On 9 December 2010 the Treasury issued further draft and updated legislation regarding a number of pension-related matters. A radical shift in pensions thinking, led by confirmation of the removal of the need to purchase an annuity by age 75 years.
The changes to tax relief and the reduction in the annual and lifetime allowance means that the maximum annual tax advantageous contribution is now £50,000 and the maximum lifetime allowance is restricted to £1.5m. However, for those with funds already exceeding £1.5m there is transitional protection such that investors will be able to apply for a 'personal lifetime allowance' provided he/she stops accruing benefits before 6 April 2012.
'Alternatively secured pension' has now been removed and, in a clarification of terminology, 'unsecured income' is now once again known as 'drawdown'. Although the need to annuitise by the age of 75 years has been removed, 75 remains a pivitol year for many of the changes. The key changes include the following.
- The changes will become effective from April 2011.
- The level of capped drawdown will be limited to 100% (previously 120%).
- A tax charge of 55% will apply on death for drawn funds, unless there are no dependants and it is paid to a charity.
- There will be no tax charge on death for undrawn funds until age 75 years where it will become 55%, unless there are no dependants and is paid to a charity.
- Pension commencement lump sums (taxfree cash) can be paid at any time after age 55 years even past age 75 years.
- Where an individual can satisfy the minimum income requirement of £20,000 per annum, he/she may take any level of income from his/her flexible drawdown arrangement. In short, where investors can generate an income of £20,000 per annum from state pensions, lifetime annuity, scheme pension or overseas pension payments they are free to use the balance of their fund broadly as they see fit, in a pensions context that is.
Broadly speaking, the draft legislation delivers what was expected and overall the changes bring welcome clarity to many areas of pension retirement income. Well, that's clear then isn't it?
The Treasury announced its formal proposals for restricting pensions tax relief from April, and it's better news than we were all expecting.
We don't yet have the complete picture, but the main changes proposed by the Treasury for pensions tax relief, which will come into force in April 2011 are set out below.
The annual allowance will be reduced from £225,000 to £50,000 from 6 April 2011. This applies to everyone, not just high earners.
The method of valuing defined contributions will remain the same: the total of employer and employee contributions to an arrangement, excluding any investment growth.
PENSIONS TAX RELIEF: A SLIGHT SURPRISE
By Peter Maher
The method of valuing defined benefits for annual allowance purposes will be a fixed rate multiplier of 16 – as opposed to the current multiplier of 10 – meaning that a £1,000 increase in annual pension benefit is now treated as being worth £16,000, instead of £10,000. Broadly speaking, annual increases in pension benefits are measured by comparing the value of the pension which would have been payable at the start, and end, of the year. Deferred members will be exempt, and the Government also says that it will include an allowance for revaluation of accrued rights for active members.
In addition, the carve-out from the annual allowance, which currently applies in the year the benefits are taken, is to be abolished, although there will be exemptions for serious (terminal) illhealth and death. There will be further consideration of an exemption for other cases of 'major' ill-health. However, the Government has rejected calls for further exemptions for redundancy or for members claiming enhanced protection.
There will be a new facility so that, where a member does exceed the annual allowance in any given year, unused allowance from up to three previous years will be available to offset against excess pension savings. It is hoped that this will mitigate the risk of members on lower to moderate incomes being caught by oneoff 'spikes' in accrual. Carry-forward will be available against an assumed annual allowance of £50,000 for the tax years 2008/09, 2009/10 and 2010/11.
Any benefits above the annual allowance would not be taxed at a fixed rate, but at a rate tailored to recoup the full marginal rate income tax relief that the member has benefited from.
Lifetime allowance changes
The lifetime allowance, the maximum level of benefits that a member can draw from all registered pension schemes without incurring penal tax charges, is currently set at £1.8m, but is to be reduced to £1.5m.
However, the Government is minded to do this only from 6 April 2012, recognising that before then it needs to consider ways of protecting individuals who have already made saving decisions based on the higher existing level.
Helpfully, the 'trivial commutation lump sum' will be de-linked from the lifetime allowance so that the maximum will remain £18,000, rather than fall to £15,000.
EBTs and EFRBS
The Government has stated that employee benefit trusts (EBT) and employer financed retirement benefit schemes (EFRBS) are to be "no more attractive than other forms of remuneration". The draft legislation for the Finance Bill 2011 is designed to ensure that income tax and national insurance contributions (NICs) on employment income are not avoided or deferred through the use of trusts or other intermediaries, including EBT's and EFRBS. This is in keeping with the changes to the pensions tax regime from April 2011.
The legislation will have effect on and after 6 April 2011 and apply to rewards which are earmarked for an individual employee or otherwise made available on and after that date. In addition, anti-forestalling provisions apply to the payment of sums and the provision of readily convertible assets for the purposes of securing the payment of sums (including loans) where the sum is paid or the asset is provided between 9 December 2010 and 5 April 2011 where, if paid or provided on or after 6 April 2011, they would be caught by the legislation.
The changes in child benefit and its removal for higher rate taxpayers may have a significant effect on a number of employees. A possible solution would be to offer employees salary sacrifice for pension contributions.
A RETURN TO SEVENTIES-STYLE SAVING - THE RESURGENCE OF MIPs
By Stephen Baker
MIPs were popular during the high-tax environment of the 1970s and 80s as an alternative for retirement planning. As we now face a similar climate, perhaps it is time to take another look at these policies?
During a period of high taxation the maximum investment plan (MIP) as a non-controversial savings vehicle could be a valuable addition to the suite of taxfavourable investment products and may help investors manage their affairs in a tax-efficient way.
Broadly speaking, a MIP is a regular savings policy where the investor effectively exchanges his/her tax rate for that of the underlying insurance company. This will typically pay an average rate of tax, i.e. income and CGT combined, of 16% to 18% on the underlying investment funds. With tax rates up to 50% the attractions are clear and the first of a new breed of MIPs is now available.
How do MIPs work?
Under the contract the investor has to pay contributions into the plan for a minimum period of ten years, although after seven and a half years the plan can be encashed with no personal tax liability for the investor. After the ten years the investor is able to gradually draw down the accumulated fund, again with no personal tax liability. This can create a stream of income to help support you in retirement or be used to finance other liabilities such as school fees.
One drawback is that most of the MIPs currently available on the market suffer from 1980s-style charging structures, making them much more expensive than other, modern investment products.
However, some leading insurance providers aim to produce a new product, which will break the mould. The intention is that there will be a suite of underlying investment funds to which the contributions can be linked, run by the major fund management groups such as Fidelity, Invesco Perpetual and Blackrock. As longer-term regular savings arrangements, market timing of investment is less of an issue, and investors could elect to pay contributions monthly to maximise the effects of pound-cost averaging. These arrangements are flexible and could be assigned into trust for the next generation if, ultimately, all or part of the funds are not required.
Could an employer fund a MIP?
Employers could fund a MIP for senior employees should they wish. From a tax point of view this would be tax relievable as a business expense for the employer but the employer would be liable for employer's national insurance. From the employee's point of view this would be treated as taxable under PAYE and subject to employee's national insurance.
The tax situation is clearly not as favourable as a pension but at a time when the ability to make tax relievable pension contributions is being restricted it is an alternative which offers the opportunity to obtain a capital sum, or income at maturity with no tax consequences at maturity.
MANAGING DB PENSION SCHEMES - AN INDEPENDENT APPROACH
By Chris Murray
The closure of most private sector DB schemes presents trustees and employers with problems, including rising costs and less relevance as an employee benefit, but there are ways to reduce costs and improve service.
Due to rising longevity, increasingly rigorous regulations and escalating scheme costs, the majority of private sector defined benefit (DB) pension schemes are no longer admitting new members. However, many are still open to existing members; this impacts on the trustees, employers and members in various ways.
Employers and the trustees of DB schemes face increasing servicing and regulation costs and other financial pressures arising from lengthening life expectancy. This problem is especially true for DB schemes of up to £50m.
Many of these schemes were originally set up with various insurance companies, and since then the trustees have transferred the administration and actuarial services to large employee benefit consultancies for administration and actuarial services while the insurance company has retained the funds for investment. Generally, this has led to higher servicing costs and limited investment management.
Furthermore, for some members they are a source of financial concern. They could feel locked into a career with their current employer offering a generous DB scheme, which will probably not be replaced if they change jobs or move to another employer.
Smith & Williamson offers a comprehensive approach to help resolve the issues faced by employers and trustees of DB pension schemes. We bring together individuals from our pension consultancy and investment management disciplines to deliver a complete solution.
Pension consultancy services
Our team of professionals offers an independent approach, securing administration and actuarial services efficiently and at potentially lower cost to the scheme.
Investment consultancy services
We provide an independent investment consultancy service to bridge the gap between trustees and investment managers. Our active investment advice can help reduce the volatility of a scheme's financial position and potentially improve investment returns.
Working with the trustees and scheme actuary we formulate, establish and review an appropriate investment strategy that reflects the scheme's changing liability profile and the current market conditions and opportunities
We also provide performance measurement and manager review services and regularly report to and meet with investment managers. Our advice is tailored, ongoing and independent, with no conflicts of interest.
Using specialist fund managers for each asset class, rather than one or two fund managers with a generalised approach, provides a multi-asset, multi-manager approach to investment management. This can help to maximise returns for a stated level of investment risk.
TAKE ADVANTAGE OF HMRC CONCESSIONS BEFORE IT'S TOO LATE
By Julia Ridger
The five-year grace period that began on 6 April 2006 (A-day) is drawing to a close on 5 April 2011. As either a trustee or employer of an occupational pension scheme, you should ensure you have made the most of these special concessions.
Concessions making it easier to amend schemes in line with the new tax rules that came in to effect on A-day run out in April 2011. Originally, following A-day, the transitional concessions managed two significant changes.
1. Keeping pre-A-day HMRC benefit limits in place for schemes that want some or all of the limits to apply indefinitely.
2. Removing restrictions on scheme alteration powers that require HMRC approval.
The transitional concessions fall away in April and if pre-A-day HMRC benefit limits are not expressly re-incorporated into the scheme rules they will be lost.
Your scheme may have already dealt with this by doing an amending 'A-Day deed'. You should check where your scheme stands. If you have any concerns we can put you in touch with one of our preferred legal advisers to address this issue.
Before A-day, amending a scheme without HMRC approval put its tax exemptions at risk. Some schemes incorporated this requirement as a restriction on their alteration power. Since A-day, approval is neither required nor possible. There was concern that a restriction which could no longer be satisfied would render all future amendments invalid. There is also a question whether an alteration power can be used to amend itself.
Recent regulations allow schemes to remove this restriction before April and you should check whether your amendment power has the restriction or whether it has been removed. If you need help in identifying this please contact us.
Pension deadline extended until 5 April 2016 for refunding pension surplus
Refunding a surplus under a DB scheme may seem highly unlikely to occur now, but who knows what may happen in the future. Surpluses arise under defined contribution (DC) schemes where employer contributions have been retained in the scheme as a result of short service benefit.
The Pensions Act 2004 included a transitional power of alteration to help schemes that might otherwise have lost their power to refund surplus. However, it was drafted very widely and applies to any payments that might be made to an employer, not just refund of surplus (e.g. routine administrative payments such as reimbursement of expenses) and it also applies to schemes in wind up. The pensions community raised these issues with the DWP during last summer.
The DWP has now expressed its intention to amend Section 251. It's not clear how it will be changed but its scope will be narrowed so it doesn't apply to:
- money purchase schemes (except earmarked schemes)
- routine administrative payments to an employer
- schemes in wind up.
Final salary schemes still fall within Section 251 but the deadline for compliance will be extended to 5 April 2016.
Direction from the DWP has come rather late in the day since many trustees have already issued notices to employers and members. Should it be the case that you have started the process, we recommend trustees and employers consider the time and expense left to complete the process and possibly finish the task as it will provide certainty to the trustees.
For final salary schemes where trustees have not yet started the communication process, trustees will have the option of complying with Section 251 by 6 April 2016 and we suggest no further action is taken until the amending legislation is passed.
For money purchase schemes, where trustees have not yet started the communication process and for schemes that commenced wind up after 5 April 2006 (final salary or money purchase), where trustees have not yet started the communication process, no action should be taken.
MAKING THE MOST OUT OF YOUR RETIREMENT FUNDS
By Ian Luck
Could you be making your pension money work harder?
When the majority of people were members of DB pension schemes there was no need for them to worry about making the most of accumulated retirement funds, as the scheme and ultimately the sponsoring employer were responsible for delivering the promised benefit.
Today, most people have at least a proportion, if not all, of their pension built up within a DC arrangement, such as a money purchase plan or group personal pension plan. As the only promise made by the employer under such arrangements is the amount of contribution, the onus has switched to the member to try and gain the greatest possible income from those pension funds. This has lead to an ever widening range of investment opportunities as members try to maximise the growth of the fund, but one of the easiest ways of making your pension money work harder is to shop around for your annuity by taking the open market option (OMO). It is therefore somewhat disappointing to find that only 36% of people are taking the OMO at retirement. If you have never heard of the OMO, then read on.
How can the OMO help boost my pension income?
DC arrangements are vehicles which allow members to accumulate funds over the years up to their retirement through a combination of contributions and investment growth. While members have a range of options at retirement, typically they will choose to secure their income for the rest of their lives by purchasing an annuity with the accumulated funds. As members get closer to their selected retirement date the provider will issue details to them of the annuity it is prepared to offer on the funds accumulated. The process is very straightforward and many members just tick the box and take the annuity income quoted.
However, it is not necessary to secure the annuity with the provider used to build up the funds, as the vast majority of DC arrangements give members the right to take an OMO and secure the funds with an annuity provider that is offering better terms. The annuity market is just like any other, with competitive forces and financial capital requirements forcing providers to move their position. This does not just result in marginal advantages – by shopping around at retirement you could achieve an increase in income of some 25%.
Choosing an annuity
There are other issues to consider. When quoting the amount of income available from the accumulated fund the provider often includes only a single life, nonescalating pension as these will show the highest level of initial income. But what if you are married and your spouse has no private means of income? The annuity that pays a pension to your spouse in the event of your death might be worth a lower starting pension payable to you. While non-escalating annuities might be appropriate in the current low inflationary environment, should circumstances change, the buying power of your income may rapidly diminish.
The provider of the annuity and its shape are important factors to consider as it is effectively taking a gamble on your longevity. A huge part of the annuity income represents how long the provider anticipates having to pay the income to you. There has existed for a long time an impaired life annuity market providing higher annuity rates and therefore greater income for those individuals where life expectancy is reduced. For example, if at retirement you are in poor health having previously suffered a heart attack the expectation is that your death will occur earlier than someone in full health. It is likely that the benefits will be paid out for a shorter period and market conditions mean that providers specialising in this market can offer higher rates than those that do not.
As better and more complete data becomes available about the effects that other medical treatment and lifestyle choices have on longevity a few providers have entered the market offering what are known as enhanced annuities. These can often be provided based upon smoking and alcohol intake as well as reliance upon prescription drugs. It has been anticipated that perhaps up to 65% of people taking out annuities might be entitled to an enhanced annuity.
So, even at the point of taking the benefits it is potentially not too late to make significant improvements to many people's income, but how should they go about obtaining them? It is possible to find this information online, but we would recommend that the first search that anyone does is for an independent adviser who can help you through the myriad of options that exist, and preferably one that offers a dedicated annuity service.
EMPLOYEE BENEFITS – ENHANCED PRODUCTS FOR SMALLER COMPANIES
By Matt Haswell
Group risk is an umbrella term for sponsored employee benefits and includes products such as group life insurance, group income protection and critical illness cover.
The benefits of group risk can be valuable to employees as they provide financial protection for both them and their families, yet they are relatively inexpensive for employers compared with some other components of the typical benefits package. The main features of each type of group risk benefit are as follows:
- Group life cover is the most common employer sponsored benefit in the UK and is believed to often represent the sole life insurance provision for low to middle income individuals.
- Group income protection enables an employer to provide a continuing income for employees if illness or injury prevents them from working for a prolonged period of time.
- Group critical illness cover pays a tax-free lump sum to an employee on the diagnosis of one of a defined list of serious conditions or on undergoing one of a defined list of surgical procedures.
These group products can often be provided by an employer at a considerably lower cost than plans arranged on an individual basis. Enrolling employees into such schemes is generally easy as group schemes often allow members to join, up to a given level of benefit, without having to provide any medical information. This given level of benefit, often referred to as "free cover limit", is affected by a number of factors, including the number of employees joining the scheme
Issues for smaller companies
For larger companies, the economies of scale bring the benefit of competitive premiums and higher free cover levels, such that most employees can be covered without having to provide medical information. However, smaller employers may find that the "free cover limit" is low such that some employees may be asked to provide full medical information. Staff with an adverse medical history may find that this has an impact on their application for these group risk benefits.
Apart from the medical issues, smaller companies may find that they are unable to access favourable terms and conditions and policy features that are granted to larger companies and the cost of the schemes may be higher than those paid by larger employers when compared on a per employee basis.
Smith & Williamson Employee Benefit Consultants has secured an arrangement with a leading group risk insurer to provide smaller employers with access to a range of group risk product terms, policy features and service levels that we believe provide terms that may not normally be available to them. This arrangement is available to firms with between 1 and 100 employees.
What is offered under this arrangement to eligible employers:
- Guaranteed minimum free cover level of £500,000 benefit for group life assurance and £60,000 benefit for group income protection scheme for each employee.
- Cover available within all UK postcodes.
- Three-year premium rate guarantees at no additional cost.
- Cover can be extended to age 75.
- Automatic cover up to the free cover level with previous adverse underwriting ignored (medical loadings or restrictions removed).
- Once a member is successfully underwritten on group life and group income protection schemes he/she will not be asked to provide further evidence in future years.
- Free employee assistance programme, supplied by Ceridian, for all schemes.
- Early intervention and rehabilitation service through a nationwide network of vocational rehabilitation consultants plus access to rehabilitation support telephone line for employers.
- Dedicated administration and underwriting contacts. Through this small schemes arrangement we want to provide access to a broad, flexible and affordable range of complementary protection solutions.
A LOOK AHEAD AT MANAGED WIND DOWN ACTIVITY
By Peter Maher
Will 2011 be a period of weak activity for managed wind downs and enhanced transfer values?
Funding DB pension schemes can be risky, but there are a number of ways that trustees and sponsors can control these risks. Smith & Williamson has helped a number of schemes through enhanced transfer value, or managed wind down (MWD) exercises, which have resulted in both significant reductions in overall liabilities and much smaller and less volatile residual commitments.
Market developments suggest the period up to April 2012, will witness a resurgence in MWD activity.
What is a managed wind down?
A scheme sponsor offers to enhance the transfers that members can make from a scheme to another approved pension arrangement, for a limited period. These enhancements, if carefully calculated, can be set at levels that are attractive to members who, with professional advice, will view a transfer away from the scheme as financially beneficial.
The fixed cost of the enhancements is attractive to sponsors – it acts as a premium for achieving absolute certainty – as the liabilities in respect of these transferring members are fully discharged. This can often be done at little or no balance sheet cost, relative to the bases used to report liabilities in company accounts.
If carried out properly, very high success rates can be achieved in a way that is positive for sponsors, trustees and members.
The regulator's view
The regulator has made a number of statements over the past couple of years and produced guidance on the management of transfer exercises. The most recent communication was a joint statement with the FSA in which it set out the requirements for independent advice to members.
At Smith & Williamson, we agree with the regulator that any transfer exercises must be carried out with full disclosure to members, with no level of compulsion, and that offers should be entirely pension based, i.e. no cash incentives.
MWD activity was high in 2007 and the early part of 2008, but the impact of falling markets into 2009 meant that it was no longer financially viable to carry out such an exercise. Asset values fell, reducing the funds available in schemes. Effectively, a transfer exercise would have meant realising investment losses for a large proportion of the total assets.
In 2010, asset values recovered and trustees are considering moving assets to more secure investments. The impact of the falls have been significantly reduced, and as a result transfer exercises are looking financially viable again.
Availability of cash
Unfortunately, the timing of the reductions in assets and the access to cash resources from sponsors to fund the consequently higher top-ups drying up coincided. In addition, access to bank lending also became much scarcer.
Many businesses have now started to rebuild their balance sheets, and bank lending restrictions have eased somewhat, increasing the scope for funding transfer exercises. Indeed, banks are potentially more likely to offer lending for such an exercise, as a positive result will remove much of the risk of enduring the type of pension funding problems experienced in previous years.
Changes to revaluation from RPI to CPI
The proposals to change the baseline for statutory revaluation of pensions for leavers and pensioners from retail price index (RPI) to consumer price index (CPI) means that for schemes where the rules refer to statutory minimum, rather than an explicit revaluation definition, the liabilities for a group of deferred members might typically reduce by around 15%. Further, the level of enhanced transfer value needed to make the option financially viable to a member might reduce by a similar amount.
Assuming the reductions in both standard and enhanced transfer values, given the scheme assets will be unaffected, the total cost of a transfer exercise might fall by something in the order of 20%-25% making the opportunity that much more valuable.
Potential abolition of transfers to defined contribution schemes
As part of the consultation provided by the Department for Work and Pensions (DWP) on its plans to implement the policy of abolishing contracting-out for DC schemes, it was proposed that, from April 2012, it would not be possible to transfer benefits from a contracted-out defined benefit arrangement to a defined contribution personal pension – the most common home for an enhanced transfer value.
However, following the consultation period the Government agreed that such action would contradict its overall 'pensions simplification' agenda. Consequently such transfers will continue to be allowed, with safeguards built in.
Many sponsors completed successful enhanced transfer value exercises up to mid-2008, enjoying significantly reduced risk and volatility in their pension fund through the global economic downturn. Since then, various market conditions have conspired to make further transfer exercises difficult. As we come out of recession through 2011, combined with the implications of legislative changes on revaluation and allowable transfer values, there is likely to be a resurgence in MWD activity over the next 12 months.
NESTs Are Set
By Ian Luck
The Spending Review reveals plan to make pension saving compulsory.
The Spending Review by Chancellor George Osborne confirmed that funding will be available for the launch of the National Employment Savings Trust (NEST).
The review commented that "the DWP settlement includes funding for the introduction of auto-enrolment from 2012 and the establishment of NEST".
Further details will follow but it is clear the Government supports the plan to make pension saving compulsory.
The National Association of Pension Funds (NAPF) and the Investment Management Association, whose members stand to benefit from auto-enrolment reform, welcomed the announcement.
From 2012, workers whose employers do not offer a pension fund will join NEST, while companies that already sponsor a pension fund will have to include all new recruits. NEST will take voluntary contributions from 2011.
Tim Jones, NEST's chief executive, said it "is now really taking shape and will be ready to launch in low volumes in 2011".
Workers over 22 earning more than £5,000 are eligible but will be able to opt out of NEST or their corporate pension.
Enrolment and contributions will be phased in between 2012 and 2016, starting with large companies. By 2017 the minimum contribution to NEST will be 8%, including employers' and workers' contributions.
We will look at the introduction of NEST in our next Employee benefits review newsletter.
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.