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.

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.