharing orders

Pension sharing orders are the most effective way to split pensions as part of the divorce process. They offer the possibility of a clean break – dividing the pension between the parties, allowing each to have a separate arrangement in their own name.

5. Pension attachment orders

Pension attachment orders are usually a less popular alternative providing for a proportion of the pension income to be paid directly to the ex-spouse at retirement. Although very useful in certain circumstances, they do have limitations and potential drawbacks.

6. Not all pensions are the same

Public sector pensions, trust-based defined benefit occupational schemes, personal and stakeholder pensions all have different rules. Each type of scheme will need to be considered separately when deciding how to share pensions during a divorce.

7. Consider equality of pension income in retirement

A pension sharing order, providing equality of pension income in retirement, is deemed the fairest way to share although it will depend on other factors.

8. Equality of pension fund values

Another option is to share the capital value of the pension funds, although this can be unfair if trying to reconcile defined benefit (final salary) pension schemes. Not all pension fund values fairly reflect the actual value of the pension benefits built up and if there are sufficient other assets, offsetting the value of the pension funds could be considered.

9. Talk to your lawyer

If you have substantial pension assets it is vital to discuss your options with a good lawyer who understands the pension issues at the same time as you considering other matters.

10. Obtain an independent pension report

It is sensible to obtain an independent pension report from a pensions expert who understands the issues and can provide practical solutions. A correctly drafted report by a suitably qualified expert can be helpful and used in court if needed.

OWN A FURNISHED HOLIDAY LETTING PROPERTY?

Take advantage of the rules while you still can Now is the time to make the most of your rental property.

The furnished holiday letting (FHL) rules covering tax rental income on qualifying lettings in the UK and EEA countries* allow losses to be set off against other income and gains. The Labour Government planned to abolish the rules from April 2010, but the draft legislation was left out of the Finance Bill following pressure from Conservative and Lib Dem MPs.

Proposed changes

The new Government has confirmed that the special regime for FHLs will continue, but has published a consultation paper proposing changes from April 2011. We expect the changes to be enacted more or less as proposed, as follows.

  • The minimum annual letting period to be extended from 70 days to 105 days.
  • The minimum annual availability period to be extended from 140 to 210 days.
  • Losses on a UK FHL business will only be off-settable against future profits from the same UK FHL business.
  • Losses on an EEA FHL business will only be off-settable against future profits from the same EEA FHL business.
  • Changes to be made to the way capital allowances are calculated when a property alters its status as a qualifying FHL from year to year.

The Annual Investment Allowance (AIA) was increased to £100,000 for 2010/11 and 2011/12, but will then reduce to £25,000, while entrepreneurs' relief was first increased to £2m from April 2010 and then to £5m from June 2010.

FHL businesses will usually qualify for the AIA so will be able to claim a deduction for the full cost of their expenditure on items such as new furniture, kitchens, electrical installations and computers up to £100,000. If the business makes a loss, the owner will be able to set it off against other income and gains in the year of the loss and the previous year. The expected changes from April 2011 may restrict loss relief so now is a good time to do refurbishments.

The gain on the disposal of a FHL may qualify for entrepreneurs' relief, resulting in a 10% rate of CGT rather than 28%. The rules are complicated but it is possible that the relief will be available if you sell up to three years after you cease to carry on a qualifying business.

Rules to qualify as a FHL for 2010/11

  • The property must be actually let for at least 70 days a year (ignoring lets exceeding 31 days).
  • It must be available for letting for at least 140 days a year.
  • Lettings of more than 31 consecutive days in the same occupation must not exceed 155 days per year.

The main benefits of having a FHL

  • Losses may be set against other income and chargeable gains of the current year and previous year (subject to changes from 2011/12).
  • Losses of a new FHL business can be carried back three years against other income (subject to changes from 2011/12).
  • The business should qualify for capital allowances, including the AIA, currently £100,000.
  • Profits are relevant earnings for the purpose of calculating maximum pension premiums.
  • Gains on the disposal of a FHL business may qualify for entrepreneurs' relief to reduce the rate of capital gains from 18% or 28% to 10% on gains of up to £5m.
  • Gains on the disposal of a FHL property can be rolled into the acquisition of a new business asset.
  • Gains on the gift of a FHL property can be held over.

*EEA countries include all EU countries plus Norway, Iceland and Liechtenstein

FORESTRY INVESTMENTS BRANCHING OUT WITH YOUR INHERITANCE TAX PLANNING

Inheritance tax planning becomes a priority for many people once settled into retirement. We consider the benefits of investing in commercial forestry.

Once retired and comfortable in the knowledge that they have sufficient assets to meet their own needs, many people's minds turn to the needs of the rest of the family and avoiding a 40% inheritance tax (IHT) charge on hard-earned assets.

Although there is the option of making gifts, the older one gets, the more chance there is of dying within seven years of making that gift and incurring an IHT liability.

There are assets, such as AIM portfolios, which are IHT exempt once owned for a minimum period of two years. Despite the IHT saving, these have declined in popularity since the credit crunch. Another option is commercial forestry, which has many attractions, particularly as demand for timber from emerging economies increases.

Statistics suggest that population growth, combined with rising GDP per capita, is closely correlated to timber consumption in developing economies and paper consumption increases as disposable income increases.

According to FIM Services Limited, a specialist in this area, due to the remoteness of many of the world's forests and the associated costs of access, as well as environmental considerations, demand for more accessible timber is likely to continue to increase, driving overall prices upwards. China's forest coverage, at around 18%, is roughly half the world average, and, per capita, at 0.13 hectares per person, is one fifth of the world average. Furthermore, China's usage of groundwood timber is, per capita, around 5% of consumption in the US and about 17% of global average. While some of the demand will be met by internal deforestation, as GDP per capita continues to increase in China, paper consumption is forecast to continue to rise rapidly.

How does this help IHT planning?

Timber has always been a highly tax efficient investment. In the 1980s it was possible to obtain loss relief for expenses incurred in the early years of a commercial forest while avoiding income tax in later years as the timber was felled and sold. This was a particularly effective tax planning tool and eventually the Government at the time decided to take commercial forestry out of the tax net altogether. There is therefore no income or capital gains tax (CGT) to pay on any profits realised from investments in commercial forests. However, gains arising from disposal of the land will still be liable to CGT.

Commercial forests are structured so that they will qualify for 100% business property relief from IHT after two years of ownership. Forestry investments tend to be long-term projects of up to 20 years although liquidity can be provided if required.

If you have young children, you could purchase an interest in a commercial forest as a nest egg for their future. Once it matures, you can transfer it to your children without any IHT implications. If you are concerned about making gifts and surviving for the requisite seven-year period, commercial forestry is an option, as, after two years, it falls outside the IHT net.

Such investments require an understanding of the liquidity and investment risks and should only form part of your portfolio. However, with demand from developing economies increasing all the time, they are worth more than a passing interest.

OUTLOOK - AUGUST 2010

World – Europe's window of opportunity

Markets have witnessed a significant rotation in expectations over the last few weeks. While the US has posted a sequence of weak industrial and consumer surveys raising concerns of a potential double-dip recession, the eurozone (led by Germany) has produced a series of robust data. The admission from the Federal Reserve chairman Ben Bernanke that the US is facing a period of 'unusual uncertainty' and that the Fed had considered the reintroduction of quantitative easing has compounded the view that the US has been losing momentum relative to Europe.

The euro has been a big beneficiary of this reversal in sentiment, rising by almost 9% against the dollar from the lows of early June. The euro has also benefited from a decline in risk aversion as fears over a systemic seizure of the banking system dissipated. The announcement to undertake bank stress tests (even though the test requirements were not particularly rigorous) were psychologically important and produced the desired result of reducing peripheral market bond yield spreads relative to German bunds and getting the interbank market functioning again.

While the US economy is hitting a weak patch the risk of a double-dip recession looks overstated. Instead the US is adjusting to a lower trend growth trajectory. Europe is undoubtedly enjoying a window of opportunity provided by the decline in the euro earlier in the year and strong export driven growth. The clear risk is that export markets start to weaken and the austerity measures sap domestic demand in peripheral Europe. In 2011/12 the US should have superior growth differentials to Europe which suggests the rally in the euro will not be sustainable.

Recent Q2 corporate earnings announcements have, on balance, been better than expected. This reflects continued margin expansion (cost containment) rather than improvements in revenue growth. Corporate balance sheets and free cash flow remain strong, providing scope for an acceleration in merger and acquisition activity. While equity markets have rallied in response to the recent earnings announcements it is important from a valuation perspective that analysts start to upgrade their 2011 earnings in order to allay fears that earnings have peaked this cycle.

UK – beginner's luck – stronger than expected growth

What a difference a quarter makes! The first GDP report released under the tenure of the new administration was much stronger than expected, registering 1.1% QoQ growth for Q2 compared with market expectations of 0.6% and Q1 growth of 0.3%. While the surprisingly strong growth was distorted by a suspiciously strong surge in construction spending and will probably be subsequently revised lower, the UK economy appears to be in a stronger position to absorb the impact of the forthcoming fiscal contraction.

Another consequence of the GDP growth report could be the attachment of greater credence to the view of Andrew Sentence (a Monetary Policy Committee (MPC) member) that interest rates need to rise because the UK is running a much lower than assumed output gap. However, the rest of the MPC maintain the view that inflationary expectations will subside as fiscal consolidation starts to kick in, and have even considered the prospect of restarting a quantitative easing programme, the quantum of the Q2 GDP recovery will test their resolve. The key to the determination of monetary policy will ultimately rest on whether this is seen as a one-off blip in growth or the beginning of a sequential shift in the growth trajectory. The MPC will need to see confirmation of at least another strong quarter before they reverse monetary policy.

The equity market has rallied from the lows established in early July. An important contributor to this move has been the rebound in the BP share price as confidence grows that the gulf oil spillage has been staunched and that they will make sufficient asset sales to fund the clear up and compensation costs. Aggregated corporate earnings per share have plateaued over the last few weeks and need to inflect upwards to lend support to a market that has seen its 12-month forward fall to 10x having been at 12.3x at the start of the year.

INHERITANCE TAX PLANNING AND BUSINESS PROPERTY RELIEF

Alternatives to lifetime or exempt gifts.

The most common way of mitigating an IHT liability is through lifetime or exempts gifts, including the following.

  • Potentially exempt transfers (PETs) – exempt provided the donor survives seven years from the date of the gift, with taper relief applying after three years to reduce the IHT liability.
  • £3,000 annual exemption.
  • £250 small gifts exemption.
  • Gifts in consideration of marriage (the amount depends on the relationship with the bride and groom).
  • Normal expenditure out of income. This is theoretically any gift, provided it is out of excess income, it is regular or habitual and does not affect the donor's standard of living.

These methods can be unattractive as they require an outright gift to be made. Many individuals do not want their beneficiaries to inherit property immediately, while others do not want to lose control of their assets in case they need them in the future. Furthermore, relief for PETs is only given in full seven years after they are made.

In recent years there has been an increase in planning, which addresses this loss of control together with other issues including liquidity, capital protection and potential problems in obtaining adequate life insurance cover.

Such planning focuses on agricultural property relief or business property relief, which both provide IHT relief after just two years. These investment vehicles are typically structured as partnerships and the investments generally involve business financing with risk mitigation strategies, such as asset-backed investments or secure revenue streams.

Investors can often choose to receive an income which may depend on investment returns, or to retain funds to roll up within a tax efficient structure.

In addition, there is often the ability to withdraw capital if necessary, and while this would prejudice any IHT benefit it can provide flexibility in the event of a future change in circumstances. Many of these investments are not directly correlated to the stock market and can also provide diversification in your portfolio, as well as an effective form of IHT planning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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