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Making allowances

Careful calculations are required to assess pension returns in the new regime.

Pension simplification was introduced because the Government believed that pension complexity puts individuals off saving.

There is, however, a real danger if future Govern- ments are seen to be penny-pinching, that the lifetime allowance could prove to be a legitimate reason for people not to save for their retirement through a pension.

Pension simplification is the most radical change to the UK pension regime in the past 50 years. The vision behind simplification is for one set of very easy to understand pension rules which will allow most people to save what they want when they want in any form of pension.

The new legislation broadly follows the same principles as the current PPP rules, with the front-end testing on contribution limits but these new limits are much more generous.

As a result, the Inland Revenue has deemed it necessary to have an overall maximum funding limit, applying to all pensions – defined contribution and defined benefit.

Given the increased flexibility available on contributions, limits have been set on the tax privileges avail- able to an individual. From A-Day, the tax advantages on a pension only apply to funds within the lifetime allowance and any excess funds will be subject to tax.

The lifetime allowance starts in 2006 at 1.5m, rising to 1.8m by 2010/11. We know the limits for the first five years but these will be reviewed in 2010 for the next five years and we have no idea what they will be.

The limits for the first five years provide annual increases above the current inflation rate. Future lifetime allowances beyond 2010 will not be less than 1.8m, even if there is nil or negative inflation but there is no guarantee that it will increase beyond 1.8m or that the limit will be held at the previous year’s level in the future.

Funds are tested against the lifetime allowance when there is a “benefit-crystallisation event”, such as normal, early, late or ill-health retirement, on increasing a pension in payment – in most instances – on death or on transfer overseas.

Where benefits are paid, a tax charge known as the lifetime allowance charge is pay-able on funds exceeding the lifetime allowance. The charge is 25 per cent of the surplus funds plus income tax at 40 per cent, giving a total rate of 55 per cent.

A money-purchase benefit is calculated at fund value while a defined benefit is valued on a basis of 20 capital for every 1 of pension. For example, a pension from a final-salary scheme of 20,000 a year is given a notional value of 400,000.

In December 2002, when first announced, it was stated that only 5,000 people had personal pension schemes worth more than 1.4m. The Inland Revenue paper specifically identified the affected “5,000” as individuals with “personal pension schemes”. Are those members of defined-benefit schemes that will be affected in addition to this estimate?

For example, the lifetime allowance equates to a pension of 75,000 a year on the basis of the 20:1 rate dictated by the legislation. Based on a “two-thirds final-salary” pension, a senior executive on a salary of more than 112,500 will be affected by the lifetime allowance, ignoring the transitional protections available.

In the original December 2002 consultation document, the Inland Revenue produced a table showing estimated post-tax rates of return on pension funds. Updating this table to take into account the reduction in the recovery tax charge gives the following real post-tax rates of return over a 10-year period (see table above).

The table shows that saving in a pension fund is still advantageous, provided that the individual remains within the ann- ual allowance and the lifetime allowance is advantageous.

Pension schemes are restrictive. The only reason for investing in one is to ben- efit from the tax-friendly environment. It is pointless inv- esting in a pension if the post-tax rate of return is half of what you could potentially could get outside a pension.

For the reasons given above, an individual will want to avoid exceeding the lifetime allowance. How easy will this be? Will companies offer compensation to senior executives opting out of defined-ben- efit schemes? How easy will it be to manage an individ- ual’s defined-contribution arrangement within the lifetime allowance?

Pension funds are typically partially invested in the stockmarket. The value of these investments will go up and down over the long term and it is therefore necessary to estimate the fund value at retirement based on assumptions on future investment returns.

Assuming the fund is valued at 1m now, 10 years before retirement, it is reasonable to assume a real rate of return of 4 per cent above inflation so it is effectively worth 1.5m. We therefore stop further contributions and estimate the value of the pension fund in today’s money by compounding it at 4 per cent a year.

However, using actual investment returns over the last 10 years, five years before retirement, you could have been predicting that an individual’s fund would exceed the lifetime allowance. But, at retirement, due to poor returns on the fund in the final run-up to retirement, the individual’s pension fund is only worth 74 per cent of the lifetime allowance and hence he or she has missed out on significant tax savings. Of course, the client may have switched to lower-risk funds at the five-year point but the psychology of all investors in a bull market is to assume that the only way is up for future returns.

But it is not all doom and gloom. The new legislation introduces greater control over the date that the individual can draw their pension and they do not have to stop work before drawing benefits.

This does introduce some control on ensuring the fund remains within the lifetime allowance as benefits could be “crystallised” but to continue to be invested with little or income being taken from the fund.

The future review of the lifetime allowance is crucial to the impact and the size of the affected population. Hope- fully, future Governments will continually review the lifetime allowance to take into account future earnings’ inflation and also changes in nnuity rates. Going above the lifetime allowance is a disas- ter in investment terms but being able to take benefits while working does give some control.

Real post-tax rates of return over a 10-year period

Saving in a pension with both the annual and lifetime limits: 7.1%

Saving in a pension above both the annual and lifetime limits: 4.4%

Saving in a pension within the annual limit but not within the lifetime limit: 0.9%

Saving outside a pension in a mixed portfolio: 1.7%

Saving in a pension with both the annual and lifetime limits: 7.1%

Saving in a pension above both the annual and lifetime limits: 4.4%

Saving in a pension within the annual limit but not within the lifetime limit: 0.9%

Saving outside a pension in a mixed portfolio 1.7%


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