PensionsJan 24 2013

Pensions legislation: Change of fortune

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Just over 10 years ago, Gordon Brown, then chancellor of the exchequer, said he was “setting out proposals for a radical simplification of the tax rules for pensions… replacing them with a single lifetime limit on the amount of pension saving that can benefit from tax relief”. Writing in the foreword to a green paper, he added that his proposals would enable people to make “clear and confident decisions about pension saving”, allowing “greater individual choice and flexibility” about when and how much to save in a pension and reducing administrative burdens on employers and providers.

Historically, pensions saving has benefited from significant tax advantages. These tax breaks are primarily an incentive to ensure as many people as possible save for their retirement, reducing those who would be dependent on state benefits in their old age. But in tough economic times, there is no question of increasing the tax benefits for pension arrangements; in fact, successive governments have looked at ways to reduce the tax incentives available to pensions savers while trying not to destroy the concept of independent provision.

In practice this has led to multiple changes – each reducing the sum that can be saved and the amount of pension that can be granted in a tax-beneficial manner – and never really established the stable environment envisioned by Mr Brown. What has happened to the main pillars of the 2006 simplification regime?

Lifetime allowance

Successive changes over the years have affected all forms of pensions, and the small self-administered scheme (SSAS) is no exception. For higher earners who have sizeable pensions, alterations in the lifetime allowance are more likely to make an impact.

The initial lifetime allowance set in 2006 was £1.5m, with a proposed stepped increase to £1.8m during a five-year period. This was broadly equivalent to a maximum pension under prevailing occupational pension rules for a man of 60 drawing an indexed pension and providing a surviving spouse’s pension. Allowing for the then-appropriate salary cap, this was effectively a pension of £70,000 pa.

After increases were made in accordance with the proposed formula, subsequent chancellors first froze the lifetime allowance and then reduced it to £1.5m from April 2012. The latest proposal, effective from April 2014, reduces it again to £1.25m. Using today’s interest rates, a fund of this size could purchase an annuity increasing at 3 per cent pa and with a two-thirds spouse’s pension of approximately £35,000 pa. In addition, the maximum pension commencement lump sum has reduced from 25 per cent of £1.8m in 2011 (£450,000) to a proposed 25 per cent of £1.25m (£312,500) after April 2014. It is clear why the chancellor thinks this is a good idea given today’s mood of austerity.

To complicate matters, it has been possible for individuals who already have reasonably substantial pension pots to apply for ‘protection’. With primary and enhanced protection in 2006, fixed protection in 2012, new proposals from the recent Autumn Statement for ‘fixed protection 2014’ and ‘personal’ protection, there will soon be five different protection regimes in place, plus lump-sum protection. Is this really the simple approach the government anticipated when the new pension regulations were introduced in 2006?

Annual allowance

When simplification became effective, the annual allowance was originally set at £215,000, to increase over five years to £255,000 pa. In reality, it was always believed that these were extremely high levels of potential contributions and a new, much lower annual allowance of £50,000 was introduced, effective from April 2011, albeit with a new three-year carry-forward provision. From April 2014, this will be followed by a further reduction to £40,000.

While the annual allowance is relevant for both self-invested personal pensions (Sipps) and SSASs, the latter probably suffers most. SSAS payments are almost always from an employer seeking to maximise contributions, whereas most Sipp payments are personal. When the original annual allowance was introduced, it was significantly higher than necessary. But for any directors whose company was making higher levels of contribution in years of profit, the lifetime allowance would soon be reached, effectively limiting the amount of tax relief being earned on the individual’s pension accruals.

The reduction in annual allowance changes this significantly. While a number of people will already have accumulated pension funds towards the limit of their lifetime allowance, an individual setting out on the pension ladder today would have to contribute £50,000 pa for 20 years to accumulate the lifetime allowance of £1.5m, assuming a 4 per cent pa rate of return.

With reductions in the annual and lifetime allowance, an individual commencing pension saving in 2014 would have to pay £40,000 pa for 21 years to accumulate the revised lifetime allowance of £1.25m. It may be argued that we are approaching an era where having both an annual allowance and a lifetime allowance is irrelevant.

Income drawdown

Possibly the greatest clamour prior to the Autumn Statement was about the significant reduction in the maximum drawdown that could be taken from pension arrangements. This was due to several factors: a reduction in yields, largely the result of quantitative easing; changes to the Government Actuary’s Department (Gad) rates accounting for greater longevity; a reduction from 120 per cent of Gad rates to 100 per cent; and poor returns on pension funds from the previous few years.

This meant pensioners who had started drawdown in, or shortly after, 2006 and had been taking the maximum income, now faced reductions in their pension income levels of around 50 per cent. New pensioners also faced low levels. Graph 1 illustrates the impact for a 60-year-old commencing drawdown in April 2006 through to April 2012 for a £100,000 fund, showing the maximum dropped from approximately £7,500 pa to £5,000 pa. While the recent proposal to reinstate the 120 per cent rate will go some way towards improving the drawdown situation, it will not reverse the significant reduction that has occurred in the past six years.

Longevity continues to improve and, as the Gad rates are supposed to reflect annuity rates, there is likely to be a further reduction due to gender equality when insurance companies finally determine how to show this in their annuity rates. Strangely, while politicians express concern that they do not wish individuals’ pension funds to reduce too rapidly so they become dependent on the state – although, in reality, the drawdown formula virtually precludes any such situation happening – it would arguably be in the chancellor’s best interests to keep pension income high in the short term to ensure a higher income tax take, which must surely be beneficial for the exchequer. Artificially reducing retirees’ income is not good, either for the individual or the Treasury.

Where next?

Regrettably, politicians will always view pensions as an area where the tax received by the Treasury can be increased without necessarily hitting an individual’s pocket today. For more than 20 years, stories have been circulating about the abolition of a tax-free lump sum, and the Labour party has recently been quoted as saying higher-rate tax relief for individuals should be abolished.

While the backlash from a withdrawal of the lump sum would be politically crippling, the limiting of contribution relief to basic-rate tax would probably create less of a stir. It is interesting to note, however, that company contributions would still be subject to corporation tax relief even though personal contribution tax relief might be limited. This would give a clear advantage to saving through a SSAS rather than a Sipp, where the majority of contributions are personal.

But there is no certainty in constant change. With Budget day rapidly approaching, it is all savers and providers can do to hope for that long-sought period of stability.

Ian Hammond is managing director at Rowanmoor Group