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Driving forces behind choice of top-up vehicle

Should people be making additional voluntary contributions after the start of the simplified pension tax regime on April 6, 2006? There are some interesting and important issues to consider.

Will AVCs still be available? It will no longer be obligatory for an occupational scheme to offer this facility and employers could be forgiven for dropping it altogether. There will be no concurrency rules to stop occupational scheme members paying into a personal pension or stakeholder.

Big employers may be able to offer AVCs at lower admin costs than the member might be able to get on a stand-alone basis but they could probably offer group personal or stakeholder pensions on equally competitive terms.

There is a factor which might make AVCs attractive to occupational scheme members. It will be allowable for the rules to state that tax-free cash can be taken disproportionately where more than one arrangement of the same scheme crystallises on the same day. For example, if the main defined-benefit scheme offers poor tax-free cash commutation factors, the AVC could provide the whole of the tax-free cash up to the amount in the AVC fund.

Another example might occur where the main defined-contribution scheme contains a valuable guaranteed annuity option but the AVC does not. In this case, it would again make sense to take as much of the tax-free cash as possible from the AVC to get maximum advantage from the guaranteed annuity option on the main scheme.

But do remember that the scheme rules must allow for this to happen. If the employer is paying for the guaranteed annuity option, as opposed to the life office, then the employer may not be keen to change the scheme rules to facilitate this.

I have so far assumed that the AVCs being considered are money purchase but let us look also at the situation where AVCs are defined benefit. This may be on an added years basis but does not have to be. This is analogous to money-purchase AVCs which have guaranteed annuity options, since it is possible that the benefit is worth more than the member is paying for it. If so, and if the member is confident about the combined financial strength of the scheme and the employer, the AVC may be preferable to a separate vehicle.

There is a particular problem attached to defined-benefit AVCs going forward. Under the old priority rules for winding-up, if there was not enough money to go round, the AVCs were at the top of the pile. This meant that employees did not usually have to worry about the possibility of their employer going bust when making a decision about AVCs. Under the new rules, defined-benefit AVCs drop to third place behind benefits covered by insurance contracts taken out before April 1997 and which cannot be surrendered and – the big one – benefits which would be provided by the Pension Protection Fund if it had to take over the scheme. This creates a serious risk that defined-benefit AVCs will not be protected if the employer goes bust.

Unless the solvency of the employer is beyond question or the occupational scheme is defined contribution, people should think carefully before taking out defined-benefit AVCs in future. They might be better paying the same money into a separate money-purchase vehicle. If this is not sponsored by the current employer, it may be easier to continue paying into it after changing jobs.

So AVCs may have their place after A-Day. They could look attractive if the scheme rules allow them to bypass poor tax-free cash commutation factors or there is some valuable guarantee in the AVC itself. But if it is a defined-benefit scheme in the private sector, think carefully about the solvency risk.

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