UK Budget Changes: Further nails in the coffin
Kevin Davey assesses pension changes announced by the government in its July Budget
When the government makes changes to pensions – often making them more expensive to deliver – it does not take long before the newspaper headlines suggest they represent “another nail in the coffin”. Usually the focus is on defined benefit (DB) schemes, but this July’s Budget changes affected a wider range of people than previously. In addition, with the increased attraction of Individual Savings Accounts (ISAs) and a Green Paper reviewing pensions tax relief, the UK pension landscape is changing.
• A lower annual allowance (AA) for higher earners from 6 April 2016: For those with income of more than £150,000 (€212,000) the annual allowance will fall by £1 for every £2 of additional income. Anyone earning more than £210,000 will have an allowance of just £10,000. All pension savings will be measured over the fiscal year.
Income for the purpose of this test (called adjusted income) is broadly total taxable income (including all employment income, property rental income and dividends) plus the value of any pension benefits accrued over the year. However, anyone with taxable income under £110,000 – usually excluding the value of pension benefits built up in the tax year – will not be subject to the reduced annual allowance.
From April 2016, the pension input period (PIP) – the year over which pension savings are measured – will be changed to tax years for all schemes. There will be a transition to this regime over 2015-16.
The change in the PIP is a short-term distraction from the reduction in the annual allowance. However, it will create opportunities for people to save more into a pension scheme this year without breaching the allowance. This is because people will be able to save a maximum of £80,000 since their last PIP start date, but no more than £40,000 after 8 July 2015 (the Budget date).
The tax implications of exceeding the annual allowance can be penal because the same benefit is generally taxed twice – the excess is taxed at the marginal rate of tax and then the benefit is taxed again as income when it is paid out. Depending on the individual’s circumstances, overall effective tax rates of over 65% are not uncommon if the allowance is exceeded.
Whether or not a member should stay in their occupational pension scheme depends on what their employer offers as an alternative benefit. If nothing is provided, opting out can be viewed as a 100% tax rate; hence it is often better to stay in to get something rather than to opt out and get nothing.
Although, people may want to maximise their pension saving over future tax years, this will be difficult as the allowance for the tax year is directly linked to taxable income over the same period. People will not know their taxable income until well after the end of the tax year, once they have filed their tax return, and may not even know what is included in adjusted income.
This will also represent a challenge for pension schemes. They currently need to provide a statement automatically if a member exceeds the annual allowance. This will not be possible in future as the scheme will not know an individual’s allowance and may not be able to calculate it until after the following 31 January (that is, almost 10 months after the end of the tax year).
For higher earners, saving £10,000 a year into a pension scheme is not going to be sufficient to provide for their retirement. Hence they need to look at savings in a wider context in their overall planning process. Some employers will now look to direct pension contributions into alternative savings products through workplace savings platforms.
• The Lifetime Allowance (LTA) will fall to £1m from 6 April 2016, as announced in the March 2015 Budget: As with the reduction in the LTA in April 2014, it has been announced that Fixed Protection 2016 and Individual Protection 2016 will be available for people potentially affected by the change. Rather than require people to apply for these protections, HMRC is considering allowing people to apply for them at any time before they take their benefits.
The impact of not applying for protection could involve additional tax of £62,500, hence affected people have a major decision to make. Extending the deadlines to apply for protection may be seen as an easement but it effectively moves workloads from HMRC to pension schemes (and their sponsors).
The LTA used to only affect high earners but reducing it to £1m widens its reach. For example, someone in a DB scheme earning £75,000 may be impacted by the LTA at the end of a 40-year career. However, the impact may be short-lived as, with the significant reduction in the AA and more people building up DC benefits, the number of people that will reach the LTA is expected to reduce. Indeed, given the wider changes being considered by the government, the LTA may be abolished.
One area the government has not yet changed is the generous approach to valuing a DB pension compared to a DC benefit. The LTA will be equivalent to a DB pension of £50,000 a year, but someone with a DC balance of £1m would today be able to buy an equivalent pension of less than £35,000 a year.
• The Green Paper – pensions tax relief and a £50bn problem: Following the Budget, the government published a Green Paper consultation document, under the guise of strengthening the incentive to save. However, the subtext was to review the pension tax relief system as it costs £50bn a year (even though some of these costs are in respect of deficit contributions to DB schemes and are offset by tax receipts on pensions in payment).
The consultation is broad but does not come with any pre-conceived solutions. One idea is changing pension tax relief so that it is more aligned with ISAs, blurring the ISA/pension boundary further. This would result in pension contributions coming out of taxed income and the government providing a match (up to a limit). This change would advance tax receipts to the Treasury and eliminate salary sacrifice schemes in one fell swoop. It does not address what this means, or how it would work, for DB schemes.
One of the biggest challenges for individuals is the constant change to the pensions system particularly as savings cannot currently be accessed until 55. The old ‘post 1989’ tax regime lasted 17 years largely unchanged but the AA and LTA regime, introduced in April 2006, only lasted three years before amendments were made.
The Green Paper consultation ends on 30 September, which has led to speculation that an announcement will be made in the autumn statement, the official announcement of economic forecasts. Whatever the timing, and whatever is decided, we can expect to see more changes in the future.
In response to all of these changes, employers are reviewing their pension arrangements carefully. Although it may be seen as a personal tax matter, employers can deliver a larger benefit to their employees for the same cost. The time has come for many employers to review their design strategy and endeavour to tackle the following four key questions:
• What should I offer?
• To whom do I offer it?
• How do I provide any alternative?
• How do I support employees?
If, however, there is limited appetite for change, those employers may find that the nails holding their pensions offerings together will become rusty. Even though this will clearly not lead to tetanus if untreated, it will result in high earners becoming disengaged. When that happens, the entire pensions package may well fall into disrepute, which will benefit no one.
Kevin Davey is a principal at Mercer