Pension simplification could transform offshore bonds from a hidden gem to a mainstream product for retirement planning.
After April 6, 2006 – known as A-Day – the revised £1.5m lifetime limit on pension contributions will apply and any contribution above this threshold will be taxed at 55 per cent.
In the run up to A-Day, pension funds can be registered for primary or enhanced protection. Primary protection is where the value of the fund on A-Day becomes the client’s personal lifetime allowance, which will grow in line with inflation. The problem is that the value of the fund could grow faster than the rate of inflation and the excess will be subject to the 55 per cent recovery charge.
Where enhanced protection is chosen, growth in the fund is protected from the recovery charge provided no more contributions are made. The obvious problem with this option is that what is accumulated will not be enough for some people who want to carry on saving for retirement.
The solution could be offshore bonds, which offer similar tax-efficiency to pensions but are more flexible and often have greater investment choice than onshore unit-linked bonds. For example, some of the portfolio-style offshore bonds allow investment in hedge funds, which are not available to onshore products.
Smith & Williamson head of financial services Mike Fosberry says: “Everyone will be looking at alternatives to pension saving, especially if it looks like the lifetime limit will preclude them from making contributions after 2006.
“The taxation of offshore bonds is similar to pensions. You have the benefit of gross roll-up and cannot reclaim withholding tax on dividends, which also applies to pensions. The main difference is payments into a bond are not subject to tax relief and there are potential income tax charges on maturity. Offshore bonds have a 5 per cent a year withdrawal facility that pensions do not have, so in some respects the bond may be more favourable.”
Origen Financial Services technical manager Bob Perkins points out that although inflexibility is a downside of pensions, the ability to access money intended for retirement is not necessarily a good thing.
He adds: “Offshore bonds are something that could run alongside pensions rather than as a replacement for them. Money in a pension is tax-deductible so you would need to put up to 40 per cent more into an offshore bond to get the same amount back as a pension. If you go over the lifetime limit, you get a 55 per cent tax hit but how bad is that? You have had tax benefits all the way through.”
Perkins explains that when money is taken out of an offshore bond, the gain is taxable up to 20 per cent, with the potential for a higher top-sliced rate. Top-slicing is where the total gain is divided by the number of complete investment years to produce an average gain, which is added to the person’s income. Higher-rate tax is incurred on the part of the gain that falls into the higher-rate band.
The Isle of Man government sees A-Day as a good opportunity for offshore products. Its pension project executive, Mike Lightfoot, reports a lot of interest in offshore bonds from the top end of the market including entrepreneurs and sports professionals whose early retirement options have been eroded.
Abbey for Intermediaries investment proposition manager Andrew Pennie says: “We believe the offshore market should be bigger as more of the mass affluent are moving into this area and costs are coming down.
“The gap between the pricing structures of offshore and onshore bonds is narrowing due to pressure and demand although most offshore bonds have higher costs. But with rising house prices and inheritance tax issues, offshore investments are not just for high-net-worth clients any more.”
Scottish Life International head of marketing Richard Jamieson feels the major obstacle for offshore bonds is unfamiliarity but he thinks this will change. He says: “The top end of the market is already aware of offshore business and the section of IFAs dealing with the middle to top end of the market who are not already doing offshore business soon will be.”
Arch Financial Planning managing director Arthur Childs is not entirely convinced by the argument for offshore bonds as a suitable vehicle for retirement savings, even for high earners. He says: “Clients can get a shock when the bond matures and they have to pay tax on it, particularly higher-rate taxpayers. Although we tell them they will have to pay tax on it, they forget.”
But Childs concedes that offshore bonds may be useful in retirement planning in some circumstances. He says: “Apart from people who will get to the £1.5m lifetime limit, the other market is where one of the spouses is a non-taxpayer. That person would pay no income tax on the money coming back to the UK and as a lump sum it would not be getting lost in an annuity.”