While I do always welcome a period of stability, a lack of activity isn’t necessarily a good thing – changes could have been made to improve the way pension contributions are tested.
What we can all probably agree on is things have got to the point where pensions are so complicated for the average pensions member that clients exceeding the annual allowance, as well as issues around declaring this and paying the appropriate taxes, all continue to be live issues in our industry.
Multiple layers
The annual allowance was quite confusing for many when it was first introduced because it appears, at first sight, to be a limit on the amount of tax relief a person can claim. But it isn’t that simple. If the annual allowance is exceeded after carry forward, a tax charge is levied at the individual’s marginal rates of tax.
It should always be remembered that any tax relief due on pension contributions that are paid personally should be claimed in the normal way. Personal tax relief can be claimed on contributions up to the member’s relevant UK earnings, and hence this is not technically limited by the annual allowance.
It is the total pension input amount that is tested against the annual allowance. For defined contribution schemes, this includes not only personal contributions and any applicable basic-rate tax relief, but also employer contributions. For defined benefit schemes, it is based on the increase in benefits within the tax year.
Should there only be a single annual allowance, there would still be two tests to worry about each year when trying to establish what can or should be paid to a pension scheme. In any case, we now have multiple annual allowances.
The money purchase annual allowance is applicable to those that have used the pension freedoms to access their pension funds and taken income. This would generally be via the uncrystallised funds pension lump sum,flexi-access drawdown, or a flexible annuity. Standard annuities, or income taken from most DB pension schemes, aren’t a trigger.
The MPAA reduces the annual allowance to £4,000 each year for DC scheme contributions. DB schemes are not impacted by this. There is no carry forward available once the allowance has been triggered.
The tapered annual allowance is the newest incarnation of the annual allowance and came into force in 2016-17. It is designed to reduce the annual allowance for what the government deems high earners, and to recoup tax relief further.
Unlike the standard annual allowance and the MPAA, the tapered annual allowance is dependent on total earnings, including income that is not pensionable, such as rental income and dividends. When the net income – less any contributions paid personally to a pension scheme – is more than £110,000, we need to go to the next stage and the actual tapered annual allowance test must to be applied.
This second test (adjusted income) looks at total income, including the pension input amounts, which includes employer contributions – or deemed employer contributions for DB schemes. If this amount exceeds £150,000 then the standard annual allowance is reduced by £1 for every £2 in excess of £150,000. The minimum tapered annual allowance is set at £10,000.
Carry forward is available under the tapered annual allowance rules, but it is only based on the tapered amount each year, so this is key to ensure the calculations are accurate.
With all of the above, it can be very confusing for a member to establish the specific annual allowance that is relevant to them. In addition, we then need to establish the pension input amount, which is tested against their annual allowance. This could add another level of complexity.
DB vs DC
Another issue that raises questions is the way in which DB pension inputs are tested against the annual allowance, compared with the way DC pension input amounts are tested. With DB, the amount paid in has absolutely no relevance to the pension input amount and how much of the annual allowance it uses.
It should be noted that the amount of tax relief claimed does have a direct relationship to the amount contributed, which can make it even more confusing.
For example, take a member of a DB scheme who earns £60,000 at the beginning of the year and gets a £5,000 pay rise just before the end of the tax year. They have been a member of their pension scheme for 20 years at the start of the year, so 21 years by the end of the year. The contribution rates are roughly 10 per cent (£6,000) member and 15 per cent (£9,000) employer, although as it’s a DB scheme the employer contribution rate will vary in real life to ensure the scheme is fully funded.
If we calculated the pension input amount based on the above, it would be £36,320 using the consumer price index as of September 2018, at 2.4%. So we are assuming this is the pension input amount for this tax year 2018-19. If the CPI had been zero, the amount would have been £44,000, and had it been 5 per cent this figure would have been £28,000.
The lower the CPI, the greater chance of an annual allowance charge. This is because the pension input amount is calculated as the difference between the capital value of the benefits at the beginning of the year, increased by CPI, and the value of the benefits at the end of the year.
If we take the example here of CPI being zero, then the member will get a 40 per cent annual allowance charge on £4,000 if they have no available carry forward. They would have no control over this unless they wanted to opt out of the pension scheme, which isn’t usually good value even with an annual allowance charge. If this is happening every year, then financial advice should be sought to establish what the best option for the member might be.
The pension input amount is simply the amount of input. It is therefore simple for the member to calculate and determine if there is likely to be tax charge, or if they can pay in more contributions. Unlike the above, there isn’t any calculation to do that involves a variable such as CPI, so it is clear from the outset what is going to be paid in.
A better way
Although all this keeps me in a job, I really feel for those that simply have no idea what the implications of all this are on their retirement.
In many cases, the pension scheme will be able to facilitate the payment of the tax charge, under a regime called scheme pays. However, this will result in a reduction of the member’s benefits at retirement, because the payment will be taken from their benefits either as a monetary amount, or as a debit that will be rolled up to retirement and then deducted. This makes working out what the individual will end up with even more difficult to estimate.
Looking to the future
I don’t like to speculate too much, but the current process feels unsustainable. Given the fact that the tapered annual allowance is becoming ever more complex as we head into each new tax year, something has to give. Personally, I would like to see a simplification of all this and a return to a single annual allowance, at whatever level the government deems suitable. This would then give members a fighting chance of some sensible pension planning, rather than just having to deal with the outcomes that are forced upon them.
The annual allowance and all of its variations appear to be more of an issue for those that historically didn’t need advice on pensions; those in well-funded DB pension schemes. Those people do now need advice, and I have sympathy for those in such schemes. Having high earnings or a generous employer simply means they will need more help going forward.
Pensions, even after ‘pensions simplification’ back in 2006, are getting more and more difficult to deal with. All that said, they remain a very good, tax-efficient way to save for retirement.
Claire Trott is head of pensions strategy at Technical Connection
