A blight on your pensions

The Budget has left pensions planning in tatters. James Phillipps tries to put together the pieces

The government’s proposals to restrict tax relief on pension contributions for high earners have been widely condemned and branded another raid on the nation’s already inadequate retirement savings.

Although billed as a revenue generating exercise targeting only the wealthiest individuals, corporate advisers fear the move may have far-reaching and unintended consequences for the wider workforce.

The new measures will see tax relief on the highest earners’ pension contributions reduced from 40 to 20 per cent from 2011 with a raft of anti-forestalling measures introduced to prevent them milking the current system in the run-up. But arguably more shocking is the move to tax employer contributions, including those of final salary schemes as a benefit in kind.

Mike Morrison, head of pensions development at Axa Winterthur, warns that while in the long term the loss of tax relief will only affect the top 1 per cent of earners, the shorter-term ramifications could be much greater, particularly at a time when companies are cutting costs and auto-enrolment is looming large.

“By reducing tax relief on contributions for individuals earning over £150,000 they are hitting the top executives in companies who make the decisions on what pension provision they make for their staff,” he says. “If you disengage these individuals the risk is that they have less incentive to offer good pensions, and will consider levelling down or just relying on Personal Accounts.”

Advisers say the extent of the impact this will have on attitudes to pension provision is already starting to become apparent.

During a conference call with 162 corporate clients last week, Hewitt Associates carried out a straw poll, which found that 80 per cent believed the Budget will make it more difficult to make general decisions around pensions, and 60 per cent said they will have to completely rethink the pensions projects they already have underway. Many have put benefits reviews on hold while they try to digest the news, while companies that have recently launched or were looking at launching more specialist arrangements for their executives, such as Sipps, are also in limbo.

Tony Baily, principal consultant at Hewitt, says: “This is making pensions more complicated and clients do not like the fact that they now have to put strategic work on hold and be reactive.”

With the legislation for the 2011 changes still to be passed, he says the industry is facing a “planning blight” as it has to cope with the intervening anti-forestalling rules without knowing the exact shape of the end regime.

One thing that is clear is the discrepancy between the treatment of the higher-earning members of final salary and defined contribution schemes. Although both types of pension scheme face the same risk that the decision-makers become disengaged, companies could adopt very different approaches over the next two years depending on what arrangements they have in place.

“On the defined benefit side, we have clarity on how the pensions tax is applied for the next two years with the value of the pension, multiplied by a factor of 10, protected,” Baily says. “It could be that the 10-1 factor undervalues DB schemes and DB ends up being more tax efficient, but at the end of the two year period it will be a case of turning off the lights and locking up, because for a lot of individuals it will not be attractive.”

Even if the loss of tax relief does hasten executives’ decisions to close DB schemes, members are likely to at least be able to accrue another two years’ worth of guaranteed benefits.

For the members of DC schemes, the picture is less rosy, however. “DB and DC members have been affected very differently by the falls in the financial markets,” points out John Wilson, head of research at HSBC Actuaries and Consultants. “DB benefits are protected as long as the employer covenant is good, but DC has taken a massive hit and anyone earning over £150,000 that wants to make a large contribution just to restore their pension pot will have it treated as a new contribution and subject to the 20 per cent special allowance charge.”

Wilson says that at a presentation made by the HMRC to the Society of Pensions Consultants last week, some DC members said they were considering taking a legal challenge to the European courts against what they considered discrimination.

At the same session, remonstrations were also made about the impact on the self-employed, many of whom only make a single annual pension contribution, which will not be recognised for protection under the anti-forestalling rules.

Although HMRC has promised to look at these concerns, many experts are not hopeful of change because of the complexities it would introduce.

While the finer details are thrashed out there are clear steps corporate advisers can take to help their clients in the run-up to 2011.

Baily points out that the new regime will introduce another layer of admin as companies will have to calculate members’ benefits over the tax year and not their own scheme year, as many currently do.

“One problem with DB schemes is that because the annual allowance is so high and a lot of people knew they were nowhere near it, they will now have to properly calculate it, which will mean a bit more administration,” he adds.

On a more forward-looking note, Lee Hollingworth, head of DC consulting at Hymans Robertson, says the changes throw down a challenge to the industry to create alternative benefits packages. The anti-forestalling rules have already done much to erode the attractiveness of salary sacrifice and flexible benefits to high-earners, meaning new innovation is needed.

“The question is where will the markets go from here and will we see an increase in demand for ‘wealth creation’ flexible savings packages,” he says. “Companies may now look at empowering employees to make their own savings choices into a number of vehicles, which could include pensions, cash Isas and share schemes,” he adds.

Clearly, the Budget changes are providing, and will continue to provide, a lot of work for corporate advisers in difficult times, but perhaps the hardest job they have on their hands is to persuade clients to stick with pensions at all and not just throw in the towel and sign up to Personal Accounts in 2012.

How the changes work – the basics

In a twin-pronged assault on higher earners’ pension contributions, tax relief will be cut in two years with the anti-forestalling rules designed to prevent individuals taking maximum advantage of the current status quo in the meantime.

From April 6, 2011, under new legislation to be introduced, anyone earning £150,000 or more will see the tax relief on their pension contributions reduced at a tapered rate so that members earning over £180,000 will receive just 20 per cent.

The anti-forestalling rules, which went live on Budget day, will penalise anyone in this wage bracket that increases their contributions above their ‘normal pattern’, crucially defined as monthly or quarterly, to get round this. Those making annual payments will not be able to build up a ‘normal pattern.’ The rules do not apply to anyone that does not increase their regular pension contributions after April 22, 2009, or where pension contributions are increased but overall pension savings are less than £20,000. Where pension contributions are increased, individuals face a 20 per cent special allowance tax on the increase. If the normal contribution was under £20,000 and the increase takes it over this amount, then the charge will only apply to the excess over £20,000.

For defined contribution scheme members, pensions savings include both the individual and the employer’s contribution. For those in a final salary scheme, this is based on the value of the benefit multiplied by a factor of 10, which is used to determine the capital value and any increase in this over the year is classed as the individual’s pensions savings.

No get out clause

Salary sacrifice and flexible benefits packages are also firmly in HMRC’s crosshairs and are likely to hold little appeal to higher earners, particularly after 2011.

Under the anti-forestalling rules, where a salary sacrifice agreement is made on or after April 22, 2009, the amount sacrificed will still count towards the member’s income, although arrangements made prior to this date will be honoured. Thereafter, however, salary sacrifice will not be deemed as reducing income for pension contribution tax relief purposes.

Robin Hames, head of technical, marketing and research at Bluefin Corporate Consulting, says: “A lot of people entered salary sacrifice in good faith and although it will still have advantages for the majority of the workforce, for high earners it will hold no benefit.”

The same holds for flexible benefits taken after 2011 but the picture is less clear in the anti-forestalling period, notes John Wilson, head of research at HSBC Actuaries and Consultants. He points out: “For us, one of the headline issues is flexible benefits, which are potentially in trouble for individuals earning over £150,000, because they are generally making decisions year by year and it may be difficult to establish a ‘normal pattern’.”

Group Sipps in the wilderness

The future of corporate Sipps has been called into question following the government’s Budget changes.

The market has been a rapid growth area over the past couple of years with many firms setting them up so directors can transfer their shares in the company in as a contribution and receive tax relief.

However, under the anti-forestalling rules, any shares obtained through annual options schemes transferred into the vehicle would not be treated as regular contributions and would incur a 20 per cent tax charge over the next two years. After 2011, high earners would also only receive 20 per cent tax relief on the contributions yet still face the prospect of paying up to 50 per cent when they draw their benefits.

Lee Hollingworth, head of DC Consulting at Hymans Robertson, says: “Virtually all group Sipps have been set up for directors to transfer shares over and get the tax relief and that market is effectively now dead.”

That said, some experts believe they still maintain attractive tax planning features, even if these have been watered down.

Tony Filbin, managing director of workplace savings at Legal & General, says they still provide flexibility around how income is taken and points to the tax-free lump sum.

He says: “Even if the recipient of the tax free lump sum was a high rate taxpayer when their contributions were made, they will have had a 25 per cent uplift in the contribution on the way in, equivalent to 20 per cent tax relief, and there is no income tax or CGT to pay on this amount.”

Pensions lose their lustre for the affluent

It is not hard to see how these higher-earning decision-makers are likely to become increasingly disillusioned with pensions.

Lee Hollingworth, head of DC consulting at Hymans Robertson, points out that just three years ago, the A-Day changes effectively placed a limit on the size of the pension pot that they can build up while still attracting full tax relief.

“Now a lot of these individuals will only get equivalent to 20 per cent tax relief on the way in but pay 50 per cent tax on the income they draw out, so as a tax-advantaged savings vehicle pensions have no relevance really,” he says.

Although A-Day introduced much greater flexibility around the size of the contributions that can be made in any one year, this has now been stripped away leaving many executives facing serious planning issues around their own retirement provision.

“A lot of executives have deferred paying into their pensions in the belief that they could make large contributions later,” says Tony Baily, principal consultant at Hewitt Associates. “Now this has thrown a huge spanner in the works of their financial planning.”

He adds that many young professionals that expect to be earning over £150,000 in the future have also been caught out and those that have taken out large mortgages will have to weigh up whether it is worth extending the term of their loans in order to be able to fund their pensions tax-efficiently.