Simplifying the taxation regime
Earlier this year, UK pensions had their biggest shake-up for almost 20 years, with a series of measures introduced by the Government in order to tackle the heavily-criticised rules and regulations surrounding the taxation of UK retirement savings. Five months later, how has the UK pensions landscape changed as a result of these changes, and to what extent have the Government's objectives been achieved?
Before 2006, the taxation of UK pensions was a hugely complex area. Much of this complexity was due to the fact that each successive set of changes which had been introduced over the years had overlaid the previous rules.
This led to the existence of eight different tax regimes governing pensions, all of which featured excessively complex rules limiting the amount an individual could contribute to a pension scheme and the benefits a scheme could pay out. These rules restricted choice and flexibility for individuals, employers and pension providers alike.
Perhaps more damaging was the fact that the taxation of pensions had become so complicated that it was further contributing to the negativity with which UK citizens viewed retirement savings, after having been hit by numerous cases of mis-selling and benefit losses on the wind-up of under-funded defined benefit schemes.
People saw little incentive to save for retirement, compliance costs were spiraling upwards and employers were becoming ever-more reluctant to sponsor workplace schemes.
So the Government set about changing this situation by means of the Finance Act 2004, which would bring in a number of fundamental changes on April 6 2006, or "A-Day" as the date is otherwise known.
The Government's objectives basically boiled down to the following: firstly to achieve a far greater degree of simplicity, in order to deliver a transparent and consistent system which could be readily understood; secondly, to ensure that the simplification measures would also lead to compliance costs being forced down and the delivery of clearer incentives to save; and thirdly, to present people with greater flexibility over when and how much they could save as pensions and also over the form in which benefits could be drawn from them.
The main step taken to meet the simplification objective was to make a clean break from the old system.
All the previous Inland Revenue rules were swept away and replaced with two basic tests: a Lifetime Allowance (£1.5m, or around €2.2m, for 2006/7) which restricts the maximum amount of tax-privileged benefits that can be built up over a member's lifetime and an annual allowance (£215,000, or approximately €315,000, for 2006/7) which restricts the maximum amount by which a member's pension benefits can increase over a year. All pension savings after A-Day within the registered framework now follow this single set of rules, which applies to saving in all kinds of pension schemes.
The basic concepts, then, are indeed very simple and do indeed serve to improve people's understanding of the restrictions around pensions.
This has been particularly important in going some way to restoring confidence and in helping to ensure that people are more inclined to save for their retirements - part of a much wider challenge of ensuring that the ageing UK population has sufficient funds to support it in its dotage.
However, the headline changes hide a number of issues which render the new system less straightforward than at first it appears.
Perhaps the best illustration of the fact that the changes are not as simple as they might appear is the fact that A-Day was the culmination of nearly 2,000 pages of consultation, regulations and technical guidance!
One of the reasons for needing such in-depth coverage of the changes is that the new regime does not always ‘fit' very well with the structure of existing defined benefit schemes - leading for example to complex formulae for the maximum level of certain benefits that can be taken at retirement.
Another reason is that there are complicated rules surrounding the ways in which people can protect their pre-A-Day entitlements (helping to limit the number of people that would be made worse-off by the changes) and on the transitional protection given to certain benefits that would otherwise be unauthorised under the new regime, such as the payment of children's pensions over age 23 and funeral grants payable to members over age 75. Simplification of the benefits that can be taken from retirement savings is not, then, as great as we may have expected.
This is perhaps a similar story, at least in the short-term, for those running occupational schemes as a result of the fact that many of the A-Day changes are in effect optional.
Considerable time and effort has been spent in understanding the A-Day changes that trustees wish to introduce for their pension schemes and in working with pensions lawyers in combing through the fine detail of existing scheme rules to determine which changes are automatically brought in, and which require some form of explicit re-writing.
One such change is the fact that the maximum tax free lump sum that a member can take at retirement is set at 25% of the value of pension savings, which for most people is appreciably more generous than before.
If the wording of their pension scheme rules does not bring this change in automatically, however, trustees and sponsors can decide not to make the change.
This can, and has, led to the expectations of many scheme members being dashed, following extensive press coverage over the improvements that A-Day would bring.
Until these initial issues are resolved, and until people get used to the administrative burden of having to calculate
the value of each of their pension arrangements when providing information about how the value of their benefits compares with the Lifetime Allowance, the advantages of reduced compliance costs will not become fully apparent.
And what about the aim of increasing flexibility? Success in this area is perhaps more clear-cut. Post A-Day, most people are now in a position of being able to pay as much as they want into whatever pension they like; they can join multiple pension schemes; they can move money from one pension into another with fewer restrictions; and they will be able to draw their pension while continuing to work.
Nevertheless, the fact that people can pay much more into their pension arrangements is likely, in most cases, to be academic; the overall amount of retirement savings is likely to change very little as a direct result of A-Day, except for the minority of people who have got the wherewithal to pay higher contributions or those ordinary people fortunate enough to be able to pay windfalls into their pensions.
The new regime is likely to take two or three years before everything is bedded in. The Government is continuing to work through further legislation following on the back of the A-Day changes, which will see additional tweaks and loophole closures.
There is also the possibility, at some point in the future, of more measures being introduced to increase flexibility still further, such as relaxing the strict regulations surrounding rule changes to defined benefit schemes and providing even greater freedom in the area of pensions savings vehicles.
For many years, pensions has been a dirty word in the UK. A-Day has played an important part in beginning the process of improving people's perception of retirement savings but there is still a long way to go.
And it is impossible to talk about the pensions situation in the UK without emphasising the significance of the challenge of finding a way to pay a retired population in the future for as long as some projections now estimate we will need to.
The A-Day changes do nothing to address this issue, but at least they provide a decent platform on which to build the additional changes that are still needed.
Adam Stanley is a principal at consultants Punter Southall