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Design of the times

The pension scheme changes taking effect from April 6, 2006 will simplify matters considerably – it would be churlish to argue otherwise.

However, the simplification of pension legislation should also be matched by simpler product design to assist those who have to administer pension schemes and communicate the benefits to members.

The changes will undoubtedly cause extra work for administrators and trustees during the next few years as they grapple with the most app-ropriate ways of dealing with high earners and others who are or are likely to be affected by the lifetime allowance.

Scheme members will exp-ect scheme administrators to explain the impact of the changes, especially where the complex transitional rules come into play.

Many employers will be considering changing their remuneration packages to take account of the pension chan-ges and this could involve a review of existing schemes, including those employers who have already made the switch from DB to DC.

Any moves to change the scheme structure, however, should make the work of scheme administrators and trustees easier and new schemes should be simple to understand and run.

One area of complexity is contribution levels, for example, the practice of making employer contributions dependent on the level of employee contributions or by creating tiers of contribution levels dependent on age and/or length of service.

Providing a member with an illustration of pension benefits that is dependent on one variable is acceptable, for example, where contributions are linked to salary increasing at a given rate.

Where contributions are linked to years of service or where the contributions are tiered to increase, say, every five years, they cause complexity. Illustrations become expensive to develop and difficult to administer and explain to members.

Members can also be lulled into a false sense of security when they see illustrations based on levels of contribution that apply years into the future and which will not apply if they change jobs.

In the past, the provision of death in service benefits has been straightforward, typically a lump sum of up to four times remuneration together with a widow’s/widower’s pension. When the simplification changes come into force, the existing limitations on multiples of remuneration will no longer apply.

Instead, lump-sum death benefits will be tested against the lifetime allowance, with any excess amount being taxed at 55 per cent, an unlikely event for the vast majority of members. Dependants’ pensions will not be tested against the lifetime allowance but will continue to be taxed as income.

This is an area where scheme benefits could be simplified. There is an obvious financial advantage to the dependants of the deceased member in receiving a lump sum tax-free compared with a pension that is taxed.

There is also an advantage to the scheme administrator in paying a once-and-for-all lump sum to the dependants rather than having to pay out a pension, after deducting tax, to the dependant for many years. The administrator may also have to check the ongoing eligibility of the claimant, for example, whether the dependant is still in full-time education.

Some people would argue that there is a danger in paying out a lump sum rather than a pension or annuity to a dependant because the dependant may be unable to handle a big lump sum and may squander it. This patronising view would be very hard to justify when there is such an obvious tax disadvantage in receiving a pension.

The employer could arr-ange financial advice for the deceased’s dependants if they are concerned about the abil-ity of the recipients on how to invest the lump sum. Even if the dependant wanted the benefit of a guaranteed regular income, a purchased life annuity would be more tax-efficient than an income paid out of the scheme.

The simplification changes will cause employers to reappraise the way they pay emp-loyees, especially high earners. Employers should also take advantage of the changes to redesign their schemes to make them easier to administer and therefore less costly, as well as simplifying the benefit structures and ultimately the take-up by employees of a valuable benefit.

Tony Reardon is principal of Reardon Consulting


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