How serious is serious?

The new definition of severe ill-health for the purposes of the £50,000 pension annual allowance will have ramifications for employers says Edmund Tirbutt

The Coalition’s £50,000 annual contribution cap on pensions will not hit those retiring on grounds of severe ill-health, but tax charges could
still arise if a scheme’s definition of disability is lower than the new description of severe disability proposed by the Treasury last month.

The Treasury has designed the new rules so that any increase in pension, even that accrued on the day an individual is awarded an ill-health early retirement pension, counts towards their annual contribution. That means, without an exemption, an award of an income of even £10,000 a year for a 50 year old could raise a tax liability well into six figures. The Treasury does not want severely disabled people being hit with massive tax bills, and has said there will be an exemption for Ill-health early retirement pensions (Iherps), but there is still some debate as to the extent of the exemption.

In a consultation published last month the Treasury has confirmed that the severe ill-health exemption is satisfied if the individual ’becomes entitled to all the benefits to which the individual is entitled under the arrange-ment in consequence of the scheme administrator having received evidence from a registered medical practitioner that the individual is suffering from illhealth which makes the individual unlikely to be able to undertake gainful work (in any capacity) at any time in the future (otherwise than to an insignificant extent), or becomes entitled to a serious ill-health lump sum under the arrangement’.

In the public sector people have been seen to be getting Iherps too easily in many cases. So the definition of an Iherp must become robust enough in the first place and those in receipt of one should be regularly reviewed

This should mean in many cases no tax charge will be raised. But debate will still continue where scheme rules allow for ill-health early retirement on grounds less rigorous than those set out by the Treasury as being necessary to satisfy the exemption criteria. The discussion does serve to underline the complexities of using defined benefit solutions for income protection.

Talk about opportunities for income protection to fill the gap for ill-health early retirement pensions (Iherps) created by the switch from DB to DC pensions schemes has been rumbling on for well over a decade. DC schemes have no surplus assets from which to fund Iherps and, in any case, when trustees have funded Iherps from the assets of DB schemes it has never represented a particularly attractive proposition for
either employer or employee.

Paul Avis, sales and marketing director at Canada Life Group Insurance, says: “The Iherps design under a DB scheme could be very harsh on employees. Definitions of disability have not been that great, benefits can reduce State benefits and are also subject to change every year.

Furthermore, once the claimant’s employment is terminated on receipt of an Iherp they lose death-in-service and private medical insurance (PMI) benefits when they need them most.

For employers, Iherps have lacked transparency, don’t always fit in with diversity strategies and, because there are so many subjective illnesses involved nowadays, it has become very hard for trustees to make decisions to terminate employment

“For employers, Iherps have lacked transparency, don’t always fit in with diversity strategies and, because there are so many subjective illnesses involved nowadays, it has become very hard for trustees to make decisions to terminate employment. Additionally, there are lots of companies with DB schemes who actually don’t realise they are offering both Iherps and income protection because they are administered through different people.”

Such arguments have been moving up a few notches in volume since the October 2010 announcement that the annual allowance for tax privileged pension saving would be reduced from £255,000 to £50,000 with effect from April 2011.

It had been feared that if the total amount involved with an Iherp exceeds £50,000 it could create a major tax liability, therefore providing an opportunity to sell group income protection instead. Indeed, even the Treasury itself has suggested in a recent discussion paper that Iherps could be replaced by what it calls “Permanent Health Insurance” – an out-dated name for a product that the Association of British Insurers (ABI) officially decreed a decade ago should be referred to as “Income Protection”.

The Government has demonstrated its desire to exempt some of those suffering from ill health from this looming tax charge but experts currently disagree whether this will be only those with major terminal illnesses or the bulk of those unwell enough to qualify for Iherps.

Elsewhere in the public sector, however, opportunities to sell income protection as an alternative to Iherps are far less abundant than in the private sector. The issue is not so much whether public sector employers should be removing Iherps from DB schemes and replacing them with group income protection but that they should be introducing more rigorous assessment criteria and stricter definitions for Iherps – which could at least result in useful consultancy work for income protection insurers.

John Dean, director of Punter Southall, says: “In the public sector people have been seen to be getting Iherps too easily. So the definition of an Iherp must become robust enough in the first place and those in receipt of one should be regularly reviewed. The income protection rigour would be great for these purposes but it should be applied to the current Iherp system.

“It’s not really an income protection issue in the public sector. The issue is that confidence in the system is shot because it’s become a given right for those who can carry on working in other capacities to have Iherps when the benefit paid should be the difference between what they are earning in a new job and what they used to earn. The public sector could outsource the assessment work to the private sector, which could boost demand for income protection providers’ rehabilitation and early intervention facilities.”

But Dean feels that DB scheme closures undoubtedly represent an opportunity in the private sector and estimates that the shift from DB to DC
schemes has accounted for the vast majority of whatever virgin income protection business has been sold industry-wide during the last two years.

Within this period Punter Southall alone has had three virgin income protection schemes with over 1,000 lives taken out as a direct result of DB
scheme closures.

Nevertheless, virgin business industry- wide has been minimal and to-date Legal & General is the only provider to have specifically packaged up an income protection scheme offering options to take the place of Iherps. Its report of “some interest” for this product, launched in 2009, makes it hard to ridicule the decision of other providers simply to tweak their income protection offerings to fill this gap as and when requested. The consensus message is that the Iherps issue is simply another useful selling point for group income protection as a whole.

Steve Bridger, head of group risk at Aviva UK Health, says: “Our key position is that it’s a great opportunity to refresh the concept of what corporate income protection is all about. Before all the recent emphasis on rehabilitation the product was basically an Iherps vehicle as well as one for supporting on-going claims. It’s a chance to remind people of one of the core benefits at a time when everyone has been focusing on rehabilitation and intervention.”

There have, however, been many such “great opportunities” to interest employers during recent years and none have created new business
momentum. So, whilst income protection experts are increasingly pointing to light at the end of the tunnel, there is also a general acceptance that patience is necessary.

Ron Wheatcroft, technical manager at Swiss Re Life & Health, says “One of the challenges employers face is increased pension costs starting in 2012 with auto-enrolment into Nest or qualifying pension schemes, so they might be reluctant to spend on income protection as well. The fundamental point is that pensions are compulsory and income protection is not compulsory, so it is always going to play second fiddle.”

INNOVATIVE SOLUTION FOR LOCAL GOVERNMENT

A specialist scheme launched in May 2010 by Legal & General exclusively in conjunction with Hymans Robertson has sought to capitalise on the April 2008 changes to local government pension rules on Iherps. It bears more resemblance to critical illness cover than to income protection.

The scheme offers local government employers the chance to insure the cost of claims to their pension scheme if employees need to retire early because of ill health. In the event of a claim they receive a lump sum and can use this to help fund an Iherp by paying it to the trustees. There is no P11D liability for employees and, if the employer is a trading company affiliated to local government, it can get tax relief on the premiums.

James Walker, technical manager at Legal & General, says: “The pension rule changes have increased the strain on local government DB schemes. For smaller employers there is a risk of claims putting them out of business and with big employers it can have a severe impact on
funding if they have a lot of claims in one year.

“It’s early days but we’ve signed up two regional funds and a number of employers within these have come on board, and we are expecting the bulk of interest to occur at the three year pension renewal period in April 2011. We think the idea could be extended to the private sector as an
alternative to offering income protection to replace Iherps.”