Issued: 1 June 2004
The Government is making sweeping changes to the law relating to pensions in the UK. The main aims of the changes are to improve the security of pension schemes and to make it easier for people to make their own pension provision.
With a Finance Bill and a Pensions Bill making their way through Parliament, there is much for the pensions industry, trustees, sponsoring employers and individuals to think about. Most of the reforms will become effective by April 2006, allowing some time for planning, seeking professional advice and implementing changes. Some of this preparatory work may involve costs, and Bursars may wish to make a provision in their budget for the coming academic year.
A note of caution – the proposed legislation is changing as the Bills progress, and much of the detail will be supplied later in Regulations. What follows is therefore a brief overview of some of the main points in their current form.
The Pensions Bill – Key Provisions
- A new pensions Regulator
- A Pension Protection Fund
- Scheme-specific funding requirement
- Promotion of financial planning in the workplace
- Changes to member nominated trustees requirements
- The requirement for trustees to have more detailed pensions knowledge
- Pensions to be included under TUPE
- The requirement to consult members on benefit changes
- Simpler dispute resolution procedures
- Removal of the requirement to provide AVC facilities
- Changes to mandatory pension increases
- Improved incentives to defer taking state pensions
Looking first at the Pensions Bill, a new Regulator will replace the Occupational Pensions Regulatory Authority (Opra) in April 2005. The new body will inherit Opra’s remit, and will have significant additional powers and functions to allow it to fulfil its objectives of:
- Protecting members' benefits
- Promoting good administration of the schemes it regulates
- Reducing the risk of situations arising that might lead to a claim on the Pension Protection Fund
In recent years, many members have lost their pension rights as defined benefit (DB) pension schemes were wound up with insufficient assets to secure all the promised benefits. Since June last year, a solvent employer seeking to wind up a pension scheme has been required to fund accrued benefits in full. The Pension Protection Fund (PPF) aims to protect members of schemes where the employer becomes insolvent. It is intended to be up and running in April 2005.
Where the employer is insolvent, the pension scheme is underfunded and it cannot secure members’ benefits, the PPF will take over the assets of the scheme and will provide compensation to members:
- Pensioners over normal retirement age (NRA) – 100% of pension
- Members/pensioners under NRA – 90% of benefits, capped initially at £25,000 p.a.
- Survivors’ benefits will be provided for spouses and civil partners
- Pension rights accrued before April 1997 will not increase in payment, and rights accrued from April 1997 will increase in line with the retail prices index (RPI) capped at 2.5% p.a.
Compensation will be provided partly from the assets that schemes bring with them into the PPF, and partly from levies on DB and hybrid schemes. The levy for 2005 will be advised in Regulations yet to be published – however, figures ranging from £10 to £25 per member have been floated.
The Regulator has powers to intervene if it believes an employer has engineered a situation to bring about a claim on the PPF.
Although the PPF levy will fall on the Trustees, they may ask the employer for reimbursement. If so, Bursars should make provision in this year’s budgeting process.
Scheme Funding
Most DB schemes will have to meet a statutory funding objective to 'have sufficient and appropriate assets' to cover their 'technical provisions' or liabilities. Trustees must publish a Statement of Funding Principles setting out their policy for ensuring they meet the statutory funding objective. An actuarial valuation will be required each year, or every three years if an actuarial report is obtained annually between valuations. If a scheme is in deficit, the Trustees must put a recovery plan in place. The current Schedule of Contributions will be retained. These changes are expected to be effective by September 2005.
In the lead up to the reforms and beyond, Trustees and employers may have more contact with their professional advisers - and should expect higher bills.
Some more features of the Pensions Bill:
- Employers may be required to promote financial planning in the workplace, though detail is not yet available. This is likely to have cost implications.
- Trustees may be required to provide members with information about their State pension entitlements as well as their scheme benefits.
- Pension protection may apply in TUPE transfer situations. The new employer may be required to offer some form of pension arrangement or contribution but will not be required to replicate the transferring employer’s provision.
- One third of a scheme’s trustees will be nominated and selected by at least some of the members.
- Trustees will be required to have a minimum level of knowledge. The Regulator is expected to issue a Code of Practice covering this.
- Schemes will not be required to offer AVC facilities for the future. Members will be able to use stakeholders and personal pensions instead.
- The current two-stage dispute resolution procedure may be replaced by a single-stage procedure.
- Pension increases for pensionable service after an 'appointed day' may be reduced to RPI capped at 2.5% pa (currently RPI capped at 5% pa).
- Employers may be required to consult with members over 'prescribed decisions' including closing a scheme to new members or to future accrual, or changing from a DB scheme to another type of arrangement.
- Individuals choosing to defer receipt of their State pension will enjoy more attractive terms from April 2005. If receipt is deferred for a year or more, a new (taxable) lump sum option is available.
Finance Bill - Key Provisions
- A Lifetime Allowance of £1.5m in 2006 for the total value of an individual's pension benefits
- Recovery tax charges on benefits above the Lifetime Allowance
- An Annual Allowance for pension savings of £215,000 in 2006
- Maximum tax-free cash of 25% of the value of pension benefits
- Transitional protection for members whose benefits exceed the Lifetime Allowance on 6 April 2006
- Members allowed to draw benefits without retiring
- Early retirement age up to 55 from 2010
The Finance Bill aims to simplify the tax treatment of pension scheme contributions and benefits, which has become extremely complex as successive reforms have generally avoided retrospection. It also seeks to encourage individuals to work for longer.
Retirement ages
With effect from 2010, early retirement will be available from age 55 rather than age 50. Members with a 'contractual right' (as at December 2003) to retire before age 55 will retain that right, provided employment ceases before benefits are drawn. Retirement at any age on health grounds will still be permitted as long as there is provision for this in the scheme rules.
Flexible retirement
In most circumstances it will be possible to draw retirement benefits while continuing to work for and receive a salary from the same employer.
Contributions
From April 2006, tax relief will be available on member contributions of up to 100% of earnings, and unlimited employer contributions, provided the annual allowance is not breached. Anyone can pay £3600 gross contributions regardless of earnings.
The 15% limit on member contributions to occupational pension schemes disappears, along with the age-related contribution limits for personal pensions. The 'earnings cap', currently £102k, all but disappears from the Revenue's rule-book.
The annual allowance applies to contributions to defined contribution (DC) schemes and increases to the capital value of DB pensions. This will be set at £215k in 2006, increasing annually to £255k in 2010. Tax self-assessment forms will include a section to enable members to check whether their pension savings for the past year fall within the annual allowance.
The annual allowance will not apply in the year leading up to retirement, provided benefits are taken. This allows for augmentations in redundancy or ill health retirement scenarios, and for generous farewell top-ups to continue in plc land.
The lifetime allowance (LA) is the total amount of tax-favoured pension savings an individual can build up. It will increase annually from £1.5 million in 2006 to £1.8m in 2010. On retirement, 25% of the value of pension benefits up to the LA can be taken as a tax-free lump sum. Benefits in excess of the lifetime allowance will be subject to a recovery charge, which will cancel out the tax concessions given.
Transitional protection will be available for individuals whose pension or tax-free cash sum rights at on 6 April 2006 are higher than the new limits. The benefits that can be given transitional protection must be within the current Inland Revenue limits. In most cases members will have to register with the Inland Revenue, having first obtained valuations from all their pension arrangements, past and present
Retirement – exceeding the lifetime allowance
At retirement, the member’s benefits will be valued. Once any transitional protection has been taken into account, benefits in excess of the lifetime allowance will be subject to the recovery charge. The level of the recovery charge depends on the form in which the 'excess' benefits are taken. If the member chooses to take all of the excess as a pension, a tax charge of 25% applies. The remaining balance is converted to a pension taxed under PAYE. The member may choose instead to take all or part of the excess value as a lump sum taxed at 55%.
The limit on death in service lump sum benefits to four times salary is superseded and the lifetime allowance applies instead. Funds in excess of the LA will be subject to the recovery charge of 55%. Provided the lump sum benefit is settled on a discretionary basis, it will be exempt from inheritance tax.
Partner's/dependants' pensions will not be tested against the lifetime allowance. In view of these changes, schools or individuals may wish to review their death benefit provision for the future. Provided the pensions and employment lawyers are happy, it may be possible to provide a higher cash benefit instead of pension.
For the first time, pension arrangements may hold residential property as investments. Specialist advice is essential.
Checklist
Schools offering pension arrangements will have to consider some or all of the following:
- Is anyone in your scheme currently subject to the earnings cap and/or expecting to receive Inland Revenue maximum benefits? If so, seek advice on the implications of the reforms in respect of these individuals.
- Is anyone likely to be affected by the Lifetime Allowance – either immediately or in the future? Will they seek transitional protection? And how will their pension position affect their overall reward package?
- Do your pension scheme Trustees and/or your Governors wish to incorporate any of the new provisions within the school's pension arrangements? Agree a timetable (and budget) for professional advice, changes to scheme rules or procedures, communication with members and production of new scheme literature.
- Will proposed changes to scheme rules have employment law implications?
- How will interested parties stay abreast of changes to the legislation as it develops? Much of the detail will be published later in Regulations (for example, financial planning in the workplace). Your professional advisers may produce bulletins and updates; otherwise, there are some excellent sources of information on the Internet.
- How soon should pension reforms feature in the agenda for meetings of the appropriate Committee(s)?
- Is your pensions administration supplier gearing up for the reforms? Will the service agreement change?
Bursars may wish to take financial advice on their personal situation. Many Bursars have generous benefits from earlier careers so the Lifetime Allowance may bite.
So what does this mean?
The reforms have been promoted under the banner 'simplicity, security and choice'. As far as taxation is concerned, for most individuals the reforms will permit higher pension contributions into a wider choice of arrangements. Otherwise, it is difficult to comment on simplicity until we know exactly what we are dealing with. In the shorter term, preparation, implementation and transitional provisions will make for more complexity rather than less.
Whether the reforms will increase members' security remains to be seen. The PPF does not seek to replicate an insolvent employer's scheme benefit provisions, so there will still be 'losers'. If it is run as a pension fund, the PPF will be subject to the same pressures as any other DB scheme, and may run into difficulties in the future. A group of senior actuaries has asked the Government to clarify its intentions and has cautioned against the use of terms like 'guarantees' unless the PPF will be unsinkable. The new scheme funding requirements and the cost of the PPF may be the last straw for some employers who currently sponsor DB schemes. If they opt for DC arrangements for the future, then member security might be reduced rather than enhanced.
Most individuals will have greater choice and flexibility regarding where, when and how much to invest in pension saving than they do at present. Whether they will choose – or can afford – to avail themselves of these opportunities is another matter.
It is largely agreed within the pensions industry that the reforms do little to encourage new pension savings on the scale Government is looking for. Means-tested benefits remain a huge disincentive to private saving for lower and middle-income groups. Until this is addressed, the Government’s 'aspiration' (downgraded very quietly from 'target') of reversing the 60% state: 40% private pension ratio for income in retirement is unlikely to become a reality.
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