Pensions Tax Relief and the Order of the Finance Act

Introduction

It has been announced today that the Finance Act 2011 received Royal Assent on 19 July 2011. The Act brings onto the statute books significant changes to pensions tax relief, including legislation to reduce the AA with effect from the 2011/12 tax year.

In this Alert:

• Key points
• Background
• Using the carry forward provisions
• Aiming-off the Annual Allowance: DB Schemes
• Paying AA charges
• Next steps

Key points

• From the tax year 2011/12, the AA will be £50,000, representing a significant reduction from the previous £255,000 figure.
• Depending on a scheme’s PIP, the new allowance can have effect from 14 October 2010, when the Government first announced its tax relief changes.1
• The Government expects that in most cases pension savings will be managed so that the AA is not exceeded.
• Where members exceed the AA, for example, due to spikes in accrual, they will be able to take advantage of new carry forward provisions.
• For those who would potentially exceed the reduced AA on a regular basis, it may be necessary to tailor scheme provisions to prevent AA charges arising.

Background

The AA is the maximum amount of pension savings that can be built up in each tax year without a tax charge applying. At its original level the AA had limited impact, generally affecting only the highest earners. Now, however, far more pension savers will potentially be affected.

The Government expects that most individuals, employers and pension schemes will adapt their behaviour so that pension savings remain below the AA. With DC benefits, it is generally straightforward to align pension savings with the AA. But it is not so simple for DB arrangements.

To protect members against AA charges, the main options are to:

• make use of new carry forward provisions and spread one-off spikes in accrual over a period of up to three tax years; or
• where members look likely to exceed the AA on a regular basis (for example, as a result of high earnings or long service) amend accrual, for example by limiting benefits to the AA.

Using the carry forward provisions

The carry forward provisions can help prevent individuals who typically have pension savings below the AA but who exceed it in a given year from facing a tax charge as a result. Key features of this facility include:

• the ability for individuals to carry forward unused AA from up to three years previously and to offset this against savings in excess of the AA in a particular year;2
• an assumed AA of £50,000 (using a valuation factor of 163 for DB accruals) for the tax years 2008/09, 2009/10 and 2010/11; and
• the requirement to apply any unused allowance (or headroom) from the earliest tax year first.

Aiming-off the Annual Allowance: DB Schemes

The Government acknowledges there are difficulties for DB scheme members in keeping pension savings below an AA of £50,000. This is because the size of the increase in pension will be determined by various factors, including: length of service, scheme accrual rate, level of salary and rate of salary increase, all of which may create uneven, and potentially substantial, annual increases in accrual in certain years.

Options available to schemes and their members include:

• do nothing and pay any AA charge which arises;
• agree to limit future pensionable salary (either for individual members or across the board) to reduce the likelihood of AA charges arising;4
• introduce a cap on future accrual; or
• opt-out of or suspend pensionable service, with the option of providing an alternative cash benefit.

Such options could, for example, be written into the scheme rules, or introduced by way of contractual agreement between the employer and affected members, although the implications of sections 67 and 91 of the Pensions Act 1995 (which protect members’ accrued benefits and entitlements) need to be considered here.

Paying AA charges

Where a member’s pension savings exceed the AA, they will need to pay tax on any liability as it falls due. Individuals can meet the charge independently or elect for their scheme to pay the charge before their benefits crystallise (subject to an eligibility threshold of £2,000).5 The AA charge is payable at the member’s marginal rate.

Next steps

Employers and trustees should:

• work out who is potentially affected by the new AA;
• decide what, if any, action is needed;
• consider whether to offer any alternative benefit; and
• contact affected members to inform them of their options.

As employers/trustees will generally only know about a member’s pension savings in their own scheme, they should also advise potentially affected members to check the impact of the reduced AA on any other pension savings they may have.

1 For more information please see our Alert: “Restricting pensions tax relief: the verdict” dated 14 October 2010
2 The facility is automatic, so individuals on incomes below £100,000 who are already within Self Assessment will not have to complete a tax return to benefit from it
3 Between 6 April 2006 (A-Day) and up to the tax year 2011/12, a factor of 10 was used to revalue DB benefits
4 Subject to anti-avoidance measures to prevent the manipulation of benefits to avoid payment of tax properly due
5 For more information please see our Alert: “Annual Allowance charge payment option confirmed” dated 8 March 2011