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Pension Simplification

Now that 06 April 2006 has arrived, a single regime for all pension types (including personal pensions, Stakeholder and executive schemes) has come into effect and replaced the eight previous tax regimes that ran concurrently.

Pension simplification has introduced two important new controls:

  • The pension lifetime allowance
  • The pension annual allowance

The other main change is to allow all schemes to offer a tax free cash of up to 25%, to allow employees the opportunity to continue working for their employer while taking benefits from their occupational pension scheme. Also, pensions schemes are to be allowed to invest in many more types of investments, (although the move to allow residential property to be held as a pension scheme asset was blocked in November 2005); effectively anything that is not explicity prohibited or disallowed for the purposes of gaining tax relief under the new rules is allowed.

The main aspects of the new changes are highlighted below:

Lifetime allowance

A lifetime allowance is the maximum amount of pension savings that can benefit from tax relief and has been initially set at £1.5 million. This figure will rise over time and the proposed amounts are as follows:

  • 2007 - £1.6 million
  • 2008 - £1.65 million
  • 2009 - £1.75 million
  • 2010 - £1.8 million

There is a lifetime allowance charge of 25% on pension funds that exceed the lifetime allowance. Funds that exceed the lifetime allowance can be taken as a lump sum and in this case the lifetime allowance charge would be at 55%. Excess funds taken as taxable income will be subject to an additional excess tax rate of 25%. To value the capital value of a defined contribution scheme a valuation factor of 20:1 will be used. Pensions in payment will be valued using a factor of 25:1. Therefore, an individual who is receiving a pension of £60,000 in the 2006/7 tax year has already used up their lifetime allowance.

Annual allowance

The annual allowance has been initially set at £215,000 and this figure will rise regularly as shown below until 2010 when the figure will be £255,000 for payments to a defined contribution scheme or as accrued benefits within a defined benefit scheme. The limit will not apply in the actual year of retirement.

  • 2007 - £225,000
  • 2008 - £235,000
  • 2009 - £245,000
  • 2010 - £255,000

The limit for contributions based on fractions of capped earnings is to be replaced to allow individuals to make unlimited contributions. However, tax relief on the contributions is to be limited to the higher of 100% of relevant earnings or the annual allowance, whichever is the lower figure. For those with no income, the maximum level of contribution of £3,600 (gross) per annum.

Minimum pension age

The minimum retirement age to be applied to all pension arrangements under the new rules is 50. From 2010, this will increase to 55. If you are in an occupation where there is an existing contractual right to retire before 55 (and these rights were documented before 10 December 2003), you will be able to retain this right. The rules also protect people who currently have pensions with low retirement ages (such as sporting professionals) to preserve this retirement age for their existing pensions. However, when benefits are taken below the minimum pension age, a lower lifetime allowance applies.

Under the new rules you will be able to carry on working for your employer and still take the benefits from your pension scheme.

Income Drawdown (now referred to as 'Unsecured Income')

There will be no major changes for those who currently hold income drawdown (a.k.a pension fund withdrawal); however, the good news is that the changes that have been introduced will make this pension arrangement more flexible. The current withdrawal amounts are limited by tables produced by the Government Actuaries Department where the maximum income is 100% of a single life annuity and the minimum is 35% of the maximum.

Pension simplification will replace the GAD tables allowing a minimum income withdrawal of £0 and a maximum of 120% of a single life annuity. This income amount is to be reviewed every 5 years. Included in this amount would be any income derived from a fixed annuity.

Pension fund withdrawal will be known as ‘unsecured income’. After age 75 the current compulsion to purchase an annuity will be removed, but there will be restrictions on the amount of income that can be withdrawn from a fund.

The new rules offer three different ways to provide income during retirement.

  • Unsecured Income
  • Secured Income
  • Alternatively Secured Income

Unsecured Income

This is similar to pension fund withdrawal, as it exists at present, which allows you to keep your pension fund invested without purchasing an annuity and drawing income from your pension fund, with a few important changes.

  • The minimum income that can be drawn is reduced to zero per annum.
  • The maximum income is 120% of a level single life annuity that can be purchased on the open market, (based on Financial Services Authority comparative tables up to 3 months before pension date).
  • The income must be reviewed at least every 5 years. With the maximum income at review is determined in the same way as the initial maximum income.
  • Term annuities of up to 5 years duration can be used to provide unsecured income up to age 75, but the income generated must be taken into account when measuring against the maximum income allowed.

The lump sum death benefit is similar to the current income drawdown death benefit i.e. a full return of fund is permitted, subject to a 35% tax charge. Unsecured income cannot continue after age 75 when the basis of payment must switch to Alternatively Secured Income (ASI) or secured income.

Alternatively Secured Income (ASI)

ASI is also similar to pension fund withdrawal and is available from any age after 50 (rising to 55 in 2010) or from age 75 when unsecured income must stop. The key features of ASI are:

  • A minimum annual income of £1 must be paid.
  • The maximum income is 70% of a level single life annuity that can be purchased on the open market at age 75, or earlier (based on Financial Services Authority comparative tables).
  • The maximum income is reviewed annually using annuity rates from Financial Services Authority tables up to 60 days before the review date.
  • Upon death, any funds returned to the members estate are liable to an Inheritance Charge if it takes the member over the Nil-Rate band.

Secured Income

If income is not secured on the ASI basis by age 75, then it must be secured either by:

  • A promise from a pension scheme e.g. a defined benefit scheme (Final Salary Scheme), or
  • An annuity purchased from an insurance company.

On the whole, it is felt that these changes will further increase the flexibility of pension fund withdrawal arrangements.

Protecting your existing pension funds.

On the whole, only a very small proportion of individuals will be negatively affected by the maximum lifetime limit. These are individuals with funds close to or over £1.5 million. However, there may be many members of occupational pension schemes who have an entitlement to a tax-free lump sum that is greater than 25% of the fund value. In these instances, a decision will have to be taken whether to protect the fund and accept the restrictions that will go with it, or to allow the changes to take their course. In such cases, we recommend that you seek professional advice to determine the best course of action.

There are two elements to transitional protection ; for the total fund value against the Lifetime Allowance, and the maximum tax-free cash. This protection produces pre A day planning opportunities.

Please Note: You now have until April 2009 to retrospectively claim protection of your pre 06/04/2009 pension funds. However, it is probably advisable that this is done sooner rather than later.

Lifetime Allowance - Primary protection

Those who have pre A-day rights over £1.5 million will have their rights indexed in parallel with the indexation in the Lifetime Allowance.

Lifetime Allowance - Enhanced protection

If you cease to contribute to or be an active member of any pension schemes prior to A-day then pre A-day funds will be exempt from the Lifetime Allowance. Can be revoked in favour of Primary protection up to age 75.

Protection against the Lifetime Allowance is portable so funds can be transferred.

Tax free cash - where Primary protection applies tax free cash entitlement at A-day will be indexed in parallel with the indexation in the Lifetime Allowance.

Tax free cash - where Enhanced protection applies pre A-day entitlement is expressed as a percentage of the fund value. It is this percentage that is used to calculate the tax free cash at retirement.

Tax free cash - where neither Primary nor Enhanced protection applies the tax free cash entitlement at A-day is indexed in parallel with the indexation in the Lifetime Allowance. Plus tax-free cash can be paid up to 25% of the fund value for contributions paid post A-day. Any protection is lost if benefits are transferred to another pension scheme (unless as part of a bulk transfer).

Self-Invested Personal Pensions (SIPPs)

One of the most talked about effect of the changes was in relation to SIPPs, largely because of the proposal of residential property as an allowable investment - a move that was subsequently blocked.

Overall, SIPPs operate under the same rules as outlined above. The only differences is what they can invest in. Previously, there was a permitted range of investments. Now, anything can be invested in that is not specifically excluded (usually these are either assets that can depreciate in value - and are therefore not 'assets' - indeed they are 'liabilities' in the true sense of the word, or assets in which the member is likely to derive personal benefit from). Assets that are excluded are:

  • Residential Property
  • Vintage Cars
  • Works of Art
  • Fine Wines

'Indirect Investment' in these assets are also blocked. For example, if a SIPP held 100% of the shares of a company that invested in residential properties, this would be viewed as if the SIPP had bought the properties directly. However, if the SIPP owned shares in a company where residential property only constituted a proportion of the company's assets, then this may not be prohibited.

There are other investments that could be considered questionable, so it would be wise to refer these to your local HMRC inspector for an opinion before any action is taken

PLEASE NOTE: If any of these prohibited investments are purchased via a pension scheme, an additional tax charge of up to 70% of the value of the investment can be levied. This will make investing in such assets an extremely undesirable option. It is the opinion of HMRC that they wish to block investment into assets which would probably be for the members direct benefit, rather than the benefit of the pension fund.

The other main changes relates to the amount that a SIPP can borrow when purchasing a Commerical Property. Before 06/04/2006, the old rules allowed a SIPP to borrow up to 75% of the market value of the property - the new rules will only allow for a maximum borrowing of 50% of the value of the PENSION FUND. This has significantly lessened the scope for borrowinbg, and SIPP plans will need a greater amount of initial funding before Commercial Property purchase becomes a viable option.

Other Significant Changes

Above are listed the main changes that are due to take effect from April 2006. However, there are other important changes that have been overlooked by many commentators who have focussed mainly on the Lifetime Allowance and changes to the tax-free lump sum.

Death benefits

Death benefits from a scheme can be in the form of a lump sum or a pension payable to one or more dependants. These benefits will vary depending if death is before or after vesting. If death is before vesting a lump sum would be tested against the lifetime allowance but a dependant's pension would not be tested against the lifetime allowance.

If death occurred after vesting there would be the protection afforded by a value protection annuity or term certain annuities or the guaranteed period of up to 10 years from a standard annuity. For income drawdown before the age of 75 a return of the capital sum less 35% tax and for income withdrawal after 75 by means of the alternatively secured income there would be no return of capital.

Trivial pensions

The proposed changes to trivial pensions aim to increase the number of options available where an individual has a smaller fund by taking this as a lump sum. There are a number of conditions that the individual must comply with as follows:

'Recycling' of Tax-Free Lump Sums

This refers to the practise of taking a tax-free lump sum from a pension scheme, using it to pay a single premium into another pension scheme in order to benefit from additional tax-relief on the contribution. This could be potentially repeated a number of times, gaining further tax relief on each occasion

Whilst this has occured to some extent in the past (i.e. recycling unwanted income from pension fund withdrawal plans, where an income had to be taken, the new pension rules make it easier to take a tax-free lump sum but defer taking the main pension benefits until a later date. It is believed that the potential for abuse of this facility would only be increased, so a limit of £15,000 has been imposed as an upper limit for 'recycling' purposes.

  • The member must take the trivial pensions within a 12 month period;
  • The total amount taken as a cash sum cannot be more than 1% of the standard lifetime allowance. For 2006 this is £1.5 million so the trivial pension limit would be £15,000 in 2006/2007 tax year and includes the capital value of pensions already in payment;
  • Pensions alredy in payment are valued at £25 capital for every £1 per annum gross pension;
  • The fund to be used for the trivial pension must be commuted in it's entirety;
  • Commutation must occur between the member's age of 60 and 75;
  • Pensions in payment may also be commuted but will be taxed in full as earned income.

Retirement Annuity Contracts

The new rules bring significant changes to Retirement Annuity Contracts (otherwise known as S226 pensions). One of the main changes is the level of tax-free cash entitlement. This is currently directly related to the value of the annuity available from a policy and varies with age. From 6 April 2006, the level will be 25% of the fund value, falling into line with other pensions. After 31 January 2007 you will no longer be able to pay contributions using unused tax relief from previous years, which could restrict contributions if you are a high earner.