PensionsNov 20 2017

Pension valuation ratios forecast for Budget change

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Pension valuation ratios forecast for Budget change

Market watchers say the Chancellor could update the ratio used for defined benefit (DB) schemes valuations in the upcoming Budget, in a move to improve fairness in the market with defined contribution schemes.

At the moment, to value DB schemes for lifetime allowance (LTA) purposes, the pension taken is multiplied by a factor of 20.

This means that if an individual takes a benefit of £5,000 DB pension, it would use up a monetary amount of £100,000, and therefore use up 10 per cent of the current LTA, which is at £1m.

The LTA represents the maximum amount of money a saver can save in their pension pot - and benefit from tax relief at their marginal rate - before incurring an additional tax charge of up to 55 per cent.

The LTA will increase by £30,000 from April 2018 to £1.03m, since it was announced in the Budget 2015 that from 2018 to 2019 the allowance will be increased by inflation, the consumer prices index.

The current 20:1 ratio was set in 2006, when the LTA concept was introduced as part of pensions simplification, and has not been changed since.

The rationale for the ration is that it equates to the amount needed to buy an equivalent annuity on the open market.

But Rachel Vahey, product technical manager at Nucleus, told FTAdviser that “over the last 11 years, annuity rates have fallen so significantly that the 20:1 factor is now seen as particularly generous”.

This means, in practice, “that those with DB pensions will, it could be argued, pay less LTA charge than those with defined contribution pensions”, she added.

“It could be that the Treasury decide to change the 20:1 factor to make it fairer. This would mean an increase in the LTA charge revenue from members with DB pensions, which would obviously be an unpopular move with those who have larger DB schemes, including those in the public sector.”

Les Cameron, head of technical at Prudential, has also pointed out this change in his Budget predictions.

He said: “The value of defined benefits are fundamentally different these days, so could we see a change in the valuation basis for DB schemes for annual and LTA purposes.”

Such a measure, however, would also have an impact in DB transfers.

Ms Vahey said: “One of the big concerns for those who transfer from the DB environment to the defined contribution environment is the strong possibility they may have to pay more LTA charge.”

With a change in the ratio, it will be more likely that the LTA will be affected, which “might influence people’s decisions about whether to transfer or not,” she noted.

Ms Vahey gave as an example someone with a DB pension worth £50,000.

At the moment, when she takes her benefits - assuming she has not previously had a benefit crystallisation event - she would use up 100 per cent of the lifetime allowance (50,000 x 20 = £1m).

The retiree is offered a cash equivalent transfer value (CETV) of £1.8m. If she transfers and then immediately designates her fund into drawdown, she will have used up 180 per cent of the LTA, and will have to pay a lifetime allowance charge on the excess of £800,000.

If the DB factor is changed to 30:1, for example, and the person remains in the DB scheme, she will have to pay a LTA charge on the excess of £500,000 (£50,000 x 30 = £1.5m).

If she transfers to a DC and then immediately goes into drawdown, she still has to pay a lifetime allowance charge on £800,000, which hasn’t changed.

According to Ms Vahey, “what has changed – or narrowed – is the gulf between the lifetime allowance charge she pays in a DC scheme compared to what she pays in a DB scheme”.

She said: “A change in the DB factor probably won’t make the charges equal, but if means the difference between them isn’t as stark.

“She is paying a charge on £300,000 more rather than £800,000 more.”

The volume of DB transfers has been soaring, as savers seek to take advantage of sky-high transfer values and to move their nest eggs into defined contribution schemes in order to access them via the pension freedom rules.

There is also a possibility that the LTA itself is going to be changed in the Budget - according to analysis from Royal London, there is a six out of 10 probability of a cut on this allowance.

maria.espadinha@ft.com