Two long-awaited pensions consultation papers were published late last year. One of them, entitled Simplifying the Taxation of Pensions, will have far reaching consequences for high earners.
The new rules will come into effect from ‘A-day’, 6 April 2005. For executives, the most important features of the proposed new regime are as follows:
- Annual Contributions/Increases in Benefit Entitlement "The Annual Limit"
For a money purchase (or ‘defined contribution’) pension scheme, any amount can be paid into the scheme without adverse tax consequences, provided that the member does not pay in more than he earns, and provided that the total contribution in any year (member’s plus employer’s) does not exceed £200,000.
For final salary (or ‘defined benefit’) pension schemes, the increase in value of an individual’s benefit entitlement from one year to the next is similarly limited to £200,000 before incurring tax charges.
- Benefit Limits "The Lifetime Limit"
The paper proposes the introduction of a ‘lifetime limit’, initially set at £1.4m, which equates to a pension today for someone aged 60 of around £65,000 pa. An individual will be permitted to take benefits (cash and/or pension) with a capital value of up to this lifetime limit without adverse tax consequences. The limit will apply to the capital value of an individual’s total benefits from all pension schemes.
Although it is proposed that these limits are set initially at £200,000 and £1.4m respectively, they will be indexed to keep pace with inflation. We interpret this to mean that they will be indexed each year in line with the RPI or some other index.
- Tax Treatment
Provided the limits above are not breached, the tax treatment of pensions will remain broadly unchanged. However, if either the £200,000 annual limit or the £1.4m lifetime limit is exceeded, then there will be new tax charges. This is where the problems lie for high earners.
How the Annual Limit works (Final Salary Scheme)
To see how this works, consider a 55 year old executive earning £200,000, who has been a member of a pension scheme for 15 years. Suppose the pension scheme provides a pension at retirement of 1/45th of salary for each year of membership.
If a year later his salary has increased to £220,000 then the pension accrued would increase. The capital value put on this increase would be perhaps £250,000, which exceeds the £200,000 limit. The individual would then be taxed on the ‘excess’ of £50,000 as if it had been paid as a benefit in kind.
In this example, the salary increase leads to a decrease in the net pay!
Breaching the Lifetime Limit
If an individual draws a pension (and/or a cash sum) with a value exceeding £1.4m then the excess funds will be subject to a 1/3rd tax. The remaining 2/3rds of the excess will then be taxed as income. This is the case even if part of the benefit is taken in the form of a lump sum. Assuming a 40% marginal tax rate, the result is that a total tax charge of 60% will be applied to the proceeds of any funds in excess of £1.4m limit.
Current rights and expectations
The Government has recognised that there is an issue for individuals who already have built up large pension rights at A-day. They therefore propose that, for those who have existing pension rights worth more than £1.4m, the value of their existing rights will be substituted for the £1.4m limit, and in this way what they already have built up will be protected.
Problems for High Earners
As we have seen above, the £200,000 annual limit can be a problem for high earners. However, the lifetime limit is likely to be more significant.
The first problem concerns future retirement provision for those executives who already have pension rights in excess of £1.4m. For these cases, because of the tax charge, it makes little sense to accrue further pension benefits. Consequently existing remuneration packages may well need to be renegotiated. Similar issues will face executives who have not yet breached the £1.4m limit, but who are approaching it.
The second issue relates to indexation: suppose the limits only increase in line with the RPI. An executive with a money purchase fund greater than £1.4m at A-day will effectively suffer a 60% tax charge on future real investment returns (ie on growth over and above inflation) even if no future contributions are made. Similarly for final salary schemes, if the pension rights have a value of more than £1.4m at A-day, then the increase in the value of the benefit due to future salary awards above inflation will be taxed.
Unapproved benefits: FURBS and UURBS
Under the proposals in their current form, future opportunities for high earners in approved pension schemes will be severely limited and it is therefore natural to turn to unapproved arrangements - FURBS and UUBS. The Inland Revenue have considered the position of FURBS and UURBS under the new regime but unfortunately have not yet come to any conclusions.
It is possible that FURBS will continue outside the new regime but whether or not new contributions will be allowed is unclear, as is their future tax treatment. Until the position regarding FURBS is clarified, it might be prudent to consider a moratorium on further contributions. (It cannot at this stage be ruled out that in future the proceeds of contributions to a FURBS could be taxed even though the contributions themselves have not benefited from any tax relief.) Similarly, decisions relating to setting up new FURBS could be postponed.
It is hoped that unfunded promises will still be permitted for providing top up benefits outside the lifetime limit without incurring tax consequences. If so then the UURBS might well form an important part of the solution for executives in the future.
The future?
The Simplification paper certainly does what it says. However simplification can come at the price of fairness. Although the paper is at consultation stage, from talks we have had with the Inland Revenue, the main features will not be changed. Furthermore, the message being put out is that Ministers will not listen to responses aimed at introducing a little more fairness if this leads to extra complexity. And it looks like any unfairness will land squarely in the lap of high earners.
No doubt some details will change and hopefully the picture will become clearer by October 2003 when we enter the second consultation period (at which time draft regulations should be available). However from what we have seen so far, there is certainly food for thought for high earning executives.
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.
