Looking at the differences in the way the pension input amount is calculated for pension annual allowance purposes.
I want to use my next couple of articles to explore some of the pension tax legislation differences between DB arrangements and other money purchase arrangements.
This week, I am going to look at the differences in the way the pension input amount is calculated for pension annual allowance purposes. The annual allowance in effect limits the amount of tax privileges available on pension savings paid by or in respect of an individual in a tax year to a registered pension scheme.
The measurement works on the principle of how much was saved from the start of the pension input period to the end of it, which is referred to as the PIA. PIPs are now aligned with tax year-ends, making it easier to calculate the PIA.
Where the PIA exceeds the individual’s annual allowance, including any carry forward from previous tax years, an annual allowance charge will be payable at the individual’s marginal rate of income tax.
For other money purchase arrangements, such as a Sipp, the PIA is the sum of the following paid during the PIP:
- All relievable pension contributions paid by or on behalf of the individual under the arrangement, and
- Contributions paid in respect of the individual under the arrangement by an employer of the individual.
Calculating the PIA for a Sipp is therefore relatively straightforward. In the case of a DB arrangement, it is slightly more complicated.
It is not, as might be envisaged, a case of taking the percentages for employer and employee contributions and applying these to pensionable earnings. Rather the PIA is a notional contribution based on the increase in benefits accrued over the PIP.
Take the following example: Assume pension accrued at the start of the PIP is £39,360 a year (lump sum through pension commutation), and the annual increase in the consumer price index to the previous September was 3 per cent. The accrued pension at the end of the PIP is assumed to be £42,000.
- Opening value = (39,360 x 16)
x 1.03 = £648,653
- Closing value = 42,000 x 16
The PIA is therefore £23,347, arrived at by taking the closing value from the opening value (£672,000 – £648,653).
“And…?” you may ask. So let’s look at this in a slightly more oblique way.
In the DB example, the individual’s PIA was £23,347 for an increase in pension income of £2,640. Compare that with another money purchase arrangement PIA of £23,347 that was used to immediately purchase an RPI linked annuity with 50 per cent spouse’s pension to give a comparison with the equivalent DB benefits.
In today’s low annuity environment, a 65-year-old male (spouse five years younger) would get around £60 a month paid in arrears, or £720 a year. Hardly an equitable outcome for the person with a Sipp with a yield of 2.73 per cent compared with the DB yield of 11 per cent.
To add salt to the wound, while the PIA for the DB scheme is only £23,347, the actual capital value of the contributions for the accrued pension could be close to twice as much.
For example, the NHS scheme has an accrual rate of 1/54 with an employee gross contribution rate of 14.5 per cent (8.7 per cent net of higher rate tax relief) for those earning more than £111,377 and an employer contribution of 14.38 per cent. That’s 28.88 per cent in total.
Using the figures in the earlier example, the individual in question would have a pensionable salary of £142,560 and a total monetary contribution amount of £41,171.
On this basis, the individual would have exceeded the current standard annual allowance of £40,000 and yet, under the actual methodology used to calculate the PIA, would be able to carry forward up to £16,653.
The PIA calculation for annual allowance purposes is not the only area in which other money purchase arrangements are treated unfavourably under pension tax legislation compared with DB schemes. Another area is when testing benefits against the lifetime allowance and benefit crystallisation events at age 75.
The one area where perhaps money purchase arrangements are more favourably treated is when it comes to death benefits, which I will cover in a later article.
Neil MacGillivray is head of technical support at James Hay