Page 1 of 6 CORPORATE UPDATE FOURTH QUARTER 2010 End of the waiting game benefit, relative to the system introduced from April 2006. Nevertheless, some change was inevitable, and the new regime is more straightforward than the overhaul put forward in the latter months of the previous Government. It also avoids much of the risk of collateral damage that would have been inherent in disenfranchising higher earners from the UK pension system. The UK Government s tax changes are less penal than was feared, but require complex decisions to be made quickly The new UK Government has continued several pensionsrelated initiatives, with an increasing number at a stage where employers have the information needed to make key decisions and limited time to make them. (The key exception is that details on the Government s intended change in statutory minimum pension increases, to being CPI-based, are still awaited.) In this update, we highlight key points of the new regime for pensions tax relief. We look at the effects of financial market movements on the funding status of UK pension plans. Finally, we highlight important developments in the pending autoenrolment regime. Even so, the new measures can hardly be described as simple and innocuous. Employers now need to make complex decisions, and need to make them quickly. Some potential implications of the new measures, centred around a reduced Annual Allowance (AA) of 50,000 pa and a reduced Lifetime Allowance (LTA) of 1.5 million, are: Overall remuneration packages of many senior executives may need to be rebalanced, with pensions potentially being a smaller proportion of the total package. Pension tax changes - decision time! You know that things are not normal when employers and pension specialists respond to Government tightening of tax treatment of pensions with a sigh of relief. This may seem especially strange given one remembers that the 14 October 2010 announcement means a reduction in annual limits for tax privileged pension savings to broadly 20% of previous limits for defined contribution arrangements and to 12% for defined An unexpectedly large number of employees with more modest incomes may be affected, especially members of final salary schemes with long service or a period of significant career progression. The ability to carry forward unused allowances from the previous three tax years should mean that the risk of middle-income employees being impacted is reduced, but not eliminated. This may influence overall benefit design, potentially favouring career average arrangements or caps on increases in pensionable salary. LCP is part of the Alexander Forbes Group, a leading independent provider of financial and risk services. Lane Clark & Peacock LLP is a limited liability partnership registered in England and Wales with registered number OC301436. LCP is a registered trademark in the UK (Regd. TM No 2315442) and in the EU (Regd. TM No 002935583). All partners are members of Lane Clark & Peacock LLP. A list of members names is available for inspection at 30 Old Burlington Street, London, W1S 3NN, the firm s principal place of business and registered office. The firm is regulated by the Institute of Actuaries in respect of a range of investment business activities. Locations in London, Winchester, Jersey, Belgium, Switzerland, the Netherlands and Ireland.
Page 2 of 6 For those in the happy position of being concerned that their total benefits could ultimately exceed the reduced LTA, it may make sense to cease pension savings earlier than previously intended, and perhaps even to start drawing their pensions. The optimal course of action will depend on specific circumstances, and the details of transitional protections which are currently under Government consideration. The decision may not be easy. The transition to the new limits involves numerous pitfalls, and in some cases also opportunities. A plan s Pension Input Period (PIP) can now be vitally important. For savings made in the current tax year, this needs to be considered in combination with the complex anti-forestalling measures introduced by the previous Government. Employers and affected members will need to understand the resulting constraints, as well as any time-limited opportunities that may be available to them. Where redundancy terms include pension enhancements, these should be re-evaluated. The Government has declined to make special provisions for redundancy situations. However, there may be aspects of the regime that still give opportunities to use pension to help out redundancy packages. Ill health retirement benefits may present more significant concerns depending on further Government deliberations currently in progress. Pension tax changes in a nutshell Annual Allowance for pension saving on a tax-privileged basis reduced from 255,000 pa to 50,000 pa, for tax years from 6 April 2011 onwards. The 50,000 pa limit is fixed until at least March 2016. The limit is applied against pension accrual in the Pension Input Period (PIP) ending in the relevant tax year. Hence the new limits apply immediately in some circumstances. Unused Annual Allowance can be carried forward up to three tax years from the previous tax year. This reduces but does not eliminate the risk of additional taxes being triggered on spikes in accrual. Pension savings in a year in excess of this level are taxed immediately as if an extra slice of income, at the individual s consequential marginal rates. Lifetime Allowance reduced from 1.8m to 1.5m probably from 6 April 2012. (Transitional protection mechanisms currently under consideration.) Defined benefit pensions valued on a fixed factor of 16 (regardless of age, sex and quality of pension) for Annual Allowance purposes, and 20 (probably maintained) for testing against the Lifetime Allowance. Increases (whether from accrual or salary linking) in accrued benefits up to the year s CPI do not count towards the Annual Allowance. Deferred pension benefits are normally completely exempt from the test. Retirement benefits accrued in the year of retirement will no longer be exempt. Benefits accrued in respect of the tax year of death are generally exempt from the Annual Allowance limits. Death lump sums themselves are subject to the Lifetime Allowance. Overall anti-avoidance principles apply, including the requirement to declare antiavoidance schemes to HMRC.
Page 3 of 6 Suggested priority actions for employers are: Impact assessment analyse the extent to which employees would be affected if no changes are made in response to the revised tax restrictions. Understand the Pension Input Period for relevant pension arrangements, and its implications for the transition and ongoing situation. Consider changing the PIP, eg to be aligned with tax years, if this change would be beneficial and feasible (which for some arrangements will depend on whether changes are made to the legislation). Consider implications in the future bearing in mind that nil or low increases in allowances over time may draw more and more key people into being restricted by the tax limits. Volatility remains uncomfortably high The graph below shows how typical funding levels have continued to be too volatile for comfort. Many periods of improving funding levels have proved transitory, underlining the importance of de-risking strategies being backed by careful planning and speedy execution. 120% 110% 100% Accounting vs Trustee Funding for a typical UK pension plan Trustee Funding Basis Accounting Basis Review benefit arrangements for affected individuals and perhaps for the membership as a whole if warranted. Understanding situation-specific issues in which the PIP(s) will be a key part is critical to making optimal decisions. Funding Level 90% 80% Develop a communication plan. This is a hot topic for employees, and it is not just those who exceed the Annual Allowance who are asking questions. Ironically for a regime that is aimed at reducing total tax relief, many employees are now planning to increase their pension savings up to the Annual Allowance. Employers should decide how to help their workforce through communication and education. 70% 60% 50% Dec Mar 2006 2007 Jun Sep Dec Mar 2007 2007 2007 2008 Jun Sep Dec 2008 2008 2008 Mar 2009 Jun Sep Dec Mar 2009 2009 2009 2010 Jun Sep 2010 2010 Notes: The liabilities illustrated above are assumed to be 75% index-linked and 25% fixed with duration of 20 years. The trustee funding basis illustrated here assumes an average discount rate of gilt yields plus 1.0% pa. The initial investment portfolio used consists of 25% UK equities, 30% overseas equities, 15% index-linked bonds, 20% fixedinterest bonds and 10% cash/property/alternatives. The liabilities have been adjusted for a two year increase in allowance for assumed longevity, spread uniformly over the period.
Page 4 of 6 Auto-enrolment coming, ready or not! Recent announcements by the UK Government confirm its commitment to phasing in requirements for employees to be enrolled automatically into pension arrangements. While employees can opt out, inertia will now be acting in favour of pension fund membership, rather than against it. This may be financially significant for many employers, especially where a large proportion of their workforce currently does not participate in employer-sponsored pension arrangements. Virtually all UK employers however good their current benefit arrangements will need to take some action in response to the changes. In addition to pension changes, many employers will also need to make substantial changes to their HR processes and payroll systems. Most of the framework put forward by the previous Government has been retained. The National Employment Savings Trust ( NEST ) has been reprieved, although employers will still have the option of automatically enrolling people into alternative arrangements that meet defined minimum criteria. Autoenrolment will be introduced on a phased basis, with the largest employers required to operate it from 1 October 2012, and all employers by 1 September 2016. Minimum employer contribution rates for NEST or alternative DC arrangements will initially be 1%, increasing to 2% from October 2016 and 3% from October 2017. However, there are some important changes, for example: The earnings threshold for determining whether an employee must be auto-enrolled will be the income tax personal allowance (which is due to increase to 7,475 for the 2011/12 tax-year) rather than the previously envisaged 5,035 increasing in line with national average earnings from the 2006/07 tax year. The auto-enrolment regime is taking shape, with farreaching implications for corporate pensions strategy as well as personnel and payroll processes Contributions will be required on income in excess of the National Insurance earnings primary threshold, which is 5,715 pa for the current tax year (rather than the previously envisaged initial figure of 5,035 pa). It will be possible to operate a three month waiting period before auto-enrolling, as opposed to the previous requirement for immediate auto-enrolment. Where a waiting period is used, employees must be allowed to opt-in during the waiting period if they so choose. This should reduce but not eliminate the risk of disproportionate costs dealing with very small pension pots. Key UK Pensions statistics* 30 September 2010 30 June 2010 31 December 2009 IAS19 discount rate 4.8-5.3% 5.1-5.6% 5.4-5.8% IAS19 RPI inflation 3.1-3.5% 3.2-3.6% 3.4-3.8% Long term gilt yield 3.9% 4.2% 4.4% FTSE100 index 5,548.6 4,916.9 5,412.9 *the figures shown are only indicative ranges; different figures may apply with regard to individual circumstances
Page 5 of 6 The revised auto-enrolment arrangements are to include a simplified defined contribution plan certification procedure (where an employer wishes to auto-enrol employees into a pension plan other than NEST) which appears to address most of the concerns about the practicality of the previous certification proposals. However, the detail is not yet finalised, so it remains to be seen what level of simplification is achieved. Given upward trends in minimum employer contributions in jurisdictions like Australia, employers may be concerned that the requirements published to date will prove to be the thin end of the wedge. We expect many employers will wish to explore changing their current pension arrangements in order to mitigate a likely significant increase in costs flowing from auto-enrolment. A key first step for employers is to understand what impact the auto-enrolment regime will have on them in the absence of any changes to their current arrangements. This will help make informed decisions on what measures to take. Actions could range from improving existing defined contribution plans, through levelling down existing arrangements, and freezing defined benefit plans. Forthcoming LCP events We hold a range of events that provide clear information and analysis on important pensions and investment topics. Our events attract excellent feedback and provide attendees with helpful information to make informed business decisions. Forthcoming breakfast briefings include: Executive pensions: 16 December Auto-enrolment: 7 December, 15 February, 16 March Annual allowance: 26 January Corporate transactions: 8 February Pension buy-outs: 10 February, 2 March Pensions and operational risk management: 8 March These briefings run from 08.30-10.00 at 30 Old Burlington Street, London W1S 3NN. For more information or to register to attend for free please see www.lcp.uk.com/events or email enquiries@lcp.uk.com
Page 6 of 6 Notes This Corporate Update is based on our current understanding of the subject matter and relevant legislation which may change in the future. Such changes cannot be foreseen. This document is prepared as a general guide only and should not be taken as an authoritative statement of the subject matter. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this Corporate Update can be accepted by LCP. If you would like any assistance or further information on the context of this Corporate Update, please contact Alex Waite or Michael Berg or the partner who normally advises you at LCP. Contact options include telephone number +44 (0) 20 7439 2266 or by email to enquiries@lcp.uk.com or firstname.lastname@lcp.uk.com Specific contacts Tax changes: Karen Goldschmidt or Mark Jackson Auto-enrolment: Mark Folwell or Andrew Cheseldine Buyouts and other risk transfers: Clive Wellsteed or Charlie Finch Investment matters: Ken Willis or Gavin Orpin