Out-Law / Your Daily Need-To-Know

Part I: The basics

Out-Law Guide | 06 Jul 2007 | 12:47 pm | 13 min. read

This guide is based on UK law.

Introduction

Pensions often go to the bottom of the pile. They are just too complicated, and there are too many decisions to make. The jargon is off putting and the subject matter is austerely mathematical. But pensions are crucially important: they can be the single biggest expense of a company and one of the most valuable elements of remuneration. You ignore them at your peril.

Main types of pension scheme

  • A defined benefit scheme or final salary scheme promises a certain level of pension once you reach retirement age. It is usually calculated as a proportion of your final salary for each year of service. For example, if you are promised 1/60th of final salary for each year you work for the company and you work for 40 years, you will be paid 40/60ths (i.e. two thirds) of your final salary. On top of that, the law requires an element of inflation-proofing to be built in.
    In effect, as long as you keep your side of the bargain and pay in the required level of contributions (typically about five or six per cent of pay), the employer takes all the risk.
    There is a downside, though. UK employers that have defined benefit schemes are currently under no obligation to put in enough money to guarantee the pension promise in all circumstances. Employers do have to contribute a certain amount, but this is not nearly enough to pay everyone’s pension if the scheme winds up. If the pension scheme winds up, the employer must then fund the benefits in full, but this potentially substantial cost may well be beyond its means. Furthermore, each member does not own a share of the funds; funds will simply be divvied up in accordance with a priority order decided by the government. The Pension Protection Fund offers an element of protection to members of these schemes that wind up with insufficient funds to provide all the promised benefits. There are restrictions on the level of benefits that are paid from the Pension Protection Fund, so it will not necessarily be as good as getting your benefits from the pension scheme.
  • A money purchase or defined contribution scheme makes no promise about what you will get when you retire. You simply contribute to the pension scheme. The money is then invested in the way you have asked. At retirement, you buy a pension with whatever funds are available. The income you get depends on how well the investments have done and how much it costs to buy the pension, as well as other factors such as whether you want any dependant to get a pension on your death and whether you want inflation-proofing built in. So, in money purchase schemes, it is the pension scheme member who takes all the risk. He or she does have a legal right to a share of the funds, but there is no certainty about what that share will be.
    Money purchase schemes can be run by employers or by insurance companies. Those run by insurance companies are known as personal pension plans or stakeholder schemes. Your employer may contribute, or it may not.
  • Cash balance schemes combine elements of the two types of scheme above. They are designed along the lines of a money purchase scheme but the employer promises a certain investment return up to retirement. They are quite popular in the US but have yet to become part of the mainstream in the UK. In essence, both the member and employer share the risk.

Unfunded schemes

An unfunded scheme is, as its name implies, not pre-funded. It is little more than a paper promise. The employer promises to pay a certain pension at retirement, but does not put aside any money to do so. This is all very well if your employer is the government, but risky if you work in the private sector. (Unlike the government, private companies can go bust.) A financial promise is only as good as the organisation behind it.

Tax breaks

To encourage contributions to schemes, the government offers tax breaks. Anything you pay into a scheme will receive tax relief at your higher marginal income tax rate. Investment returns within the scheme are also tax free. Employers get corporation tax relief on what they contribute.

Restrictions

To discourage abuse of the system, there are restrictions on the amount of pension that can be built up each year.

Annual allowance

The annual allowance is the amount of pension you will be allowed to build up each year without incurring tax.

For money purchase schemes, this limit applies to the contributions that you or your employer make. Increases in investments within the scheme are ignored.

For defined benefit schemes, the annual allowance is the annual increase in the capital value of your benefit. The capital value is basically how much more your pension is worth. The government has set down in legislation how this will be calculated.

The annual allowance is £225,000 for 2007/8 and will be increased each year. The government has already announced the annual allowance for the years to 2010/11.

Lifetime allowance

There is a further limit on the amount of pension that can be built up during your life. This lifetime allowance is £1.6m for 2007/8. Again, it will be increased every year; by 2010/11, it will stand at £1.8m.

The amount of pension that you build up in a money purchase scheme is simply the value of your pension account. If you have a final salary benefit, the capital value is the annual pension you are entitled to receive multiplied by 20, plus the value of any additional lump sum benefit.

Pension funds are tested against the lifetime limit each time a new benefit is paid, on death and if you transfer to an overseas scheme. If you take your benefits in stages – for example, if you reduce your working hours and therefore only take part of your pension entitlement – some of your lifetime limit will be used up each time.

Compliance and tax collection

The onus is on individuals to ensure that they are within the limits or pay the necessary tax. Pension schemes are also responsible for the payment of the lifetime charge.

The annual allowance tax is calculated through the self assessment system. Tax will be charged at 40 per cent on any contributions above the annual allowance.

The lifetime allowance tax charge is only payable on pension benefits above the lifetime limit. If you decide to take the excess as a lump sum there will be a one-off tax charge of 55 per cent. If you opt for an additional pension, you will incur a tax charge of 25 per cent on the excess capital value. On top of this, you will be liable for income tax on the additional pension.

Protection of benefits accrued before 2006

The current rules date from April 6, 2006, so-called “A day”, when a new pensions regime came into force. The government allows people who were then already close to or above the lifetime limit – £1.5m for 2006/7 – to protect their retrospective” pension investments. There are two forms of protection available.

  • Enhanced protection allows you to protect benefits accrued before April 6, 2006 from the tax charge provided you comply with the relevant requirements. It means, however, that you can only build up further benefits in limited ways. And if the earnings cap (part of the old regime) applied to you, it will be taken into account when calculating your final pension. Subject to some exceptions, the earnings cap will have applied to you if you joined your pension scheme after 1989. You are able to opt out of enhanced protection if you find that you would be better off without it at any time before you reach 75.
  • Primary protection is only available if the value of your benefits was above the lifetime limit at April 6, 2006.
    If you choose this form of protection, your lifetime limit will be increased to the value of your pension benefits at April 6, 2006. This personal lifetime limit will then rise annually by the same percentage as the statutory lifetime allowance. Any growth above this will be taxed. If you choose this form of protection, you will be able to continue to contribute to a pension arrangement, but you will be taxed when you come to take your pension.

To take advantage of one or both of these forms of protection, you will need to register with H M Revenue and Customs by April 5, 2009. If you think that you may need protection, seek independent financial advice as soon as possible.

The investment regime

Investment rules include:

  • a limit on scheme borrowing to 50 per cent of scheme assets at the date of loan;
  • a five per cent restriction on shares of the sponsoring employer. Schemes are permitted to invest in residential property, subject to trustee approval.

Phased retirement

Since April 6, 2006, you’ve been able to continue working and draw a pension – in full or in part. In theory, at least, directors can now step down gradually and carry on in a parttime capacity, perhaps as a non-executive.

Such flexibility is only possible if your scheme allows it, and many defined benefit schemes have now changed their rules, particularly in the light of age discrimination legislation.

All benefits must be in payment by the time you reach 75.

Minimum retirement age

The earliest age at which most people can draw their pension will officially increase to 55 (from 50) by 2010. Some schemes may introduce the requirement earlier; the trustees will need to keep you informed.

You will still be able to get benefits before you reach 55 if:

  • you are eligible for an ill-health or incapacity pension. (The rules for this are fairly prescriptive and will be set out in the pension scheme booklet.)
  • you had the right to do so under the terms of your pension scheme, and the right was documented before December 10, 2003. (If you exercise this right, you will need to take all of your benefits at the same time and leave employment completely.)

People in certain occupations, such as sport, are allowed, as a result of a special concession by H M Revenue and Customs, to retire before 50. The lifetime allowance will be reduced by 2.5 per cent for each year that the person takes the pension before 50.

Generally, retirement before the age of 55 will only be practically possible for those people who have other savings.

Tax-free cash payment

It is possible to take up to a quarter of your pension fund (including any additional contributions you have paid) as a tax-free cash payment.

Membership of more than one pension scheme

You are able to join more than one registered pension scheme at the same time – in fact, you are able to join as many as you want. Annual tax relief will be given on the higher of £3,600 (the threshold for total yearly contributions to pension schemes) and your UK earnings (subject to the overall annual allowance limit of £225,000 for 2007/8).

Income drawdown

Ten years ago, a member of a personal pension plan or a defined contribution scheme had no option but to buy an annuity on retirement.

An annuity is a product, usually sold by insurance companies, that promises a certain income until death. What you get therefore depends on how expensive annuities are at the time you retire. Whether they are good value depends on how long you live. If you live a long time, you will do very well. Some people, however, do not survive long after retirement and so do not do so well (even if their wife, husband or partner gets a pension after their death). It is all a bit of a gamble.

Not surprisingly, annuities have been unpopular with retirees. To make things fairer, the government introduced what is known as income drawdown. Income drawdown allows the retiring member to put off buying an annuity and take some of their pension pot as income each year.

You do not need to buy an annuity when you reach 75. Instead, you will be able to buy what is known as an alternatively secured pension (ASP), which allows you to continue drawing income from your pension pot but in a reduced amount once you are 75. This helps to ensure the funds are not used up too quickly.

However, the government was concerned that some people saw an ASP as a good way to accumulate capital rather than as an alternative to an annuity. In December 2006, therefore, it announced changes to ensure that ASPs are used to provide an income in retirement and not to pass on capital tax free to dependants.

Income drawdown is a tricky area as the rules are complicated. In addition, you need to have sufficient funds to make the costs worthwhile. And your income will fluctuate in line with the performance of your investments.

If you think income drawdown is for you, seek advice before making a final decision.

Other forms of pension

Small self-administered schemes (SSASs)

SSASs used to be very attractive to controlling directors. They offered a tax-efficient vehicle that allowed directors to be trustees and members of their occupational pension scheme.

Trustee members had control over how the assets were invested, and the restrictions were few.

The relative attractions of SSASs have diminished since April 6, 2006, when all pension schemes became subject to one investment regime. The schemes, however, will not disappear quickly, and will continue to operate for some time.

Executive pension plans (EPPs)

EPPs, when used, were normally set up for directors and senior executives. They are usually contracted into the state scheme and are defined contribution schemes. Like SSASs, they will become less common in future.

Self-invested personal pension plans (SIPPs)

SIPPs are personal pension plans that allow individuals to select their own investments. You must use an external provider to hold the money for you.

SIPPs offer members more control in managing investments and are therefore attractive to sophisticated investors. Investing in residential property, paintings, antiques etc is, however, prohibited.

Pension rights on dismissal

Your pension rights are likely to be found in a number of documents, including those below.

  • Your service contract: this should refer to any pension arrangement to which your employer will make contributions. If the arrangement is a personal pension plan or a stakeholder scheme, it will typically give details of the pension provider and the level of contributions. If your company has an occupational scheme, the service contract will probably refer to the pension scheme booklet, where more detailed information can be found. Usually, the contract will give your employer the right to change the pension scheme, either expressly or by invoking the power of amendment in the pension scheme.
  • The pension scheme booklet: the trustees of any occupational pension scheme are required by law to give you certain details about the scheme. These include an outline of how to join, the benefits available, how much you will need to contribute and how to make a complaint.

If you are made redundant or are asked to leave your company you may be entitled to compensation. Your rights will depend on your circumstances and what your service agreement says (see the section on Directors' service contracts). You should always seek legal advice.

In summary, you are entitled to be put back into the position you would have been in had your service agreement been properly complied with. So, if you are over 50 (55 from 2010) this may mean that you should be retiring on pension.

If you are a member of a personal pension, stakeholder or defined contribution scheme you should be entitled to compensation for lost pension contributions during any period of notice. This loss will be reduced to reflect the fact that you will be receiving the contributions as a single lump sum rather than over a period of time.

If you are a member of a defined benefit scheme the position is more complicated. To calculate your pension loss, you need to look at your pension rights at the date you leave and the pension rights you would have had at the end of your notice period. The difference is the pension loss. An actuary will have to calculate the value of this difference, unless you are offered an additional period of service in the pension scheme to cover the notice period. Several factors will need to be taken into account. They include:

  • any pay rises you might have been entitled to during your notice period;
  • the fact that you are being paid the money before you would have been entitled to it;
  • any new job you may get, as this is likely to offer some form of pension;
  • any contributions that you would have had to make during the notice period.

If you are entitled to a pension when you leave employment, your employer is not allowed to take any pension benefits that you receive during your notice period into account when calculating compensation for the loss of your job. This is the case even if you receive an enhanced pension under the pension scheme rules on dismissal or redundancy. What is more, if your pension at the end of your notice period is less than it would have been had you been allowed to serve out your notice, you may claim for pension loss without any adjustment for the pension payments you receive in the meantime.