New pensions tax regime could offer big boost to tax
- free cash for final salary scheme
members
The new Inland Revenue tax regime coming into
effect next April will allow schemes to permit members to take much
higher tax-free lump sums at retirement and provide new
opportunities to use AVC's as tax-free cash as well. Members and
trustees of schemes will want to take note of these changes if
action is to be taken to maximise these opportunities.
We look at these new rights under two
headings:
lump sums from the main
scheme
lump sums from
AVC's
Lump sums from the main
scheme
The new simplified single tax regime for
pensions will allow members to take a lump sum of up to 25% of the
value of their pension. This value is calculated by a special
formula of the IR's devising, which for most members will generate
a much bigger potential lump sum.
At present the general limit which applies is
that the lump sum can be no greater than 3/80 of salary for each
year of service but with a provsion that it can rise to a maximum
of 1.5 x salary of you have 20 years service of more. Members of
schemes will generally see reference to such terms in their scheme
booklets/rules.
The new formula, for schemes which offer a
pension but with the right to commute a part of it for a lump sum,
is:
20 x Pension/ (3 +
20/CR)
In this formula CR is the commutation rate
applicable to the member i.e the exchange rate used to convert
pension to lump sum. A typical commutation rate at present is 12
i.e you get a £12 lump sum for each £1 of pension
surrendered.
In practice commutation rates vary widely
both between schemes and within schemes they will usually be
different for people of different ages and (sometimes) sexes.
This will mean that the size of tax-free lump sums will differ as
well.
Consider the example of a person retiring
after 30 years service in a scheme offering a 1/60 pension with a
final salary of £24,000. Their pension would be £12,000 a
year.
Under the present tax regime their lump sum
would be limited to either 30 x 3/80 x £24,000 = £27,000 or
1.5 x salary = £36,000.
Under the new regime, assuming a commutation
factor of 12, their maximum lump sum would be: 20 x £12,000/
3 + 20/12 = £51,400.
In most cases scheme rules will need to be
changed in order for members to be able to take advantage of
this.
The right to take bigger lump sums will
generally be welcomed by members. But since at present schemes do
not usually give full value for the pension in the commutation
factor, members will need to think carefully before taking
advantage of this, if it is offered.
While the cost and value of pensions have
been rising commutation factors have lagged behind enabling schemes
to make savings. If full value were given commutation factors would
probably be about a third higher than they typically are.
Schemes have generally been happy to take
advantage of savings from commutation to help offset rising
costs.
Because commutation does save the scheme
money, trustees are unlikely to be opposed to allowing members to
take advantage of the new IR limit.
In making this new freedom available, Amicus
would want to suggest that at the same time trustees should review
the commutation factors. At minimum the savings expected from
increased commutation could be used to up-rate current commutation
factors. and so we would want trustees and negotiators to bring
this issue into the discussion.
Lump sums from AVC
savings
The most efficient way for final salary
scheme members to get tax-free lump sums is by being able to draw
them from AVC savings. This is because this avoids their having to
commute pension at what are generally unattractive rates and also
means they do not have to buy pension at much higher rates, whether
by annuity purchase or within their schemes.
At present IR rules say that only AVC savings
based on contracts started before April 1987 can be drawn as
tax-free cash, AVC savings made after that (unless they are of the
added-years variety) have to be drawn as a pension. The maximum
amount of AVC contributions is also limited by the ceiling on
tax-assisted contributions to pension of 15% of pay. While the
rights of pre-1987 contributors are being protected, all of these
other rules are changing.
The minimum benefit to AVC contributors is
that they will be able to draw 25% of their AVC savings, whenever
saved, as a tax-free lump sum.
Where AVC benefits and main scheme benefits
are, after April 6 2006, drawn together at retirement then the tax
free lump sum is calculable on the basis of the combined benefit.
The Revenue will allow the tax free lump sum to be drawn from AVC
funds up to the 25% limit'
In effect the AVC savings can be used to
provide the lump sum from the main scheme as would otherwise have
to be taken through commutation. This is highly advantageous to the
member as they do not have to buy pension at expensive rates with
their AVC savings and they do not have to sell pension at generally
low commutations rates.
Whether this can happen in practice will
depend on scheme and AVC rules, which may require amendment to
achieve this outcome. While it is very beneficial for members it
may be construed as an increase in costs for schemes who will make
lower 'profits' on commutation.'
The next issue to consider is whether the
Scheme will allow the higher levels of AVC saving as are going to
be permitted. Under the new tax regime members will be able to get
tax-relief on pension contributions of up to 100% of their
earnings. If the member has a substantial main scheme pension then
this could make the idea of very large AVC savings attractive given
the potential for tax saving.
The issues for schemes to consider will be
the effect on scheme costs of members commuting less of their
pension, because they can access lump sums through the AVC route.
This potentially adds to scheme costs. They may also be wary of
allowing higher AVC contributions if the schemes offer attractive
rates for converting AVC's to pension.
Removal of obligation to offer AVC
option
A final background issue here is that the
Pensions Act 2004 will at the same time be removing from schemes
the obligation to provide an AVC arrangement at all. This is being
allowed on the basis that the new tax rules allow members of
company schemes to be members of other pension schemes, without the
restraints as previously applied. So trustees may be faced with
proposals to close the AVC scheme. In considering that proposals
the trustees will need to consider carefully the impact on members'
potential tax-free lump sums.
Amicus assessment
These tax changes are potentially of such
significance that they could lead members to consider delaying
their retirement until after the new regime takes effect next
April. They could also lead them to take decisions now in terms of
starting or increasing AVC contributions, given the greater
attractions AVCs will have as a means of getting a tax-free lump
sum.
The changes also raise some key issues for
trustees which they will need to take into account when reviewing
their scheme rules in the light of the tax changes.
The overall impact could be a much-needed
boost for members of final salary schemes which have recently been
going through very difficult times.
