Matt Pitcher is a financial consultant at Towry Law.
Britain's former primer minister John Major wanted wealth to "cascade down the generations" through pension reforms. Now New Labour is tinkering with future of family wealth. Is your family trust fund safe? Matt Pitcher explains
The UK's recent proposed changes to pensions are the widest ranging since the introduction of personal pensions in the 1980s. What many people haven't grasped is how the changes will affect them, their companies and their staff.
It is fair to say that the humble pension may undergo a transformation in the next two years which will leave many people regarding their pension as the family trust fund. If used to its full potential this could improve on former prime minister John Major's 'wealth cascading down the generations' and become a cascade of tax-free wealth for the next generation.
The changes are known as 'pension simplification' which very neatly describes the government's intentions. There are currently eight separate tax regimes for pensions each with different rules about how much you can put in – little wonder that most people find the subject confusing. The proposal is to replace these regimes with a single universal set of pension rules from 6 April 2006.
From this date it is anticipated that all pensions will be able to offer 25% of your pension fund as tax-free cash as most personal pensions now do. In addition pensions will all be able to invest into a wider range of assets than before. In terms of payments into a pension the new system revolves around two rules called the lifetime allowance and the annual allowance.
The lifetime allowance determines the maximum amount that anyone can accrue in their pension fund. The value of the lifetime allowance will be set at £1.5m on introduction rising as follows: 2007 (£1.6m); 2008 (£1.65m); 2009 (£1.75m); 2010 (£ 1.8m). While this might seem like a high figure some people have already fallen foul of this limit. One of the main problems with this figure comes for executive members of final salary pension schemes. Some larger companies and the civil service still offer this generous type of pension to their staff but because this pension does not have a quoted fund value a formula is used to work out the equivalent value. This formula is simply the pension payable multiplied by 20 = the equivalent fund value. This means that anyone expecting a final salary pension of over £75,000 per year from 2006 onwards may exceed the lifetime allowance.
If you know that your pension fund has breached the lifetime allowance, there are two types of protection you can register for.
Primary protection will be given to the value of the pre-April 2006 pension rights in excess of £1.5m. This means that your 2006 pension fund value will be worked out as a multiplication of the cap. In other words, a pension fund in 2006 of £2m would be treated as a factor of 1.33 because this is the amount needed to divide £2m into the total of £1.5m. This factor of 1.33 would be applied to the final retiring fund to see if it breached the higher cap in place at that time. This allows people to continue contributing and only if contributions and growth make the fund value rise faster than the cap will a recovery charge be applied.
Enhanced protection will be available to individuals who stop paying into pension schemes by 6 April 2006. Provided that they do not resume payments into any registered scheme, all benefits coming into payment after 5 April 2006 should be exempt from the lifetime allowance charge. Given that enhanced protection protects all funds registered, if you find yourself in this position then you should pay in as much as you can afford to before 6th April 2006. Leave it any later than this date and you will have lost the option to receive valuable tax relief on the money you pay in.
The second rule is around how much you can pay into your pension. Currently contributions are set as a percentage of salary but in less than two years the annual allowance will replace this. Essentially anyone will be able to pay in the same amount as they earn each year capped at an annual allowance initially set at £215,000. This limit will increase steadily each year such that in 2010 it will be at £255,000. For the majority of us this will hugely increase what we can contribute to our pensions and these payments will still attract full tax relief which remains the main advantage of pension over any other type of investment. Tax relief will remain the same with basic rate taxpayers having their contributions topped up by the Inland Revenue to the tune of 22% and higher rate taxpayers gaining an additional 18% rebate on top of this via their tax return. Pensions are the only investments where for a higher rate taxpayer a fund of £10,000 will have only cost them £6,000.
The huge opportunity for large contributions into pension schemes after 2006 should not be underestimated. Business owners may be able to extract significant value from their businesses at retirement by increasing their final year drawings from the business to the maximum and then paying a large percentage of this into their pension. The effect of this is to extract value from a business at retirement without having to pay tax.
The relaxation of the rules surrounding how a pension fund can be invested also represents an opportunity. For the first time residential property becomes a valid pension fund asset and the fund can borrow to invest. For many people their home has become the only reason they face paying inheritance tax. If their pension fund owns the property (even raising a mortgage for the purchase) then the tax situation changes. There is no tax on the underlying pension assets and as pensions are commonly written under trust this may possibly allow children or grandchildren to inherit pension funds free of all tax including inheritance tax.
Currently this inheritance tax saving only helps the unlikely few who die before drawing their pension income as an annuity. This is because once an annuity is taken, the latest in law being age 75, there is no value to pass on after death. However an alternative to annuity purchase at 75 has been proposed. Alternatively secured income allows someone in retirement to draw down on their pension fund for their own income needs but with the possibility that if there is any left, it will pass to their beneficiaries. If this is extended to include everyone then we may find ourselves in a situation of having a family pension fund passing from generation to generation tax-free. Then the pension fund might start to be regarded as the family trust fund if it contains business assets and the family home.
It is not clear how wide ranging this legislation will be but it is possible that as well as including children and family in your pension fund this may allow friends or business associates to become part of your pension fund as well. It is a huge departure for the government to allow you to benefit from a pension fund and then others to benefit after death because of the valuable tax relief that is then passed on.
Pensions will also be able to be used to purchase business premises for small firms. This is already possible with small self-administered schemes and self-invested pensions. However, the amount a pension fund can borrow for property purchase is being reduced so those considering purchase of business premises with their pension fund need to borrow before 2006 or put more money into the pension now to give a bigger fund for purchasing property after 2006.
The benefits of pensions to companies large and small have always been staff retention and tax savings. Increasingly firms are turning to IFAs and employee benefits companies to produce total reward statements for their employees. In simple terms these list out all staff benefits such as pensions, healthcare, life assurance and give them a monetary value. This allows staff to understand the value of their total package from an employer and may persuade them not to move companies for a higher salary but lower benefits. This has resulted in many cases in staff appreciating for the first time the cost to their employer of the pension they offer.
There is also tax savings to be had by employers as well. Salary sacrifice allows a company to pay money into a pension in lieu of salary. Doing this saves the company employers' National Insurance at 12.8%. Many of the bigger companies have started to do this on a large scale, in some cases passing some of the saving to the employees but adding the rest back into the company's profits. Salary sacrifice need not mean employees taking a cut in earnings but may rather form part of an annual pay review.
It is surprising how few companies have actually taken advantage of this scheme but as pension simplification makes administering company pensions easier more time may be found to grasp some of these opportunities.
Clearly 2006 marks a watershed in the opportunities presented by pensions. It is therefore important for everyone to review their personal and corporate pension offerings before then to ensure no opportunities are missed.