Pension check

New legislation aims to make pensions more simple, but Chris Clarke warns that the changeover might not be so easy

Gordon Brown confirmed in the Budget that new legislation aimed at simplifying pensions will come into effect on 6 April 2006 (‘A’ day). This is likely to impact on high-earners and could result in considerable financial loss if you are not fully prepared.

The aim of the legislation is to make the future administration of pension schemes more straightforward. However, the transition process is far from simple and its impact on those who will be affected, not least lawyers, could be significant. The legislation as proposed will be the biggest change to pensions in 30 years.

The purpose of the following questions and answers is to enable you to start to understand the impact of the legislation upon you personally, so that you account fully for the changes and start to mitigate any negative issues.

Q: Who should take notice of this and take action now?
A: Anyone who has the potential to accumulate a pension fund or pension rights of greater than the statutory lifetime allowance (SLA), set initially at £1.5m on 6 April 2006. Do not forget to include benefits from occupational pension schemes, earned earlier in your career, which might be worth more than you think. Equally, funds of around £1m now could exceed the SLA over time if good investment growth is achieved. You might have to take action prior to A day.

Q: How much should I contribute?
A: Traditional advice on pension funding is to maximise contributions now, as you will gain tax relief at your highest marginal rate. However, if you knew that the tax rate that applied to the benefits in retirement was higher than the rate of tax relief on contributions, would you still follow tradition?

Q: Are you saying that I should not maximise my contributions so that I can receive as much tax relief as possible?
A: It depends on what you are trying to achieve and whether the consequences of such a strategy beyond retirement have been considered. Our experience with clients in this situation is that the tax relief on the contributions has been the main focus, rather than the long-term objectives.

Q: That seems a bit vague. So, how much should I contribute?
A: Only you can answer this. In order to start to understand how much you should contribute, why not start with the end in mind? It is sensible to start with your objectives and work back. This is best done by answering three questions: what is the earliest age that you would anticipate retiring, in an ideal world?; what level of income will you need in today’s terms, assuming you were that age today?; and what income will you have, based on your current assets and earnings, at this age?

These might seem simple questions to answer, but it is worth taking the time to think them through properly, as you can then target your contributions against your objectives. This will dictate the strategy appropriate for you from this point onwards, giving you understanding and clarity. It might mean that you have already reached an appropriate sum within your pension fund and that it would not be the best strategy to contribute any further to your pension plans.

Q: Presumably, only those close to retirement will be affected?
A: Clearly, the urgency for clear planning is greater the closer you are to retirement. However, if you are aged under 44, you should note that you will not be able to draw pension benefits until age 55. This might have an impact on your retirement strategy and the funding of pension plans if you anticipate retiring between 50 and 55.

Q: What date in the diary do you suggest I enter this as a task to do?
A: If you are thinking this, it indicates that you need to appreciate the urgency. You need to act now if you think you will be affected.

Q: Why? There are 21 months to go. I can’t see why I need to look at this until next year.
A: There are thousands of busy people who will be affected and are probably all saying the same thing. In order to be able to plan diligently for the future, it is essential to gain a clear and accurate assessment of your existing pension arrangements. This may involve not just gaining information from your current providers, but also tracking down benefits from former employers. Both of these are likely to be inundated by such requests, with the volume increasing as we approach A day. It is worth re-emphasising that you cannot make any decisions until a thorough analysis of all your existing pension arrangements is complete. This is currently taking up to six months and will only get worse as enquiry levels increase.

Equally, if it is appropriate to fund pensions prior to A day, it will tell you which plans should receive the contributions, as the charges and benefits may vary greatly.

The changes at a glance
  • Eight existing sets of tax rules will be merged into one, so that everyone will have one maximum annual contribution allowance of £215,000 (to rise to £255,000 by 2010) and a lifetime limit of £1.5m (to rise to £1.8m by 2010).
  • Tax relief will be available up to 100 per cent of earnings up to £215,000 or £3,600 if you have no earnings, such as for non-working spouses or children. This will be extremely beneficial to those of you who have been subject to the earnings cap.
  • Everyone will be allowed to take up to 25 per cent of their total fund as tax-free cash.
  • Anyone exceeding the statutory lifetime allowance £1.5m limit will face 55 per cent tax, known as the recovery charge, but there will be various ways of mitigating this, such as via ‘primary’ or ‘enhanced’ protection, which allow individuals to gain protection from inflation growth or investment growth in their fund, respectively.
  • Primary protection will ring-fence the value of the pre-April 2006 pension rights and benefits in excess of £1.5m in line with inflation. Clearly, funds may grow significantly above this if the investment markets recover.
  • Enhanced protection will protect the investment growth in post-April 2006 pension funds for those who stop all contributions to their funds by April 2006.
  • Any person who has a regular monthly contribution being paid into a plan who forgets to cancel it before 6 April 2006 will lose the enhanced protection option forever, with potentially serious tax consequences. This includes small premiums being paid for life cover under a pension, such as a Section 226A policy. A thorough background check is essential, including old employers’ pension schemes.

This article is for generic purposes only and independent financial advice should be sought before make any financial decisions. Levels and bases of taxation are based on our current understanding.

Chris Clarke is a consultant in the London office of the Cavanagh Group