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Take it to the limit

There has been general agreement in the industry that the Inland

Revenue&#39s tax simplification proposals for pensions are a good thing.

According to the consultation paper, over 99 per cent of people will

be free to save more into pensions than they can at the moment.

Cynics might argue that the number of people caught by the limit is

more than suggested, maybe 2 per cent or 3 per cent, but this is just

splitting hairs. What is important, is that the percentage affected,

whether it be 1, 2 or 3 per cent, remains the same in 20 or 30 years.

In referring to the lifetime limit, the consultation paper states:

“It will be indexed to keep pace with inflation – asthe earnings&#39 cap

is now.” This is a serious flaw in the proposals that needs to be

addressed.

The proposed £1.4m would currently buy a 60-year-old male a

pension of about £50,000 a year with RPI indexation and a 50 per

cent spouse&#39s pension. Against the traditional target of two-thirds

earnings, this implies a final salary of £75,000. This is where

the cap will bite for a 60-year-old but what about a 30-year-old?

According to the Government Actuary, earnings have historically grown

faster than prices by between 1.5 per cent and 2.5 per cent a year.

If this continues in the future, a 30-year-old targeting a two-thirds

retirement income would only need to earn about £41,000 today to

be caught by the lifetime limit.

It does not stop with the current generation of savers. Fast-forward

20 years and today&#39s 20-year-old bec-omes tomorrow&#39s 40-year-old. How

many 40-year-olds earn £34,000 or more? A lot more than 1 or 2

per cent, that much is sure.

If the number caught gradually creeps up, the penny will quickly drop

with the saving public that the Government wants to reduce the role

of private pensions in the longer term. This would not be a good

message to give to a group of people who you want to save more rather

than less.

For people who have already breached the proposed limit or are likely

to do so in the future, planning to avoid going over it will be an

ongoing and intensive process. If this activity remains restricted to

the top 1 or 2 per cent, then there should be no major problem. These

people will have to pay for advice but they can probably afford to.

They also know that a few hundred pounds invested in seeking advice

now from their IFA will likely save them thousands in a few years.

However, if the lifetime limit eventually catches those on lower

incomes, they will be the ones who end up paying the recovery tax

charge. Again, this penalty could hit the very people that ought to

be encouraged to save.

The main reason that the lifetime limit will be such a fearful

benchmark is what happens to your savings when you go above it.

First, your fund is subject to a recovery charge of one-third or 33.3

per cent. Then the remainder is subject to income tax at your

marg-inal tax rate – in this case,a euphemism for 40 per cent. The

combination of this double whammy is a 60 per cent tax charge.

Second, despite recovering any tax benefits you have received (that

is, what is left in no way resembles a pension fund), three-quarters

of the excess must still be used to buy an income.

Why is the treatment of these excess funds so markedly different from

the treatment of surplus AVCs and FSAVCs? A higher-rate taxpayer in

this situation gets their entire excess fund back as cash after

paying a single recovery charge of only 48 per cent.

If funds above the lifetime limit were treated in the same way as

Oeics, unit trusts and qualifying life policies (or surplus AVC funds

for that matter), the lifetime limit would not induce the same dread

that the current proposals threaten. People would not need to worry

about straying into the land above the limit. They would be able to

say to themselves “even if I do go over on those excess funds I am no

worse off than had I invested in an Oeic or unit trust”.

But there is hope. These proposals are, after all, still only

proposals. In its series of public meetings, the Inland Revenue has

also signalled its willingness to hear views on these specific

issues. If it listens to practitioners now, as it obviously did when

it came up with the new regime, then we may be in for a pleasant

surprise when the proposals are firmed up. Then we can all start

telling the public what a good thing these new pensions really are.

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Trouble ahead - thumbnail

Pensions: trouble ahead?

The pace of change in the pension’s space has been little short of astonishing, and has left thousands of employers struggling to keep their pension policy compliant, and also on the right side of current best practice and governance. Many employers, and indeed many in the pensions industry itself, would like to see a period of no change during the next term of government. This would give all sides a chance to catch up and draw breath. 

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