A5.01: CURRENT TOPICS - PENSIONS

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1 A5.01: CURRENT TOPICS - PENSIONS SYLLABUS Changes to annual allowance test Planned changes to lifetime allowance test Removal of requirement to secure pension income Capped drawdown Flexible drawdown Tax treatment of crystallised benefits on death Withdrawal of anti-forestalling provisions Auto-enrolment and NEST Current and planned changes to State Pensions Current and planned changes to contracting out Changes to State Pension Age Statutory revaluation basis for deferred DB benefits Use of CPI to replace RPI as inflation measure Default retirement age Changes to annual allowance test The annual allowance was initially set at 215,000, and increased each year up to 2010/11, when it reached 255,000 In 2011/12, the annual allowance is reduced to 50,000, as the major part of a number of measures which have replaced the previous government s proposal to restrict higher rate tax relief on input The government has stated that this level of allowance will remain frozen until at least the end of the 2015/16 tax year The total pension input amount for an individual is tested against the annual allowance The total pension input amount is: - total gross contributions (including any made by an employer) to defined contribution (DC) arrangements other than cash balance schemes - the increase in the value of retirement benefits (but not death before retirement benefits) under defined benefit (DB) arrangements and cash balance schemes Up to and including 2010/11, the pension input amount under a registered scheme for a tax year in which all benefits were crystallised in full did not count towards the annual allowance test From 2011/12, this exclusion no longer applies unless the member crystallises all benefits in circumstances of severe ill-health This includes a situation where all benefits are taken as a lump sum because life expectancy is less than one year It also covers the taking of benefits on the grounds that the scheme administrator has received medical evidence that the individual is unlikely to be able to work again before reaching pensionable age It is possible from 2011/12 to carry forward any unused amounts of the annual allowance from the three previous tax years if otherwise the allowance for the current year would be exceeded The current year s allowance is used first, then anything unused from the previous years which has not subsequently been used

2 In 2011/12, unused allowances can be carried forward from 2008/09, 2009/10 and 2010/11, but the unused amount is calculated as if the new annual allowance rules had applied in those years This means assuming an allowance of 50,000 and using a valuation factor of 16:1 for DB scheme benefits (after adjusting input for the effect of inflation as measured by the CPI) To make use of the carry forward provision, the individual must have been a member of a registered pension scheme at some time during the tax year from which the allowance is carried forward (even if pension input was nil) If the annual allowance is exceeded, a personal income tax charge on the member arises on the excess Note that the charge always falls on the member, even where the input is funded wholly or partly by an employer (or other party) Up until 2010/11, the charge was always at the rate of 40% in 2010/11, irrespective of the individual s tax position From 2011/12, the rate will affect the individual s tax position, with the excess taxed as if it was additional income The charge could therefore be at 20%, 40% or 50% (or a combination) The rate of charge cannot be zero even in the unlikely event that the individual had unused personal allowance Following the changes to the annual allowance in 2011/12, a new provision has been introduced which allows the member to opt for the tax charge to be paid from the pension scheme in some circumstances This will apply if the liability to the charge exceeds 2,000 and the input amount under the scheme exceeds the annual allowance This will be attractive for members in many cases where a substantial charge arises Benefits provided by the scheme will be reduced to reflect the charge paid by the scheme Planned changes to lifetime allowance test The standard lifetime allowance (SLA) was initially 1.5m in 2006/07 and has increased to 1.8m for 2010/11 and 2011/12 The allowance will then reduce to 1.5m in 2012/13, as part of the measures introduced by the current government (instead of removing higher rate relief for high income individuals) A form of transitional protection known as fixed protection is available This allows the individual to opt to retain a lifetime allowance of 1.8m, but no further pension input is then permitted Those subject to primary protection or scheme specific lump sum protection under the existing transitional protection rules introduced from A-Day are protected from the reduction in lifetime allowance Their protection, which has been linked to the level of the standard lifetime allowance up to 2011/12, will continue to be linked to a figure of 1.8m in 2012/13 Removal of requirement to secure pension income Before 6 April 2011, benefits had to be secured no later than the day before the individual s 75th birthday or 77th birthday if the individual had not reached age 75 before 22 June 2010

3 This requirement has now been abolished, so drawdown can continue indefinitely if the individual so wishes New drawdown rules New drawdown rules were introduced from 6 April 2011 for those crystallising benefits on or after that date These introduce two options - Capped drawdown (similar to the previous unsecured pension option) and flexible drawdown Those already taking unsecured pension will migrate to the new basis, usually on the first reference date on or after 6 April 2011 The new basis will apply earlier in some circumstances, for example where a memberinitiated review takes place Those already in ASP will migrate on 6 April 2011 Capped drawdown There is no minimum income requirement at any time under the capped drawdown option (subject to any contracted out minimum requirements) The maximum annual withdrawal is 100% of the basis amount, which is the pension that could be bought with the individual s fund based on annuity tables generated by GAD (the Government Actuary s Department) These are referred to as GAD rates and are an approximation to market rates for a single life level lifetime annuity The GAD rates differentiate by age and gender and vary according gilt yields The rates end at age 85, and the rates for this age will continue to apply to older individuals New rates were introduced in 2011, taking account of current life expectancy There are no separate tables for Protected Rights benefits The same tables are therefore used for Protected Rights as for other benefits, even though where Protected Rights are effected by annuity purchase, the annuity rates must not discriminate on grounds of gender Where some income is being taken from the arrangement by means of short term annuities (see below) the normal maximum withdrawal of 100% of the basis amount includes the income from the short term annuities As a result, the scope for withdrawals from the fund would be reduced (and could possibly be eliminated) The level of capped drawdown income can be varied within this maximum limit and subject only to any requirements of the product provider (see below) The maximum limit under capped drawdown arrangements must be reviewed at intervals of generally 3 years up to age 75 Once the individual reaches age 75, reviews must occur each year, starting with the anniversary date immediately following age 75 Flexible drawdown A radically new option was introduced from 6 April 2011, and is known as flexible drawdown This allows unlimited amounts of income to be taken provided the individual makes a declaration that the Minimum Income Requirement (MIR) is met

4 There is no minimum withdrawal amount Under this option, the whole fund designated for drawdown can be taken in one payment if required (but would be fully taxed as non-savings income in the tax year of receipt) The MIR has been set initially at 20,000 per year and can only be met with pension income in the form of - State pension - Scheme pension from a scheme (which can be on a defined benefit or defined contribution basis) with at least 20 members - Lifetime annuity (level or increasing, but NOT investment-linked) Note that income from a Purchased Life Annuity (PLA) does not count towards the MIR Neither does income under a drawdown arrangement It is not required that the income escalates in payment (although in some cases this will already be required by law, for example under the Limited Price Indexation provisions) In the tax year of the declaration, there must have been no contributions to defined contribution arrangements by or for the benefit of the individual This means that any such contribution paid, for example on 6 April 2011 will mean that the declaration cannot be made until 2012/13 at the earliest He or she must have ceased to be an active member of any defined benefit scheme before the declaration is made The scheme administrator will need to check that the declaration is valid The 20,000 income level required must actually be received in the tax year in which the declaration is made - it is not sufficient simply to have started to receive income at that rate by the time of the declaration So, for example, if an individual plans to meet the MIR by means of a lifetime annuity of 20,000 pa purchased in November 2011, this will not do so if the income is payable monthly in advance, because only 10,000 would be received in 2011/12 It would be sufficient if the annuity was arranged on an annually in advance basis because then 20,000 would be received in 2011/12 Once the declaration is made, there is no subsequent retest of income, even if the level of the MIR increases in the future Any future pensions input by or for the individual would be subject to the annual allowance tax charge, which will effectively claw back any tax relief available This will therefore make any further input unattractive in most cases Tax treatment of crystallised benefits on death On death whilst in drawdown (whether capped drawdown or flexible drawdown), any remaining fund can be paid out as a lump sum after deduction of tax at 55% The rate of tax was 35% prior to 6 April 2011 There is no test against the lifetime allowance in these circumstances (the test will have been carried out when the retirement benefits crystallised) There are no circumstances where the tax deducted from a lump sum death benefit can be reclaimed, irrespective of the circumstances of the recipient If there are no dependants, the lump sum can be paid to charity, and in this case, there is no tax charge at source

5 Alternatively, income benefits can be provided for the spouse, registered civil partner and/or other dependants of the deceased, and again no tax charge is deducted from the fund, although the income is taxed as the recipient s non-savings income The 55% tax charge does apply where a lump sum death benefit is paid under an annuity protection or pension protection provision It also applies if a lump sum death benefit is paid on death after reaching age 75 from an uncrystallised fund or a life insurance arrangement Withdrawal of anti-forestalling provisions It was proposed by the last Labour government that relief on pensions input would be restricted for high income individuals from 6 April 2011 These proposals have now been withdrawn by the current government in favour of measures including the reduction of the annual allowance as described above The new measures are seen as simpler, but are designed to produce a similar tax yield for the government The anti-forestalling provisions applied from 22 April 2009 until the end of the 2010/11 tax year and applied a special annual allowance tax charge in some circumstances where pension input by or for high income individuals was increased They are no longer in force from 6 April 2011 Auto-enrolment and NEST A Pensions White Paper (Security in retirement: towards a new pensions system) was published in May 2006 The proposals were carried forward in the Pensions Bill published in November 2006 and became law in the Pensions Act 2007 Further provisions were included in the Pensions Act 2008 Although there has been a change of government since the proposals were developed, they will be carried through by the new government The aim is to address the way in which pensions must change in the light of demographic changes and economic conditions generally NEST (National Employment Savings Trust - previously known as personal accounts) are to start to be introduced in October 2012 as a low-cost savings vehicle The NEST Corporation has been established to launch the scheme and act as trustee Membership for employees will not be compulsory However, employees aged at least 22 and under State Pension Age will be subject to autoenrolment into NEST (or a suitable alternative work-based scheme) Auto-enrolment means that employees will become members of the arrangements unless they take positive action to opt-out Those who opt-out will be re-enrolled at intervals of three years, though the detailed mechanism is to be developed Occupational schemes will also be encouraged to operate auto-enrolment, which should become the norm for all schemes NEST will be funded by contributions based on earnings within a defined earnings band

6 There will be a minimum earnings level at which auto-enrolment is required, this being in line with the income tax personal allowance The earnings band for those eligible is likely to be in line with the NI threshold, which will be at a lower level (this avoids a requirement for very small contributions which would result if the auto-enrolment threshold and the starting point of the earnings band were aligned) The contribution rates based on earnings within the band will be: - 5% from employees, including 1% in tax relief - 3% from employers The tax treatment of personal accounts will be in line with current practice, with employees benefiting from 20% relief through the RAS (Relief At Source) system and higher rate relief available (where applicable) through self-assessment Whether additional rate relief is available will reflect the treatment of registered pension schemes generally, and the outcome of the current review of restrictions on relief discussed above Employers contributions would attract relief as a business expense, subject to the agreement of the Inspector of Taxes Other provisions are in line with the simplified regime, including the availability of a tax free pension commencement lump sum Employers would not be required to contribute for employees who have opted out Otherwise, employers will be given a start date between October 2012 and October 2015 (with larger employers being given earlier dates than smaller employers) The contribution levels will be phased in over a period with employer contributions being 1% for the first three years that the new arrangements operate (ie from October 2012) Employee contributions will be 1% during this period (gross) In the fourth year, contributions will increase to 2% (employer) and 3% gross (employee) Thereafter, contributions will be 3% (employer) and 4% net (employee) plus 1% tax relief on the employee contribution (higher and additional rate relief can be claimed by the member if applicable) There will be a cap on total contributions of 3,600 pa, in order to avoid eroding the position of existing schemes The 3,600 cap is stated in 2005 terms and will be increased in line with earnings Personal accounts are intended to be low charge arrangements, with a target charge level of 0.3% pa originally suggested Following consultation carried out by PADA, it has been concluded that although a single charge such as an annual management charge is seen as most simple, this would make it difficult to met the costs of establishing NEST Initially therefore, there will therefore be a contribution charge of 1.8% in addition to an annual management charge of 0.3% NEST will not take transfers in from other schemes. nor make transfers out This is intended to ensure that NEST does not compete with other schemes Occupational schemes will be regarded as a suitable alternative to personal accounts if they meet certain standards

7 Essentially defined benefit schemes which are contracted out on the reference scheme basis will be acceptable, but there will also be a lower standard, based on an accrual rate of 1/120ths This however is intended to be based on total earnings, which is likely to complicate administration For defined contribution schemes, the requirement will be contributions of a minimum of 8% of pay within the personal accounts earnings band, of which at least 3% must be paid by the employer Group personal pensions (PPs) will also be acceptable Current and planned changes to State Pensions S2P will become a flat rate scheme over a period of time, with conversion fully completed by around 2030 The government has announced that it would like to introduce more radical reform, with the introduction of a higher basic pension to replace S2P, or to accelerate the current process However, consultation is taking place regarding these issues and for the moment, the position remains as detailed below The process of moving S2P to a flat rate basis started with the introduction in April 2009 of an Upper Accrual Point (UAP), which is 770 per week ( 40,040 per year) The UAP is the maximum level of earnings on which S2P benefits are provided It is fixed in monetary terms, and will not increase The contracted out reduction/rebate in Ni contributions is based only on earnings between the LEL and UAP, although employees pay full NI contributions on earnings between the NI primary threshold and the Upper Earnings Limit (UEL) The LET will continue to increase and will eventually overtake the UAP, which will then be abolished This will leave S2P providing benefits on a flat rate basis (providing 40% of the difference between the LEL and LET for all who complete a full career in S2P) This position should be reached by around 2030 under current proposals, although as already mentioned, the process may be accelerated As a further step, the target benefit on earnings between the UET and UEL has reduced from 20% to 10% from April 2010, so simplifying S2P to two bands rather than three In addition, the number of years required to qualify for a full State pension has reduced to 30 for both men and women who reach State Pension Age on or after 6 April 2010 The requirement was 39 years for a woman and 44 years for a man for those who reached State Pension Age before 6 April 2010 Changes to the basis of increases in State pensions were also announced in the June 2010 Budget From 2011, the basic pension will be increased in line with the greater of growth in National Average Earnings and prices, now measured by the Consumer Prices Index (CPI) A minimum increase of 2.5% per year is guaranteed SERPS/S2P benefits will continue to be increased in line with prices only and the measure will be the CPI from 2011

8 In recent years, the CPI has increased more slowly than the RPI, and the change to using the CPI may therefore mean that increases to SERPS/S2P benefits will be reduced Current and planned changes to contracting out Contracting out of S2P will be abolished for defined contribution (DC) schemes from 2012 It was originally intended that this would coincide with the time the earnings link was restored for the State basic pension, but the latter was brought forward to 2011 The withdrawal of contracting out applies to both occupational DC schemes and personal pensions (PPs), including Stakeholder Pensions The option will be retained for defined benefit (DB) schemes It is also intended that the unisex annuity rate requirement for Protected Rights will be abolished, together with the requirement for 50% spouse or registered civil partner pensions This will be effective from 6 April 2012 Changes to State Pension Age State Pension Age (SPA) is in the process of being equalised between men and women, and is being increased as a response to rising life expectancy The original proposals were to increase SPA for women from 60 to 65 over the period 2010 to 2020 The government has now announced that the increase will be accelerated so that it reaches 66 for both men and women in 2020 Under the Pensions Act 2007, State Pension Age will increase further for both men and women, to 67 over two years starting in 2034 and to 68 over two years starting in 2044 However, this schedule is also likely to be accelerated, although final plan have not yet been decided Use of CPI to replace RPI as inflation measure The government is seeking to move towards the use of the CPI in place of the RPI in various areas, including in determining the increase levels for a range of State benefits The CPI can also be used in place of the RPI from 2011 in determining the required increases in pensions in payment under the Limited Price Indexation (LPI) provisions, and for preserved pensions under the Statutory Revaluation requirements These measures are primarily aimed at easing the cost burden on defined benefit schemes and so increase the chance of more such schemes surviving However, some schemes include the link to the RPI in their rules and may therefore not be able to change to use the CPI without the agreement of members This is likely to result in a situation where some schemes continue to use the RPI whilst others use the CPI Default retirement age In the past, legislation has allowed a default retirement age (DRA) - an age at which an employee can be retired by the employer without any reason other than age The default retirement age was set at 65, but is being abolished As a result, any employee who has not received notice of retirement before 6 April 2011 cannot be retired on the basis of the DRA

9 Retirement at the option of the employer can only be enforced if justified on objective grounds, for example because the individual is no longer able to perform the duties associated with his or her role