People need encouraging to save, and the bait of a tax-free lump sum is one of the best lures. Government, as usual, believes it knows what for us, however, and is always keen that we should concentrate more on a sustainable income, rather than a nice wad of cash. The fact that the words “tax” and “free” are linked to such payments is also anathema to our rulers.
Nevertheless, aware of the popularity of lump sums, and the flexibility which pension holders seek, the Treasury in the UK is not about to phase out this element, and the new stakeholder pensions confirm that.
As to the question of funding Ros Roberts at the UK’s National Association of Pension Funds says the lump sum payments should not affect the manner in which pensions are funded. “Generally the commutation, the rate at which you exchange pension for cash, should be actuarially neutral, so it should not matter whether one is funding for cash or pension. Obviously it varies from scheme to scheme, and indeed some schemes offer an unfavourable exchange rate, but people still want the tax free lump sum, even though if they looked at the calculation they would realise it was better to take it as pension.”
Roberts believes that given the loss of tax credits on dividends it is possible to argue that without a tax free sum the plans may not be the most effective way of saving for a pension. One of the worries of government, however, is that lump sums tend to act contrary to the concept of pension income, and clearly their value must be limited by what is actually in the pot. “While lump sums have always been an intrinsic part of the system from day one, clearly there are limits. On that point, if schemes are contracted out and have to provide a guaranteed minimum pensions (GMP), you cannot commute and leave a pension lower than the GMP. Often low earners in schemes, who barely have their GMP covered can take only a small lump sum. This is an example of the government safeguarding the income part of the pension, while recognising the importance of lump sums.”
In Ireland meanwhile, the major difference to the UK is that there is no salary cap to calculate lump sums, though some consultants believe that could change soon. But otherwise arrangements are similar to the UK. Legislation two years ago allowed individuals to cash in private pension schemes, and fears have been expressed that if this were to spread to corporate schemes, the concept of annuities could be undermined.
Across Europe, pensions systems are under review, but lump sum payments still play an important part. In Austria, for example the three pillars are treated differently. Occupational pensions can be taken as annuity or lump sum, but whereas the annuity is taxable at full rate, the lump sum is taxable at half that rate. Private pensions again can be taken as annuity and/or single payment, but contributions come from taxed income and so the payments are theoretically tax free. Kurt Bednar of Constantia Neuberger Bednar & Partner in Vienna points out however that “there is a law which says that if someone retires at 60 once they have used up their capital payment, they will be taxed on the annuity. Currently the tax office does not apply this law, but may well begin to do so because of budget problems.”
One of the most interesting contrasts in Europe is between neighbours Belgium and the Netherlands. In the former it is almost a cultural necessity that once a plan matures individuals take their benefit as a lump sum. “In 99% of cases the lump sum is the preferred option,” says Eric Baeckelandt, of Buck Heissmann in Brussels. “In Belgium lumps sums are taxed at approximately 20%, if taken as an annuity it would be classed as income and would be taxed far higher, depending upon which tax band you fall into.” Baeckelandt believes this is unlikely to change, unless European directives force countries to pensions as annuities.
In the Netherlands, meanwhile, lump sum payments are prohibited by law, and all benefits are taken as annuities. All pensions are then treated as income and subject to taxation.
Across the German border lump sum arrangements apply to direct insurance schemes, and these sums are subject to a flat rate of tax, but the rate may well fall in the future. In corporate book reserve schemes, there are some tax disadvantages as the lump sum is treated as income, although there are plans to shift the tax burden over the next few years.
French pay-as-you-go schemes do not offer the possibility of a lump sum, but top up pensions, available to high wage earners do make lump sum payments.
Life insurance policies are typically used as supplementary pensions in France, and here the individual may opt for up to 25% as cash. Typically these sums would not be taxed, but it depends upon the individual scheme.
The annuity would be taxable, unless it is a term assurance in which case it would not be taxed.
In Spain the government has moved to encourage pensioners to take part of their benefit as a lump sum by reducing taxation on such payments by 40%.
There is no current data to show how successful this legislation has been, and Inverco in Madrid estimate that the decision to take annuity or lump sum is split around 50-50.
Next door in Portugal lump sums are often paid on retirement, but these are not part of the pension system, but rather a contractual agreement between employer and employee. These sums are not taxable. The private pension system allows for annuity payments, but not lump sums, and taxation depends on which tax band the retirees contributions have placed him in.
Similarly in Italy the TFR book reserve payments result in a lump sum payment, and the government is keen to give employees the option of transforming these into pension contributions. The new bill is likely to have a rough ride however, since both employer associations and trades unions have differing ideas. Private schemes offer the possibility of receiving a part of the benefit in a lump sum, but this is subject to taxation. The cash can represent up to 50% of the total benefit, but the government recently introduced legislation limiting the tax benefits to the first 30%. It is still possible to take half the sum, but the tax rules make it a less attractive prospect.
Next door in Switzerland it is possible to take benefits as a lump sum, provided the scheme is notified, normally a number of years in advance. This may be the whole sum, or a proportion thereof, and beneficiaries are penalised by a higher rate of taxation on lump sum payments than annuities.
Denmark is similar to France in that third pillar insurance policies are typically used to top up pensions, these are known as “capital pensions”.
These sums are taxable, but were originally taxed at the lowest rate. The government has recently changed the rules, and now it is not as attractive to save in this manner. Corporate pensions, now mainly defined contribution schemes, are paid as annuities, except where the beneficiary is single, when a lump sum can be made available. These sums are subject to taxation.
It is not surprising that the rest of Scandinavia should adopt a position which is opposed to lump sum payments. A review of the pension system confirms that long-term annuity payments are at the heart of the governments’ policies. Whereas in the rest of Europe the view is predominantly that pensions are seen as savings, and that the saver should be able to withdraw as he or she wishes at the end of the cycle, across Scandinavia the emphasis is on ensuring that pensioners have a living pension reflecting their savings, and there has been little penetration of the view that savings should be seen as double tax deductable, both in premium and on payout. The more sophisticated social security systems in place there are probably the reason for this comparative anomaly.
“Pensions and the social security system have been highly integrated in Scandinavia,” says Hasse Nilsson of Alcifor Advisory Associates. “Tier one and tier two retirement benefits are often linked to what the social security system might provide, particularly in Norway, but also in Denmark and Sweden to a lesser extent.”