In favour of Choice Architects this time

When the UK Treasury announced the new rules on Restricting pensions tax relief through existing allowances on 14th October, my reaction was and remains very much the same as my colleague, Brian Spence, who was quick to welcome the straightforward, simple and well thought out policy announcements.

With the benefit of a weekend to reflect and with my defined benefit trustee hat firmly on, here are some further specific and general thoughts, including quotes directly from the HMRC’s summary of decisions.

“A.1: From April 2011, the annual allowance (AA) for tax-privileged pension saving will be £50,000 (reduced from £255,000 in 2010-11)”;

In general, contributions above £50,000 in a single year only occur if you are a high earner paying tax at the highest marginal rate on all of the contribution, you have a sudden wind-fall (such as redundancy) or you are approaching retirement and are able to afford and benefit from such high contributions.

Unfortunately, for most people, contributions of this size never seem to happen – or do they? I think they do.

“A.22: From April 2012, the lifetime allowance (LTA) for tax-privileged pension saving will be £1.5m (reduced from £1.8m in 2010-11)”;

Again, figures such as £1.8m and £1.5m are out of the reach of most people in today’s money.

Comparing the new LTA with the AA, a ratio of 30 (£1.5m / £50,000) seems fairer than the previous ratio of around 7 which allowed (and encouraged?) people to defer pension saving and then, for the lucky few, contribute very large tax-efficient amounts over a short number of years pre-retirement.

“A.2: There is no proposal to index the level of the AA during the forecast period. Beyond that, the Government will consider options for indexing the level of the AA”;

The AA is to be flat for 5 years and then indexation is to be considered. Interestingly, there doesn’t appear to be any mention of indexation of the level of the LTA. Assuming inflation of 2.5% over 5 years, the AA will be around £44,000 in today’s prices and the LTA around £1.33m – still high figures but creeping ever closer in just 5 years.

“A.5: Deemed contributions to DB schemes will be calculated via a flat factor…set at 16,..meaning that an increase in annual pension benefit of £1,000 would be deemed to be worth £16,000;
A.7: The previous year’s accrued pension benefits will be revalued for active members”;

The combination of a lower AA and higher AA factor (increased from 10 to 16) could lead to active members of DB schemes facing a tax bill when they enjoy a pay rise of under £10,000 and, in some cases, under £5,000. Let’s consider two examples:

For an active member with 24 years in his 1/60 ths DB scheme, a pay rise from £60k to £66k in his 25th year and CPI assumed at 2.5%, the deemed contribution would be £46,400, which is just below the £50,000 AA. Whilst such a pay rise might be rare these days, it can happen.

A member with 35 years accrual,  a £100,000 salary and the same percentage increase would find themselves at nearly twice the AA and facing a significant tax charge.

“A.14: Where individuals exceed the AA in a given year, unused allowance from up to three previous years will be available to offset against the excess pensions savings”;

“A.19: Where individuals have (deemed) contributions over the AA in a pension arrangement, the scheme must provide the member with their pension input amount for the relevant year within six months of the end of the tax year. Where individuals request this information, pension schemes must provide details on the pension input amount by the later of 3 months from the request and 6 months from the end of the tax year”;

“A.20: Employers must provide information about employees’ pensionable pay, benefits and service to pension schemes by 6th July following the end of the tax year”;

Those responsible for monitoring pension input amounts will find themselves quite busy, not to mention the many other parties that will be required to do the calculations and give advice to members.

“A.23: The Government is minded to maintain the LTA valuation factor at its current level of 20”;

I’m not sure that I fully understand why the AA factor of 16 is set differently to the LTA factor of 20. The 16 factor allows you to accrue DB pension of £3,125 pa (£50,000/16) and the 20 factor limits the ultimate pension to £75,000 (£1.5m/20), meaning that you could theoretically get there from scratch in 24 years (£75,000/£3,125)  if you put the maximum tax-relieved amount in each year.

“A.24: The LTA tax charges will remain unchanged (55 per cent if paid as a lump sum and 25 per cent if paid from annual pension income, on top of marginal rate tax on the pension income)”;

In other words, don’t go over the limits.

Finally, two positive snippets to finish….

“A.25: The maximum tax-free lump sum will remain at 25 per cent of the standard LTA;
A.6: Deferred members will be exempt from the AA regime”;

In conclusion

The government is still offering tax relief on contributions at the highest marginal rate and the ability to take a 25 percent tax-free lump sum on retirement. This is good news.

The lower LTA, significantly lower AA and higher AA factor will prevent the wealthy from benefitting as much from pensions tax relief as they have done in the past.

Unlike before, going forward, the ONLY way to acquire a sizeable pension pot is to start saving early and to save consistently.

Pensions may be inflexible but how many times have you saved into a PEP or ISA then taken the money out two years later to spend it on something that seemed essential at the time? Even worse, how many people have an offset mortgage which enables them to pay down more quickly but the opposite occurs?

Pensions are too important and, for me, it is right for government to create a framework that steers our choices towards saving for retirement.

I’m in favour of choice architects this time.

PS. The apparent ease at which active members of DB schemes are deemed to reach the new annual contribution limit is an unfortunate example of why so few active DB members still exist.