Advising those at risk of breaching the pension lifetime allowance can create an interesting dilemma for advisers as they search for ways to maximise opportunities for clients. Yet while pension saving may be the El Dorado of tax-efficient investment, there are still plenty of other options to consider.
The pension lifetime allowance was ushered in with A-Day in 2006 and while initially set at and#163;1.5 million, increases are scheduled each year to raise the threshold to and#163;1.8 million by 2010. Currently the cap sits at and#163;1.65 million.
But for wealthy clients who break through this ceiling, the penalties are severe. A hefty 55 per cent tax is charged on funds over this amount when the money is vested.
National Audit Office figures from 2004 – before the lifetime allowance was brought in – suggested that around 10,000 people would be affected by a limit of and#163;1.4 million. But Standard Life head of pensions policy John Lawson suggests that once investment growth between now and retirement are taken into account, between 500,000 and 1m people are today likely to be affected by the lifetime allowance.
Lawson says that for wealthy clients at risk of breaching the lifetime limit, deciding whether or not to move into risk-free assets within their pension portfolio is a big issue.
“You’ve got to say well, should I take risk at all, or should I just invest in risk-free assets like gilts for example. Because what’s the point of trying to exceed the lifetime allowance if 55 per cent of the upside is going to disappear?” he says.
Lawson uses the example of the lifetime allowance increasing at 2.5 per cent a year, while equities increase at a notional 7.5 per cent a year.
“In this scenario, if you are on course to go over the cap, you’re going to outperform the lifetime allowance by 5 per cent a year, but half of that out-performance – in other words probably about 2.5 – 2.75 per cent – is going to go in tax. So you might just say to yourself, why shouldn’t I just invest in risk-free assets that will return 4.5 per cent, 2 per cent above inflation, and not bother bearing the risk.”
He also suggests that clients in this situation may want to vest the fund as early as possible, rather than waiting until the intended retirement age is reached.
“At the moment you can strip funds out from age 50 and that goes up to 55 in 2010. The best way would be to go into draw down and just take your maximum draw down every year,” Lawson says.
Then the client can effectively recycle the money drawn out into investments or into pensions for the children, for example.
“That would be a way of passing money on efficiently between the generations. The beauty of having money inside a pension wrapper is generally it’s inheritance tax-free. The moment you take it out it’s subject to your estate, but if you can roll it into your kids’ pensions quickly, then it’s back out of your estate,” Lawson explains.
Another choice for many clients bearing down upon the lifetime limit is to invest offshore.
“We think that offshore contracts have got a big part to play for people in that kind of position,” says Steven Whalley, head of marketing for investment products at Aegon Scottish Equitable. “It seems to be that outside of things like Isas, this is the second best tax treatment that people could look for,” he says.
This is because offshore bonds can offer virtually tax-free growth, with the advantage over pensions of offering the ability to take all the proceeds as a lump sum, rather than having to buy an annuity, he says. The option exists to bring the proceeds back onshore when the investor has become a lower rate tax payer, or to put it in the name of a spouse in a lower rate tax bracket. “And you can take the benefits before age 55 – so I think there’s a really good opportunity there,” Whalley says.
Offshore bonds also offer the ability to pay in a single premium, or make use of a regular premium contract – which can be useful for clients who have become accustomed to paying into a pension on a regular basis. Whalley says it is one of only a few companies with a regular premium contract based on the UK market.
However, some advisers recommend using unit trusts and Oeics as regular use of capital gains tax limits will make this avenue more tax efficient than offshore bonds, particularly as anyone up to the lifetime limit on their pension is not likely to be a basic rate taxpayer in retirement. Towry Law senior client partner Chris Cole is not convinced offshore bonds hold all the answers.
“The use of your more traditional offshore bonds are now less important, we think, because in theory an offshore bond just rolls up gross – which is great. But when it does come back onshore and crystallise it’s at 40 per cent, because it’s subject to income tax,” he says.
“You compare that to paying 18 per cent capital gains tax and using your exemptions onshore. You’ve got to have a large amount or a very long time horizon before the maths works right now,” he says.
Nick McBreen, an adviser at Worldwide Financial Planning says there is a raft of opportunities open to those who have funded up to the maximum lifetime pensions limit. “I think the offshore potential for them is enormous,” he says.
This includes making use of Qualifying Recognised Overseas Pension Schemes [QROPS], in the case of clients who are considering leaving the UK in the future, he says.
Meanwhile, Klonowski andamp; Co principal Francis Klonowski points to the benefits of building up a growth oriented investment portfolio, through individual funds, or funds of funds.
“There’s nothing really that is comparable to pension funding. It’s really a question of building up a non-pension portfolio that suits your risk profile,” he says.
“The nice thing about having a growth oriented portfolio of investment trusts for instance, is that you can control the income that you take from that to a large extent. If there are two of you and you’re saving into one of those between you, you’ve got the best part of and#163;20,000 between you to draw from each year without paying any tax.”
Cole describes cash as another interesting investment vehicle currently, both because of the peace of mind it offers and the opportunities available. This includes the 16th and 43rd tranches of National Savings andamp; Investments Index-linked Savings Certificates, which have three and five year terms respectively and which couples can invest up to and#163;60,000 within tax-free – at and#163;15,000 per tranche per person.
“They’re not as attractive as the last tranche, but you would still need to be grossing in excess of 7 per cent on cash as a higher rate tax payer to match them,” he says.
Meanwhile, Cole says there is also a tax anomaly currently being talked about within wealth management circles following the Budget. While dividends from offshore cash products did used to be taxed at 32.5 per cent, this is now 22.5 per cent, significantly more attractive than the 40 per cent tax higher rate tax payers currently pay on cash onshore.
Cole says it is making clients aware of the loophole, but also of the fact that they expect it to be shut down fairly promptly.
For the more aggressive investors, advisers also point to Venture Capital Trusts [VCTs] and Enterprise Investment Schemes [EIS] as offering further tax-effective investment options.
But while slowing down the growth on pension investments, or moving to investments outside the pension wrapper may be the order of the day for many wealthy clients closing in on the lifetime limit, for others, paying the 55 per cent tax rate over and above the funding ceiling could be worthwhile, Lawson suggests.
This is relevant for those who have 20 or more years until retirement, such as young high-earning city workers with employer contributions, he says.
“Bearing in mind the benefits of the tax-relief, the tax-free cash and the gross roll-up and all of that, it has to have a really beneficial effect over long terms,” Lawson says.
“But if you’re within 15-20 years of retirement, if you’re going to get close to the lifetime allowance, you’re better investing in something else.”
Protection selection – which capital protected products?
Chartwell Private Client financial planning manager Ed Green has dealt recently with clients on track to come up against the lifetime allowance. “Either they are Green: Looking at alternativescurrently in that situation, or they’re predicted to be,” he says. “You’ve got people who are say in their 40s and they’re predicted to hit the lifetime allowance by the age of 52, so we’re looking at alternatives now to use up their excess income.”
As a result Green has looked to options such as setting up pensions in the wife’s name – particularly if they have no or low earnings – in order to benefit from the tax relief available there. He has also looked to make use of mutual fund portfolios to capitalise on the capital gains tax allowance for clients in retirement. Green has also turned to offshore bonds. “A lot of these people’s wives – or husbands for that matter – tend to be lower rate tax payers. Moving funds into an offshore bond means you get gross roll-up and when you eventually draw down on them, you don’t necessarily pay higher rate tax,” Green says.
He says there are a number of offshore investment bond schemes that take regular contributions. “It means you can set up a and £1,000 a month regular contribution – or whatever it might be – in a similar way to a pension and it allows the investment to grow very tax efficiently. They can draw down 5 per cent in retirement, or put them in the wife/husband’s name and pay very little tax on that.”
Green says it has looked into products from Canada Life International and Axa, in particular.
“They offer reasonable terms and you’ve got a good fund choice – so either of those tend to be the ones we look at,” he says.