AUTO ENROLMENT MINIMUMS AND THE ANNUAL ALLOWANCE

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1 TECHTALK This article originally appeared in FEB 18 edition of techtalk. Please visit for the latest issue. AUTO ENROLMENT MINIMUMS AND THE ANNUAL ALLOWANCE The minimums imposed by auto-enrolment can sometimes be greater than the annual allowance, particularly the tapered and money purchase annual allowances. This interaction and ways of mitigating it are looked at in detail. THOMAS COUGHLAN Tom has spent over 15 years in technical roles. He has wide experience including the provision of technical support to financial advisers covering life, pensions and investment compliance. He currently specialises in pension planning. Automatic enrolment requires a minimum level of contribution for each member of a workplace pension scheme. The annual allowances, on the other hand, restrict how much can be paid into a pension scheme and raise a tax charge where those limits are exceeded. So what happens when the minimum amount under auto-enrolment exceeds the maximum amount that can be paid within the annual allowance? And what steps can be taken to minimise the impact of this? AUTOMATIC ENROLMENT The first few years of automatic enrolment (AE) have improved the retirement savings of millions of workers and boosted the public image of pensions generally. To be effective, the rules had to contain as few exceptions as possible, with the result that many for whom the policy was not intended e.g. high earners were brought into the net. This is not necessarily a bad thing, as they were most likely already benefiting from access to their s pension scheme with generous contributions, so switching to an AE-compatible scheme was of little consequence. The subsequent introduction of the tapered annual allowance (TAA) created a potential tax issue for a number of these high earners whose total contributions to their s scheme now exceeded their reduced allowance. The money purchase annual allowance (MPAA), with its even lower annual limit the effects of which are not restricted to high earners is a potentially more wide-ranging issue. Before moving on to the interaction between these thresholds and how to mitigate the tax consequences, we will recap on each rule in turn.

2 WHAT IS THE MINIMUM CONTRIBUTION UNDER AUTOMATIC ENROLMENT? There is not a single answer to this question. It differs for each worker depending on their earnings. However, where the scheme uses the standard contribution basis qualifying earnings (QE) the minimum annual contribution cannot be higher than a certain amount. Under QE, total earnings between 5,876 and 45,000 must be pensioned (in 2017/18). In the current tax year total contributions must be at least 2% of that band of earnings. This means the total minimum contribution cannot exceed If the minimum contribution was 5% or 8% (the minimums that are being phased in starting in April 2018) the equivalent figures would be 1, and 3, These are well below the MPAA of 4,000 and the lowest level of the TAA of 10,000, so membership of a single workplace pension that operates on the QE basis will not in itself cause a worker to exceed the MPAA or TAA, either in this tax year or in future tax years.

3 Predictably, though, that isn t the end of the story. Employers may be obliged to pay minimum contributions, but they can utilise a higher contribution basis. If they do so, there is no compulsion on them to allow a particular worker to pay the minimum levels. Furthermore, the may decide not to use the QE basis, instead preferring an alternative definition of pensionable earnings. This is covered by certification, which provides three alternatives to QE: Set 1, Set 2 and Set 3. The minimum requirements are: SET 1 Pensionable earnings must include basic pay. Minimum total contributions are: 3%, of which 2% must be paid by the 6%, of which 3% must be paid by the 9%, of which 4% must be paid by the SET 2 Pensionable earnings must include basic pay and at least equal 85% of total earnings (averaged across the scheme). Minimum total contributions are: 2%, of which 1% must be paid by the SET 3 5%, of which 2% must be paid by the 8%, of which 3% must be paid by the Pensionable earnings must include total pay. Minimum total contributions are: 2%, of which 1% must be paid by the 5%, of which 2% must be paid by the 7%, of which 3% must be paid by the Under the Sets, all earnings within the definition from the first pound are pensionable. Accordingly, total contributions are theoretically unlimited. For example, a worker receiving salary of 200,000 and a bonus of 50,000 in 2019/2020, could be funding their workplace pension to the tune of: Set 1 18,000 Set 2 17,000 Set 3 17,500 These amounts are significantly greater than what would be paid under QE ( 3,130) on the full 8% basis and well above the level of the MPAA and the minimum level of the TAA.

4 THE RESTRICTED ANNUAL ALLOWANCES Whereas automatic enrolment requires a minimum contribution, the two restricted annual allowances impose a maximum contribution before tax charges apply. The money purchase annual allowance The Government introduced the MPAA alongside Freedom & Choice in April It is a tax-avoidance measure that prevents the pension freedoms being exploited through recycling. The MPAA is 4,000 and applies to all contributions to money purchase schemes once it has been triggered. The triggers are broadly anything under the heading flexible access, such as receipt of flexi-access drawdown income or an uncrystallised funds pension lump sum. It normally only applies after age 55. The tapered annual allowance The tapered annual allowance applies from April 2016 onwards and affects high earners. Adjusted income determines whether the restriction applies, which broadly speaking includes taxable income before personal contributions to pension schemes plus contributions. If this exceeds 150,000 and taxable income after personal contributions is more than 110,000 referred to as threshold income the annual allowance is reduced. The tapering is 1 for every 2 of adjusted income above 150,000, subject to a minimum tapered annual allowance of 10,000. THE INTERACTION The interaction between the rules can result in a worker being subject to a tax charge because total contributions to the workplace scheme are greater than one (or both) of the restricted annual allowances. The following examples illustrate the problem: EXAMPLES ANTHONY ELEANOR Age: 60 Salary: 50,000 Contribution: 9% (4% ) Anthony, age 60, receives a basic salary of 50,000 and triggered the MPAA in 2016/2017. He is a member of his workplace pension scheme which operates on a Set 1 basis. The scheme already pays contributions on the full 2019 basis: 9%, with 4% paid by the. His total contribution in 2017/2018 is 4,500, which is 500 above the MPAA. The annual allowance tax charge will be at 40% because the excess falls in the higher rate tax band. The charge will be 200 and will be paid through self-assessment. Age: 40 Salary: 200,000 Contribution: 8% (3% ) Eleanor, age 40 has adjusted income of 206,000 (including contributions of 6,000). She is a member of her workplace pension scheme which operates on a Set 2 basis. The scheme already pays contributions on the full 2019 basis: 8%, with 3% (the 6,000 mentioned above) paid by the. Her total contribution in 2017/2018 is 16,000, which is 4,000 above the TAA. The charge is at 45% because the annual allowance excess falls in the additional rate tax band. The charge will be 1,800 and will be paid through self-assessment.

5 The key to dealing with the interaction between these rules is for s to open a dialogue with workers. WHAT EMPLOYERS CAN DO There is no one-size-fits-all solution, but s can help their staff mitigate a tax charge in a number of different ways. However they choose to do this they must ensure that they meet all of their legal duties under AE and not encourage workers to leave the scheme. Any tax charge that does arise falls on the worker, so only they can take the decision to leave the scheme. Assuming they do wish to remain a member of the scheme, they may benefit from discussing the following options with their. Reduce contributions Employers can try to highlight which of their workers have a restricted annual allowance and reduce their overall contributions. The contributions should not be taken below the AE-minimums unless the client has specifically requested this. This will reduce the worker s total reward package, so the shortfall should be compensated in some way. If the original contribution was contractual an amendment to the contract is required, which might involve enhancing salary in exchange for the reduced contributions. It should not be forgotten that any increase in salary to make up for a reduced pension contribution will itself be subject to income tax and national insurance contributions. The decision to swap some pension contributions for salary, therefore, is a tax comparison looking at the overall tax rate for alternative components of the reward package. Switch to the QE basis / entitlement check As it is only a certified Set 1, 2 or 3 basis that leads to this problem, the could switch the affected worker s contributions to the QE basis. The total contribution to the scheme will, in itself, be well within the MPAA or the TAA. Similarly, an entitlement check allows an to confirm that whatever the contribution structure, the total amount payable is at least equal to the monetary amount that would have been paid under QE. Either of these routes can ensure the AE minimum is met, but would still amount to a reduction in contributions and thus the overall reward package. The points highlighted in the paragraph above, therefore, must be addressed. Do nothing As the tax charge falls on the member, they may prefer the full contributions plus a tax charge to a reduced contribution with no tax charge. This should involve an objective analysis of the monetary benefit of the existing contribution and the tax charge that it leads to. Employers can help workers in this regard by pointing them towards an independent financial adviser or an impartial source of information such as The Pensions Advisory Service or The Money Advice Service. Use carry forward The tapered annual allowance can be enhanced by carry forward, which may enable a worker to avoid a tax charge even where their workplace pension contributions exceed their tapered annual allowance for the current tax year. Further action may then be required when carry forward has been exhausted. The MPAA cannot be enhanced by carry forward. SUMMARY The key to dealing with the interaction between these rules is for s to open a dialogue with workers. It is ultimately a personal tax issue, so it makes sense that the final decision is made by them. This may be difficult for very large s, however a stock solution should be avoided where possible. The difficulty of a broad brush approach is highlighted by one frequently suggested solution: capping total contributions at 10,000 for those whose reward package exceeds 150,000. Say, a worker earns 151,000 including contributions. In the absence of additional income their tapered annual allowance is 39,500 only 500 below than the full annual allowance. This leaves plenty of scope to pay contributions above 10,000 yet their contributions would have been capped at this level. Likewise, a worker with a total reward package of 149,000 and 65,000 additional income from separate consultancy work has the lowest tapered annual allowance of 10,000. The s 150,000 cut-off would have failed to identify this individual as being at risk of having a restricted annual allowance. Employers should, therefore, rely on workers to inform them that they have a potential tax charge caused by workplace pension contributions exceeding their restricted annual allowances. Through discussion, they can promote awareness of the issue and the different solutions. Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. Scottish Widows Limited. Registered in England and Wales No Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number