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Stewart Ritchie on Pensions

One of the most extraordinary aspects of pension tax simplification is the new investment regime after April 6, 2006. For more than a quarter of a century, the Inland Revenue has policed small self-administered schemes to prevent incestuous transactions, investment in residential property, non-income producing assets and so on. When self-invested personal pensions started, the Revenue introduced a similar set of investment rules.

This will all be swept away at midnight on April 5, 2006. There is one example I use which encapsulates most of the changes. Let us assume you personally own a villa in Tuscany. You take six weeks&#39 holiday a year in it and the rest of the year you let it out to tourists. After April 5, 2006 you will be able to sell that villa to your Sipp, provided that it does not involve borrowing more than 50 per cent of the value of your Sipp pot at the time.

You will still be able to occupy it yourself for six weeks a year and it is up to you to decide whether to pay six weeks&#39 rent to your Sipp. You will, of course, declare any benefit in kind from your Sipp on your annual income tax return. For the remainder of the year, your Sipp can let out the villa to tourists but does not have to. After all, your Sipp will have invested in some nice post-impressionist paintings which hang on the walls of your Tuscan villa and you would not want the tourists to nick them. You will, of course, declare as a benefit in kind on your tax returns the value you get from admiring these paintings while in Tuscany.

This one example illustrates the power to invest in residential property using borrowing and an incestuous transaction.

If we assume that the property purchase required all the Sipp&#39s funds plus 50 per cent borrowing, it becomes clear that there is a potential problem over concentration of risk. It is not just that 100 per cent of the fund is invested in one asset class but, actually, 150 per cent of the fund is invested in one asset. If the Tuscan residential property market takes a nosedive or the villa burns down without insurance, is the adviser confident that he or she will not end up being liable?

One potential way to overcome this huge concentration of risk is by investing an allocated percentage of the fund in some form of pooled property investment. There are many ways this could be done and this market may evolve rapidly between now and April 2006.

An added attraction of property investment in a pension wrapper after April 5, 2006 is the existence of alternatively secured pensions. These allow annuity purchase to be deferred so people do not have to liquidate their property investment by 75 to buy an annuity – unless, of course, they want to. Once again, it is important to fully understand the risk as well as the potential rewards of such a strategy. After 75, there can be no lump-sum payout to beneficiaries although it looks as if there could be an in specie transfer of the property to the pension pot under the same Sipp umbrella. However, you cannot live on bricks and mortar alone and the upper drawdown limit under ASP is heavily restricted and mortality drag will be very high.

So what does this mean for advice in the run up to April 2006? If your client has specific residential property investments in mind, work out now what they ought to have in the pot and recommend contributions now which are consistent with that. In short, for most people, maximise the contributions today.

Make sure also that you discuss with the client all the risk factors involved in such a strategy and make sure that discussion is confirmed in writing. Clearly, one of the risk factors is the possibility that residential property values will fall but, if a fall happens prior to April 6, 2006, that could actually be to the Sipp client&#39s advantage.

Stewart Ritchie is director of pensions development at Scottish Equitable


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