Wealth Management: Pensions
Wealth: How to manage it
With top earners targeted in Alistair Darling’s last Budget, James Smith examines whether pension contributions are still a viable option
Tax changes in 2009’s Budget have drastically reduced the benefits of pension contributions for high earners and will likely force them into alternative retirement provision. Alistair Darling’s April speech included two further blows against top earners, introducing a 50 per cent top rate of income tax from this year and also eroding the personal allowance on incomes over £100,000. As with most pension legislation, the changes outlined are complex and the situation was exacerbated by further tweaks in December’s Pre-Budget Report (PBR). In basic terms, the Budget originally proposed to restrict tax relief on pension contributions for anyone with a gross income over £150,000 from April 2011.
A taper will apply up to £180,000, restricting relief to the 20 per cent basic rate beyond that earnings level, although details on how this will apply are yet to appear.
In the PBR, the Chancellor tightened the definition of income to include pension contributions by an employer - which effectively reduced the earnings barrier to £130,000.
Ian Wright, partner at law firm Mayer Brown, says that with income tax also increasing to 50 per cent, high earners will end up paying 30 per cent tax on pension contributions or defined benefit (DB) accrual.”Given that at least 75 per cent of the emerging pension, after any tax-free cash lump sum, will be taxed again when the scheme pays out, high earners will need to think carefully about whether they want to build up any additional pension at all after April 2011,” he adds. “In many cases, they might find they’d be better off opting-out completely.”
In a further complication, there are several rules in force until April 2011 to stop anyone taking undue advantage of higher-rate tax relief before they lose it.
Under the system, people can continue to benefit from full relief on so-called normal ongoing pension contributions, or up to £20,000 if higher, until next year. These anti-forestalling regulations are in place to stop anyone establishing a history of ongoing contributions after April 2009.
In most cases, any saving in excess of the £20,000 special annual will be taxed at 20 per cent.
John Richardson, head of technical planning at Towry Law, says where high earners currently have no normal ongoing pension savings, they should use the £20,000 allowance in 2009-10 and 2010-11 as they will receive higher rate tax relief.
“Those making less regular payments may also be able to contribute up to £30,000 if their previous contributions are sufficient,” he adds.
This increased allowance is only applicable where pension contributions for the 2006-07, 2007-08 and 2008-09 tax years averaged over £20,000.
Richardson says it is largely no longer appropriate for higher earners to make additional contributions over the £20,000 limit so they will need to consider alternative means of retirement planning.
Nick Couldrey, partner at Sacker & Partners, agrees that while traditional registered pensions remain an effective savings vehicle for most, they are off limits for high earners. “What worries us is that although high earners only make up a small percentage of the workforce, they’re typically the decision-makers when it comes to workplace pensions,” he adds.
“If the directors can no longer take part in the company scheme, the political weight behind it will fall away so the end result of this change is much more than holding back tax relief from a few rich people. The real issue is that a tax relief system that worked well - albeit very generous to the highest earners - could fall into chaos in the coming years and if the general corporate view towards providing pensions shifts, that’ll clearly have serious consequences for everyone.”
At present, there still remains widespread complacency, with many believing that if the Conservatives win the imminent general election, they will simply reverse the proposals. Couldrey believes that any rapid changes on this front would prove unpalatable, with the Conservatives trying to move away from their image of pandering to the rich.
Even if the Tories do reverse the changes, this would be unlikely to happen on day one, so high earners could still face years of exposure to higher tax and restricted relief on pension contributions.
John Broome Saunders, actuarial director at BDO Investment Management, says astute pension savers might be well-advised to take their tax-free cash and start drawing benefits now, to avoid possible post-election changes.
So what can high earners do in the face of such punitive changes? For anyone earning just above £100,000, there are ways to at least claw back your personal allowance, everyone’s first slice of tax-free income.
From April, this is set to reduce at a rate of 50p per £1 earned over the £100,000 limit. Those earning above £112,950 will see it wiped out entirely, calculated by doubling the 2009-10 allowance of £6,475. Effectively, this means there is a band of income where the marginal tax rate is currently 60 per cent, with the additional 20 per cent created by each £1 that pushes another 50p into the 40 per cent earnings bracket.
As ever with complex pension legislation, there are ways to take advantage.
A £110,000 salary for example will wipe out £5,000 of the personal allowance from next year but it is possible to get this back by bringing your salary under the £100,000 threshold.
One way is to contribute £10,000 into a personal pension. By reducing salary, you can effectively regain the lost £5,000 personal allowance and will also benefit from the usual 40 per cent tax relief on this additional pension contribution. Another potential tax-efficient route is to consider reducing earnings to £100,000 via a salary sacrifice arrangement.
Given impending changes, someone earning £112,950 (the point where personal allowance is lost completely) would receive the highest relief, tallying up to slightly over 65 per cent. Consultant Towers Watson said the restriction of tax relief for high earners has, at a stroke, undermined a key principle of pension saving - that it is deferral of taxable income.
This means the race is on for other forms of tax-efficient saving and of the alternatives available, Employer Financed Benefit Retirement Schemes are currently generating the most interest.
This is the post-2006 version of schemes previously known as FURBS and UURBS (funded and unfunded unapproved retirement benefit schemes) - designed for those who want to accumulate retirement benefits outside the HMRC environment and its various restrictions.
Among financial advisers, Saunderson House director Tony Overy cautions that unapproved schemes can be complex and advocates a blend of more conventional savings vehicles to replace pensions.
“Our basic view, from April 2011, is that pension contributions are no longer a viable option for high earners, with 20 per cent tax relief not sufficient compensation for locking capital up until 55,” he says. Despite this, Saunderson House feels pension contributions enforce a savings discipline worth maintaining and is designing financial plans for its high-earning clients using a mix of alternative vehicles.
Other options include income-producing vehicles to use up any spouse/partner’s allowances plus investments for capital growth where gains of £10,100 per annum are tax-free and the rate is 18 per cent beyond that.
Elsewhere among more conventional assets, Overy highlights National Savings Certificates - with a £15,000 limit per issue and up to four available at a time - and index-linked gilts, where the indexation element is free of tax.
“Using National Savings, it is possible to build up a substantial tax-free cash pot over time as maturing certificates can be rolled over in addition to subscribing for current issues,” he adds. “There are investment-linked life insurance policies with basic rate tax deducted at source from income and gains, but the proceeds available after 7.5 years free of further tax.”
“All of these options should be considered in light of appropriate allocations to equities, property, bonds and cash, which varies according to the investor’s time horizon, risk appetite, the economic situation and market outlook,” adds Overy. “Some high earners might favour increased allocations to residential property as a pension alternative, for example, but we would warn against relying too much on one asset class and also note potential interest rate rises in the horizon, which could hit house prices.”