In April 2006, the government introduced a lifetime limit on the amount that can be held in a pension free of tax. Today, the lifetime allowance is £1.25m.
People who have, or expect to have, more than the lifetime allowance saved in their pension pot can apply for protection. The most recent options are Fixed Protection 2014 and Individual Protection 2014. Fixed Protection 2014 allows the scheme member to retain the tax advantages of their pot up to the previous year’s lifetime allowance, in this case £1.5m.
However, a condition of the rules is that anyone with Fixed Protection 2014 must stop making contributions in most circumstances. Any further contributions are likely to invalidate their protection and cause their lifetime allowance to fall to the current rate. The excess would be subject to 55 per cent tax.
Implications
The introduction of auto-enrolment, therefore, causes problems for people who have taken out Primary Protection, Enhanced Protection, Fixed Protection 2012 or Fixed Protection 2014 (these protections are no longer available).
Under auto-enrolment, anyone who is aged between 22 and state pension age, and earning more than £10,000 a year, is automatically enrolled into the pension scheme by default — they do not need to sign anything or take any action for this to happen.
It is critical that people with these protections understand the implications of not opting out immediately. However, employers are specifically barred from encouraging any employees to opt out, regardless of the circumstances. This means that the onus for advising people in this situation lies squarely with their financial adviser.
And to complicate matters, employees who opt out must be automatically re-enrolled into the pension scheme every three years. This is not three years from the date the employee last opted out, but the third anniversary of the company’s staging date, which relates to its PAYE reference. Advisers need to be mindful of these dates for those clients with lifetime allowance protection.
Individual Protection 2014 was introduced to mitigate this issue. Unlike the protections listed above, Individual Protection 2014 allows individuals whose pension pots are worth between £1.25m and £1.5m on 5 April 2014 to maintain their own personal lifetime allowance, up to a maximum of £1.5m, even if they continue to make contributions. Unlimited future contributions are allowed and individuals can still use salary sacrifice arrangements, if available, to contribute from their pre-tax income, saving income tax and national insurance on this portion of their total remuneration. Individual protection is still available and can be applied for until 5 April 2017.
The client’s circumstances will dictate whether it is appropriate to continue funding a pension that is larger than the lifetime allowance. This means that the role of the financial adviser remains critical for these individuals, because in this situation deciding whether to accept auto-enrolment or opt out can be a complex decision.
Saving into a pension still has various potential advantages, even if additional contributions lose their tax efficiency. Recent changes announced in the Budget have relaxed the restrictions on pensions savings, allowing pensioners more flexibility in taking an income or lump sums from their pots. A pension sits outside of the estate for inheritance tax purposes, is generally protected from bankruptcy, grows tax free and can often be passed on to dependents. All of these points should be considered in the context of the individual’s overall financial situation.
It is also important to ensure that the pension offered adds value within the context of the individual’s overall investment portfolio. Under the auto-enrolment legislation, workplace pensions must offer a default fund designed to be suitable for the majority of employees. This default fund is unlikely to suit those with lifetime allowance protection, who are likely to be higher net-worth employees with a greater capacity to absorb losses.
If alternative fund options are available, the individual will need advice on which is most suited to their risk profile and ambitions. The impact on overall investment strategy and asset allocation is particularly important if the pension offered is a master trust, since these typically offer few, if any, investment options.
Organisations with several high net-worth individuals who have taken out protection or expect to build up substantial pots in the future, should consider engaging a financial adviser to discuss the options for complying with auto-enrolment in a way more suited to their circumstances. These individuals can potentially take advantage of the wider investment options available through Group Sipp and Ssas schemes, for example, which can be used for auto-enrolment as long as they can be managed within the charge cap.
The future
It is by no means certain that the lifetime allowance will continue to apply in the future. The pensions minister, Steve Webb, recently said he was considering introducing a 30 per cent uncapped flat tax rebate on savings and removing the annual and lifetime allowances.
This would result in significant changes to saving opportunities and there will be individuals who will need professional advice to plug the gap in their retirement plans.
In some cases, it could be worth starting to plan for a flat rate tax rebate early; for example, by maximising current contributions while marginal rate tax relief remains available. Other individuals might benefit from waiting to see if an uncapped rebate is introduced, as this would potentially give them a higher tax relief overall.
Although individual protection may have simplified auto-enrolment for certain high net-worth individuals, the ‘automatic’ nature of auto-enrolment may invalidate some forms of lifetime allowance protection if the member does not ‘opt out’.
For these individuals, the need for financial advice has in fact never been greater. Many individuals are used to seeing pensions as something in which significant restrictions are compensated by generous tax reliefs, and it may be that neither of these is the case. They will need support to reframe their opinions and understand their options.
Example of a client with protection who can still benefit from additional pension contributions
A client with protection who can still benefit from additional pension contributions
Brian is aged 53, an additional rate taxpayer and a member of his employer’s money purchase pension arrangement. On 5 April 2014, his company pension was valued at £1.5m.
Outside of his pensions, Brian and his wife have assets in excess of their current IHT nil rate bands (£650,000), and with six children Brian is concerned about the impact of IHT on his estate.
Brian had recently made the decision to register for fixed and individual protection, following the fall in the lifetime allowance to £1.25m from 6 April 2014 and wants to know whether to opt out of auto enrolment.
His adviser explains that by making contributions to his pension using salary sacrifice, for each £100 net contribution Brian sees £214.72 paid into the fund (assuming the employer re-invests their NI savings in full). If he dies after the age of 75, funds left in the pension will pass to his family net of a 55 per cent tax charge. Even with no growth, his family would inherit £96.62 (effective tax rate of 3.38 per cent).
Saved outside the pension, each net £100 would be added to his estate. A 40 per cent inheritance tax charge would be incurred on his and his wife’s death, leaving his family with £60 (effective tax rate of 40 per cent). Brian decided not to opt out.
David White is managing director of Creative Auto Enrolment and Craig Harrison is managing director of Creative Wealth Management
Key points
Individuals who have taken out fixes protection may be affected by auto-enrolment
Employees who opt out must be automatically re-enrolled into the pension scheme every three years
Saving into a pension still has various potential advantages, even if additional contributions lose their tax efficiency