The UK government finally seems set to bring in a radical reform to the UK pension taxation system. Many critics believe the new cap is too low and will affect many more people than the government thinks. The Chancellor has asked the UK’s National Audit Office to check that his figures are correct, with an all or nothing ultimatum.
Assuming the new regime goes ahead, it will be the greatest shake up to pensions taxation since the late 1980s. Merging eight existing tax regimes into one, it will cap the benefits of employees who had hitherto enjoyed cap-free benefits.
For the first time ever, a new tax regime will not allow for existing benefits to continue to accrue under the pre-existing tax regime as has happened in the past.
Those whose earnings were not capped when they joined a scheme prior to 1989 will now have a cap on the ultimate value of their overall combined pension benefits. The new cap, known as the Lifetime Allowance, is to be set at £1.4m (E2.1m) from 6th April 2005 and will increase in line with prices each year.
If the value of benefits exceeds the lifetime allowance when they come to be paid, the excess suffers a recovery charge of 25%. The remainder of the excess is then subject to tax at 40%, making a cumulative tax charge of 55%.
For the vast majority of pension scheme members the new regime means no more pointless testing against a benefit limit they may never reach. There will be no more controls on a scheme’s funding rate, and no more checks on the maximum personal contribution members can pay. Maximum personal contribution rates currently range from 15% of earnings to 40% of earnings depending on which tax regime applies. The new personal contribution limit will be 100% of earnings (or £3,600 if higher).
Members even have the option of paying more than 100% of earnings, but they will not receive any tax relief.
Valuing a defined contribution scheme will be straightforward – it is simply the accrued fund value. Valuing a defined benefit scheme will be a bit trickier as the government needs to keep the rules simple, yet not afford too much room for tax abuse. In the end, they have decided that defined benefit pensions will be valued at £20 for each £1 of annual pension regardless of how old, or how young, the member is.
This will create some anomalies between DC and DB schemes, but the government sees this as worthwhile for the sake of a simpler tax treatment of pensions overall.
The radical, sweeping approach is to be welcomed. There will be short term costs associated with implementing the new regime, but costs in the long term should be less. That is, of course, as long the government gets it right and doesn’t need to overhaul the system again in another five years’ time.
Tim Webb is director and chief actuary at Gissings Consultancy Services, the UK affiliate of ASINTA, a global benefits consulting network

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