With the implementation date for the new pension legislation looming, Johanna Gornitzki takes a closer look at the forthcoming changes and the implications they may have
In December 2002, the Government published its first consultation document suggesting the current taxation of pensions in the UK should be simplified. Apart from a few minor exceptions, the rules are now set in stone and ready to come into effect on 6 April 2006. Coined A-day, this day is expected to bring about the most radical changes ever to pension provision in the UK, as the British pension system will see its current eight tax regimes moulded into one.
While there is an exhaustive list of changes that will come into effect, there are a number of issues that have been widely discussed and are most likely to be important to intermediaries giving advice on these alterations.
Radical changes
One of these issues is the restriction on how much savers will be allowed to contribute to their pensions. From A-day, there will be an annual ceiling on the total amount paid into a pension pot, with the maximum amount being £215,000 in 2006/2007 and rising to £255,000 in 2010/2011. Thereafter, it will be reviewed every five years. Besides the annual ceiling, a lifetime limit will also be introduced.
This will be the total amount an individual could have in his or her pension pot. It will be capped at £1.5m in 2006/2007 and will then be set to increase year-on-year until 2010/2011 after which it will be reviewed in the same manner as the annual limit. Any excess will become subject to a 55% tax, called the recovery charge, if taken as a lump sum, or 25% if taken as income.
The recovery charge may sound steep, but figures from the Inland Revenue (IR) suggest that only around 5,000 people are likely to be hit by the lifetime limit. This estimate has however been met with some dispute, with some pension experts arguing that the numbers are likely to be tenfold. John Lawson, senior technical manager at Standard Life, is one of them. He thinks the limit is "more likely to affect 50,000 people" and adds that, "this figure is likely to rise over the years."
However, regardless of how high this figure will turn out to be, there will be ways these individuals can protect their pension funds. In fact, in order to avoid these added charges, the IR has introduced two types of transitional protection - primary and enhanced. A pension scheme member, who before A-day has accrued a pension pot of more than £1.5m, will qualify for 'primary protection.'
The advantage with this type of protection is that the scheme member can continue to make further contributions if the fund growth lags behind increases to the standard lifetime allowance. On the flipside, however, if the fund grows faster than the lifetime limit then the member will be liable to the recovery charge.
'Enhanced protection,' on the other hand, is available to anyone, regardless of the size of their pension pot. The individual's total fund will be protected no matter whether the fund exceeds the lifetime allowance. However, the disadvantage is that no further payment can be made into the scheme. Effectively, this means that for money purchase schemes, no further pension payments can be made into any scheme post A-day and for defined benefit schemes, no further benefits can be built up and existing benefits cannot be augmented other than as a result of an increase in pensionable earnings.
Enhanced protection
It is worth noting that individuals who opt for enhanced protection can opt for primary protection at a later stage. The reverse will not be feasible, however. They can opt for both types of protection.
Post A-day, there will also be a limit to how much people can take out in tax-free cash. This will be limited to 25% of the pension fund. As the maximum pension fund will initially be £1.5m, the maximum tax-free cash someone can take will be £375,000. However, clients exceeding this limit can still protect their entitlement. One way to protect any tax-free cash exceeding the 25% limit is to switch clients out of executive personal pensions and other occupational money-purchase schemes into a section 32 plan (s32). By opting for a s32 plan, they will retain the pre-A-day benefits enjoyed under the occupational pension scheme they were previously in.
However, this move has caused a heated debate among leading pension experts, as some of them believe this may not be the best option for everybody and that other alternatives could offer better solutions. Partially agreeing with this sentiment, Alasdair Buchanan, group head of communications at Royal London, believes it would be wrong to suggest moving into a s32 should be seen as a blanket benefit. "It may be useful for some, but not for everyone," he says.
Commenting on the current debate, Buchanan adds: "Some industry experts have even gone so far as to suggest that advisers recommending s32s could be accused of churning, as giving this advice would bring more business to the adviser. It therefore does require a close judgement on the adviser's part."
Buchanan however thinks it is unlikely intermediaries will recommend this option just to top up their commission following the announcement that the Financial Services Authority (FSA) will be watching the matter very closely.
As well as changes to how much money can be put into a pension pot, the new pension legislation will also bring about a more lenient set of investment rules. These will allow people to invest their pensions in a wider range of investment vehicles, including residential property as well as more obscure things such as classic cars, art or fine wine. With the housing market continuing to defy predictions of a crash, the former is likely to become a popular option. However, this opportunity should be treated with caution as wrapping up a property in a pension could prove to be quite a substantial risk. "While it is a good thing to have this investment flexibility, as it will ultimately get more people interested in pensions, the downside is that for the vast majority of the population this will not be an appropriate option due to the fact that a good asset allocation structure to a pension is crucial," says Buchanan.
Close judgement
There are also other disadvantages as Elizabeth Gibling, pensions technical manager at Chase de Vere, points out: "Holding a buy-to-let property in a pension may look attractive, but beware of the benefit-in-kind charge if the investor decides to use the property. There will also be higher related costs, including solicitors' fees, stamp duty and property management fees."
The new pension legislation will also bring about changes affecting individuals in or near retirement. As a response to the fact that people are now living longer, the Government has decided to increase the minimum retirement age from 50 to 55 by 6 April 2010. While the majority of the population cannot afford to retire early anyway, this amendment will largely have an effect on individuals like sportspeople or models, who previously enjoyed early retirement. From an adviser's point of view the increased retirement age could also have implications when it comes to other types of financial products. "The increase in retirement age, from 50 to 55 in 2010, will for example, have an effect on both income protection and long-term care products as they will be needed for a longer period of time," says Rachel Vahey, pension development manager at Scottish Equitable.
Perfect alternative
Post A-day, future retirees will also have more choice on how to withdraw their pensions. There will essentially be three different options. Until the member is aged 75, the pension may be taken either as a secured income, such as an annuity, or as an unsecured income, which is similar to current drawdown. From the age of 75, however, pensions could either be taken as an annuity or as an alternatively secured pension (ASP). The latter will be similar to unsecured income, although much more restrictive, only allowing the ASP holder to take up to 70% in income. Praising this choice, Buchanan says: "It will offer a perfect alternative for individuals who want to have more control over their income as it allows them to effectively review income on a more regular basis."
One thing that may deter consumers from going for this alternative however, is that it may attract Inheritance Tax (IHT). According to a recent consultation paper issued by the IR, individuals opting for ASP may get stuck with IHT bills on their remaining funds on death aged over-75. Although nothing has been confirmed yet, if this will come true, ASP is likely to be abandoned by the majority especially as this tax is "likely to even apply between spouses," according to Lawson.
Cautious
Intermediaries advising on the new legislation should first of all, if they have not already done so, try to understand as much about this new system as possible. If in doubt over anything, they could turn to the major providers that all offer a wealth of information in the form of websites, roadshows and information packs especially dedicated to the matter. Besides trying to get on top of the forthcoming legislation, advisers should also contact their entire client base and ensure that they are aware of the changes.
Following this, they need to identify those clients who will be affected by the changes. They are typically the ones affected by the lifetime allowance and entitled to a tax-free lump sum of more than 25% or near retirement. These clients should also be divided into two groups - those who must take action before A-day or lose out, and those who can wait until A-day before taking action.
"For instance, registration of an individual's pension should be completed within three years of A-day, however some clients who wish to transfer to an alternative pension will need to take action immediately," Gibling says.
Additionally, advisers should always take a client's personal circumstances into account before advising on the best option, which would include their attitude to risk and the numbers of years before they intend to retire. For example, clients approaching retirement in the next year or so could be better off taking the benefits before the changes.
However, while the last thing IFAs should do is to sit on the fence and do nothing, they also have to be cautious when advising on some of the issues that have not been settled yet and may not be until a few months after A-day.
Admittedly, it will not be easy for them, as they will have to walk a tightrope between giving enough advice and giving the right advice. Buchanan argues that advisers should be wary of reacting to aspects that are not yet certain. "Advisers should go for what they know. At the same time though, they need to start giving advice now and that includes the matters that have not yet been settled. The pitfalls are that you really need to spot the unknown."
This should however not deter advisers from entering the pensions market because while intermediaries may feel less than sure of what is going to happen, the wider public seem somewhat bewildered about what to do and urgently need the helping hand of an adviser. So instead of shunning away from this rather complex area, advisers should grab this opportunity to show the public how crucial their advice really is. Because, as Vahey says, "the people losing out when the new regime comes into effect will generally not be those who have got an IFA, but those who haven't."[TB]POST A-DAY LIMITSLifetime Limit:2006/07 £1.5m2007/08 £1.6m2008/09 £1.65m2009/10 £1.75m2010/11 £1.80mAnnual Allowance:2006/07 £215,0002007/08 £225,0002008/09 £235,0002009/10 £245,0002010/11 £255,000
ADVISER CHECKLIST
- Learn as much as possible about the new rules.
- Contact client base and make them aware the changes.
- Identify those clients who will be affected by the changes.
- Divide them into two groups: those who need to take action pre A-day and those who can wait.
COVER NOTES
- The new pension simplification legislation will come into effect on 6 April 2006.
- It will cause radical changes to Britain's current pension system.
- It will bring plenty of advice opportunities for intermediaries.
