Pension funding options

Scheme registration

Pension schemes subject to the new tax regime have to be registered with HMRC. Once registered they become “registered pension schemes” subject to the tax privileges described below.

Such registration procedures apply to all schemes. Unlike arrangements set up prior to 6th April 2006, there is no longer a requirement for a scheme to:

Be set up under trust

Appoint a pensioneer trustee under a small self administered scheme

Set a normal retirement age.

Tax privileges

Once...

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...s either a sole trader or a partner in a partnership

Income arising from patent rights and treated as earnings; or

General earnings from an overseas Crown employment that are subject to income tax.

The maximum that an individual can contribute to a registered pension scheme in any given tax year is the greater of £3,600 or 100% of relevant UK earnings. An individual can pay more than this but they will receive no tax relief on the excess. Note that dividends are excluded from the definitions of earnings above.

Pension simplification which came into force on 6 April 2006, known as 'A-Day', attempted to put in place one set of overall rules applying to all types of pension. The basis of the legislation behind this new regime was to be found in The Finance Act 2004 and the Pensions Act 2004, though further Pensions Acts and Finance Acts post A-Day have subsequently made changes to the initial &lsqu...

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...ailable via the HMRC website is the guide to registered pension schemes. It is a comprehensive guide to the pension schemes tax regime introduced in April 2006. It includes Technical Pages that act as a guide to legislation and regulations underpinning the new regime.

What is the name of the HMRC guide to registered pension schemes called?

 

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The lifetime allowance is a limit on the overall value of pension savings that qualify for tax relief. It is intended to have a similar effect as the earnings cap under the old regimes.

The lifetime allowance is set by the Treasury. The amounts set for the first five tax years of the simplified regime were as follows:

2006/07 - £1.5M

2007/08 - £1.6M

2008/09 - £1.65M

2009/10 - £1.75M

2010/11 - £1.8M

The lifetime allowance for 2011/12 is £1.8M (frozen at the same level as 2010/11), and which the Government has announced would reduce to £1.5M from 6 April 2012.

Fixed protection

One interesting point to come out of the Government’s announcement regarding the reduction in the lifetime allowance is that the Government recognises that there should be a ‘protection regime’ for those who have already made pension saving decisions based on the current lifetime allowance. This is designed to cover those with savings above £1.5 million or who believe the value of their pension pot will rise to above this level through investment growth without any further contributions or pension savings and who do not already have primary or enhanced protection. They will be able to apply for ‘fixed protection’ i.e. a new personalised lifetime allowance of £1.8 million providing they cease accruing benefits in all registered pension schemes before 6 April 2012. Any excess value above £1.8 million will still be subject to a lifetime allowance tax charge.

Notifications in writing for this must be received on the prescribed form by HMRC by 5 April 2012. To avoid losing fixed protection care must be taken to avoid being auto-enrolled into a new pension sc...

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...’s defined benefit scheme. The crystallised value of this pension is £360,000 (i.e. 20 x £18,000). This uses up a further 20% of Jimmy’s lifetime allowance (i.e. £360,000/ £1,800,000). This leaves Jimmy with 30% of his lifetime allowance available for his next BCE (i.e. 100% - 50% - 20%).

Lifetime allowance charge

The lifetime allowance charge is a tax charge that applies at any BCE where the crystallised value of the new benefits exceeds the member’s available lifetime allowance. The tax charge applies to the excess over the available allowance, known as the chargeable amount. The charge is designed to recoup the tax breaks the member has received on the excess funds over the years they have been sheltered inside the pension tax regime.

The amount of tax charged depends on the form in which the excess benefits are paid:

If the excess is paid as a lump sum, it will be taxed at 55%

If the excess is used to provide pension, it will be taxed at 25%. But remember, the pension provided by the remaining 75% will also be subject to income tax at the member’s marginal rate of income tax.

Example

Rashid crystallises excess benefits valued at £200,000. If he takes this chargeable amount as a lump sum, it will suffer tax of £110,000 (i.e. 55% x £200,000), leaving a lump sum payment of £90,000. If he decides to use the chargeable amount to provide pension, it will suffer tax of £50,000 (i.e. 25% x £200,000). The pension provided by the remaining £150,000 will also suffer income tax at his marginal rate of income tax.

What tax rates are used to calculate the lifetime allowance charge?

 

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The annual allowance is a limit on the value of pension savings that qualify for tax relief each tax year. As with other tax allowances the annual allowance is set by the Treasury. The amounts set for the first 5 tax years of the simplified regime were as follows:

2006/07 - £215,000

2007/08 - £225,000

2008/09 - £235,000

2009/10 - £245,000

2010/11 - £255,000

In the 2010/11 tax year the annual was £255,000 but has been reduced to £50,000 from 6 April 2011 and is likely to remain at that level until the end of the 2015/16 tax year. 

From 6 April 2011 it is also be possible to carry forward any unused annual allowance from the previous three years to offset against contributions in excess of the annual allowance in a single year. 

Prior to 6 April 2011 the annual allowance did not apply to a pension arrangement in the year of death or to any arrangement in a tax year when benefits were taken in full from that arrangement. This relaxation prevented the annual allowance from applying on early or ill-health retirement. It also meant that, at least in theory and subject to the then restrictions on higher/additional rate relief, all pension funding could be deferred until the year of retirement. However, from April 2011, the annual allowance will apply in the year of taking benefits, except on death or on severe ill-health.

Carry forward

Reducing the annual allowance to £50,000 will however catch some individuals who have one-off increases in pension accrual.

For example, an individual may make a sizable pension contribution because in one year they make a large profit or receive a large bonus. Alternatively a member of a defined benefit occupational pension scheme may find that they have breached the annual allowance as a consequence of a promotion where the increase in salary creates an exceptional increase in the value of their defined benefits.

In recognition of this, from 6 April 2011 the Government has introduced a 3 year carry forward rule. This rule allows individuals to make occasional large pension contributions without incurring an annual allowance charge by carrying forward any unused annual allowance from the 3 previous tax years prior to the current tax year. For example in the 2011/12 tax year once the individual has used up all their annual allowance for the 2011/12 tax year, he or she will be able to carry forward any unused annual allowance for the 3 previous tax years (2008/09, 2009/10 and 2010/11) based on a £50,000 annual allowance for each of the 3 years.

In or...

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...r increase at a rate agreed before 22 April/9 December 2009.

For an individual pension arrangement a ‘normal regular ongoing contribution’ had to be made to the relevant pre-22 April/9 December 2009 arrangement. If total regular contributions were maintained, but paid to different arrangements, then they did not count as ‘normal regular ongoing contributions’.

The requirement that contributions were made quarterly or more frequently meant that no account was taken of annual payments or one-off lump sums, regardless of their consistency over the years.

Defined benefit arrangements all pension savings (which were measured by reference to the change in value of accrued benefits over the tax year). If the basis of benefit calculation was improved (e.g. accrual rate increased) on or after 22 April 2009, the value of the increase did not count as ‘normal regular ongoing contributions’, except in limited circumstances.

Total pension savings were all of pension savings (from whatever source) that received UK tax relief, including employer contributions. For defined benefit schemes the pension savings value followed the annual allowance calculation basis, i.e. the value was calculated as 10 times the increase in accrued pension plus any increase in a separate cash lump sum. For example, an extra £2,000 pension accrual was deemed to be £20,000 of pension savings.

Special annual allowance was the greater of:

£20,000, and

The average of infrequent money purchase contributions (i.e. less frequently than quarterly) from any source in the tax years 2006/07, 2007/08 and 2008/09, subject to a maximum of £30,000.

If an individual failed all 3 parts of the ‘anti-forestalling’ conditions, they continued to receive full tax relief on their ‘normal regular ongoing contributions’ but any additional pension contributions (from whatever source) or the value of any additional benefit accrual were effectively restricted to basic rate relief to the extent that their ‘total pension savings’ exceeded their special annual allowance in the tax year.

The way in which relief was restricted to basic rate was by the levying of the special annual allowance charge (at between 20% and 30% in 2010/11) on the additional contribution of value of additional benefit accrual. This was collected via the Self Assessment return.

Which contributions to a registered pension scheme are not included in the calculation of the total pension input amount?

 

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There is no longer a statutory concept of a normal retirement age. Retirement can now take place at any time after the normal minimum pension age of 55. Of course, employers may still choose to set a standard retirement age under their pension scheme.

There are 2 exceptions to the normal minimum pensions age:

Where deferred or current members of occupational or statutory scheme...

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...ormal minimum pension age is 55 and the lifetime allowance is £1.80M. As he is retiring 20 years early, Didier’s normal lifetime allowance is reduced by 50% (i.e. 20 x 2.5%) to £900,000.

By how much will the lifetime allowance charge be reduced where a scheme member takes benefits early on the grounds of ill-health?

 

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Pension benefits – Compulsory Purchase Annuity

The pension is the amount of income the member’s defined contribution fund will buy at retirement after any pension commencement lump sum has been provided.

For an insured defined contribution scheme – occupational or individual – the pension is determined by current compulsory purchase annuity (CPA) costs. It is an FSA requirement that providers of individual pensions give members the opportunity to choose the insurer which is to p...

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... selects the maximum available, and under pension simplification and provisions in the Pensions Act 2004, it is now possible to take up to 25% of the protected rights fund as a PCLS.

Taking the maximum PCLS is almost always the best option even if the scheme member’s objective is income rather than capital because the PCLS can be applied to income-producing investments in a tax-efficient manner.

Members of what types of schemes must be offered an OMO?

 

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Pension at normal retirement age

The level of benefits that a member receives at normal retirement age depends on the following factors:

Scheme accrual rate

Pensionable service

Pensionable earnings.

The interaction of these factors will determine the level of pension payable at retirement.

Pension increases

As a pension may be paid for 25 years or more, especially if there is provision for it to continue to a surviving spouse, a scheme’s pension increases policy can therefore be crucial to establishing its quality. At current annuity rates for a man aged 65, a pension that is guaranteed to increase at 3% each year after retirement is worth around 40% more than a pension which does not increase at all.

Guaranteed minimum pension

Despite the diversity, nine in every ten scheme members who were contracted out of the State Earnings-Related Pension Scheme (SERPS) all have an extra protection in common. The guaranteed minimum pension (GMP) element of their total pension accrue...

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...oted however that a contracted-out scheme cannot allow any part of any GMP to be exchanged for cash. This has the effect of restricting or even eliminating the lump sum when the non-GMP part of a pension is small.

Commutation factors

Before 1989, men retiring at 65 and women retiring at 60 were usually required to surrender pension at the rate of £1 a year for each £9 (men) and £11 (women) of cash taken as a lump sum, though many schemes used other factors. From 1989, many schemes used £12 for men and women regardless of age, either because it was an HMRC requirement for their post-89 joining members in calculating maximum benefits or because it simplified matters.

Many schemes reviewed their commutation factors following the A-Day changes, and increases to a 15:1 basis were common, although wide differences between schemes remain.

On what basis do pensions escalate if they are accrued between 6 April 1997 and 5 April 2005?

 

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All registered pension schemes can pay up to 25% of the value of the benefits as a pension commencement lump sum (PCLS) when the payment of benefits commences.

In the tax year 2010/11 there were four different ways of providing a pension incom...

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...ber attained age 75 before 22 June 2010).

From 6 April 2011 unsecured pensions and alternatively secured pensions ceased to exist and were replaced by drawdown pensions which can either be in the form of capped drawdown or flexible drawdown.

Once a lifetime annuity or scheme pension has commenced in payment there are two types of death benefit available depending on the options selected at outset:

Guarantee periods : Scheme pension and lifetime annuity payments may be guaranteed to continue for a period of up to ten years from commencement regardless of the member’s age. Such payments are taxable for the recipient(s) and cannot be commuted.

Pension/annuity protection : This form of death benefit is more commonly known as ‘capital protection’ in the annuity market. Since 6 April 2011 annuity protection is available both before and after age 75, whereas previously it was only available up to age 75. From 6 April 2011 the maximum lump sum payment on death is the original pension/annuity cost, less gross income payments made, less in the case of members of defined contribution schemes a flat 55% recovery tax charge. Prior to this date the recovery charge was 35%.

In addition to a guarantee period and/or pension/annuity protection the member may make provision for survivor pensions/annuities.

Where a mem...

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...ums after the death of scheme members the death benefits will be subject to IHT.

Death while in receipt of scheme pension or lifetime annuity: Where an annuity is already in payment when death occurs no IHT will be payable.

Death while in income drawdown (and drawdown pension from 6 April 2011): Prior to 6 April 2011 it was also free of IHT if paid to other beneficiaries unless the decision to start or amend income drawdown was taken within two years of the member’s death and the member was aware at that time that their state of health was poor. Though from 6 April 2011 an IHT anti-avoidance charge resulting from this ‘omission to act’ has been removed. Also with effect from 6 April 2011 IHT will not typically apply to drawdown pension funds remaining under a registered pension scheme including when the individual dies after reaching the age of 75.

Death while in alternatively secured pension (prior to 6 April 2011): See section above.

How has the upper age restriction for annuity protection changed from 6 April 2011?

 

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If an individual's total pension arrangements are relatively small in value it may be possible to convert them into a cash payment. This trivial commutation option is available when the total capital value of all of the member's retirement benefits does not exceed 1% per cent of the lifetime allowance (£1.8m x 1% = £18,000 in 2011/12). There will be a window of one year within which to commute all the arrangements.

In these circumstances the entire sum may be commuted for a lump sum but this option is only available to thos...

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... £1.8 million to £1.5 million. Using the rules above this would reduce the threshold for converting pensions into cash payments under the triviality rules from £18,000 to £15,000. The Government has however announced that the link to the lifetime allowance will be removed from 6 April 2012 which means the threshold will continue to be £18,000 from 6 April 2012.

How are small ‘stranded’ occupational scheme pots treated under the triviality rules?

 

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Ill-health benefits

Subject to certain transitional reliefs, drawing benefits before normal minimum pension age of 55 is possible on grounds of ill-health.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for this to occur. The condition is that the scheme administrator has received evidence from a registered medical practitioner that the member is (and will continue to be) incapable of carrying on the member’s occupation because of physical or mental impairment, and the member has in fact ceased to carry on the member’s occupation. Although the rule implies a permanent condition the legislation has evolved so that a scheme can suspend or reduce payment of an ill-health pension if the member regains their health.

If the member has a life expectation of less than one year it is possible to commute their uncrystallised arrangements for a ‘serious ill-health lump sum’. The member must have some lifetime allowance remaining and each arrangement must be commuted in full. However, not all arrangements have to be commuted. Where an uncrystallised arrangement is to be commuted and it contains protected rights funds, if the member is married or in a civil partnership, provision must first be made for 50% of the fund to be se...

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...n purposes the member’s pension is usually taken as the amount he/she would have received without commuting any of it for a pension commencement lump sum. If a guarantee is built in to the member’s pension for example on death occurring within 5 years then the full pension will continue for the balance of the guarantee period and the survivor’s pension will not commence until the full member’s pension has stopped being paid at the end of this period.

There is no limit on the amount of survivor’s pension that can be drawn if the member dies before their 75th birthday. If the member dies after age 75 then the survivor’s pension is restricted to 100% of the member’s pension in the year to death plus 5% of any pension commencement lump sum drawn by the member.

Many schemes allow an allocation option giving retiring members the chance to surrender part of their pensions so as to increase the potential survivor’s pension.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for a defined benefit occupational scheme pension to become payable in the event of early retirement due to ill health. State the main elements of this condition that must be adhered to.

 

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