Widening reach of cruel accrual

The new annual limit will hit high earners in their wallets - but there are ways to lessen the pain, says Fraser Smart, managing director of Buck Consultants

April 6, 2011 marks a major sea change for the UK pensions landscape, with the annual allowance for pension contributions falling from £255,000 to £50,000.

When the pension tax system was “simplified” on A-day back on April 6, 2006, the intention was to provide an environment of high pension savings, achieve fairness across defined benefits and defined contributions participants, and recognise that earnings may vary greatly over each individual’s career. This system was meant to last a generation without major change. But nothing can survive the appetite of the Treasury for long: it lasted just five years.

When the full extent of the public finances shortfall became known, Alistair Darling announced that employees earning more than £150,000 would get basic rather than full tax relief on their pension contributions. This would have led to effective double taxation in many cases, in effect excluding ’higher earners’ from the tax-favoured pensions system.

Following pressure from the industry, the Coalition Government opted to implement this major reduction from £255,000 to £50,000 in the annual allowance, rather than explicitly target the higher earners. In addition, the lifetime allowance was reduced from £1.8m to £1.5m. These changes were intended to achieve as much in tax revenue as Darling’s plans but in a simpler and fairer manner: for those keeping within the limits, including higher earners, there would be no double taxation. However, one important principle of the 2006 system was lost, in that flexibility to vary pension contributions throughout one’s career is now much diminished.

At first glance these changes might seem quite straightforward to implement. But while only a handful of employees were previously affected by the £255,000 limit, enabling employers and administrators to deal with them on a case by case basis, many organisations now employ sizeable groups of employees affected by the reduced allowance, in particular where a generous DB plan is provided to a long-service workforce. Employees breaching the limit, by contributing more than £50,000 to a DC or accruing benefits in a DB worth more than £50,000, will be subject to a pensions tax charge on the excess at their marginal rate.

We do not believe that it is the duty of employers to compensate the employee for any eventual reduction in pension income or tax charge incurred. This would go against the principle that the cost of doing business in Britain should be reduced – the alleged backbone to recovery as outlined by the current government

So what should employers do about this? Ultimately, these tax measures are the consequence of the colossal UK deficit; reduced spending was deemed to be insufficient to resolve it. However it must be noted that it is not corporation tax which was increased by the Treasury – on the contrary, corporation tax is on a downward course. By reducing the amount of tax-favoured pension savings and introducing the pensions tax charge, the Treasury is intent on increasing the amount of tax paid by individuals.

We do not therefore believe that it is the duty of employers to compensate the employee for any eventual reduction in pension income or tax charge incurred. This would go against the principle that the cost of doing business in Britain should be reduced – the alleged backbone to recovery as outlined by the current government.

But this does not mean that employers cannot help their employees. The first way they can help is through communication and education – identifying the employees affected, meeting them individually to explain the changes, providing them with their pensions data and, ideally, with a tool allowing them to assess the personal impact of the new tax rules. If nothing else, this will enable employees to plan their tax bills. When companies have taken this route it has tended to be extremely well-received.

Furthermore employers can set up alternatives to the main pension arrangement in order to reduce or eliminate the pensions tax charge, in a way that will be cost neutral. For example, restricting DB accruals to the maximum level not breaching the limit, providing a wider range of accrual rates, restricting DB accruals by capping the employees’ pensionable salary or reducing DC contributions, whilst paying a taxable cash supplement for an amount equal to the difference between the value of the old benefit and the new benefit, will all help.

Measures such as these will undoubtedly lead to higher administration costs and additional pressure on management time, but this is arguably a price worth paying for enhanced employee satisfaction.