Proposed UK Pension Changes

By Spectrum IFA
This article is published on: 30th March 2014

The UK Budget for 2014 took the financial services industry by surprise. As details of the proposals were unveiled, it became obvious that we were hearing some of the best kept secrets (for a long time) of a government’s plans. Banking secrecy may be dead, but the UK government had managed to build a wall of secrecy around itself before the budget was made public.

So after “A-Day Pensions Simplification” in 2006, now we have another major reform proposed for “Freedom and Choice in Pensions”. I have seen a few reforms during my working life and as I get closer to pension age myself, I am thinking that this might be the last time that I have to get to grips with yet another. But who am I fooling except myself. Pensions is a political football that the politicians will kick around and of course, keep moving the goalposts.

To understand the reform, you need to understand the two main different types of pensions. The first is the defined benefit pension (DBP), where your employer basically promises to pay you a certain amount of pension, which is calculated by reference to your service and your earnings. DBPs are a rare breed now, as employers have found this type of arrangement too costly to maintain. This is because the liability for financing the scheme falls upon the employer (after anything that the individual is required to contribute) and if there is any shortfall in assets to meet the liabilities – perhaps because of poor investment returns –  the employer must put more money into the scheme.

The second type of pension is what is known as a money purchase plan (MPP). You put money into an MPP, perhaps your employer does/did also, as well as the government in the form of tax rebates and in the past, national insurance contribution rebates. Maybe your ‘MPP’ was not through an employer at all and you just set up something directly yourself with an insurance company. They are several different types of MPP arrangements, but they all result in the same basic outcome, i.e. the amount of the pension that you get depends on the value of your ‘pension pot’ at retirement and so the investment risk rests with you. There is no promise from anyone and therefore, no certainty of what you might receive.

The proposed reform is all about the MPP, although there is nothing to stop a person from transferring their private DBP to a MPP (at least for the time being), if they have left the service of the former employer. But why would someone do this and take over the investment risk of their pension from the former employer? Well there are some very limited situations, but I will not go into them here. The more normal position is that people would not voluntarily transfer their DBP to a MPP unless perhaps, there was a case of serious underfunding of the DBP.

Without getting into too much of the technical detail, the bottom line of the reform is that people will have more choice about how and when they can take their benefits from a MPP. For example, from April 2015, people over the age 55 will be able to take all of the MPP pension pot as a cash sum. Actually, this possibility has already been available for some time in certain situations and the reform basically relaxes some of the requirements that have to be met to do this. The minimum age will progressively change from age 55 to 57 by 2028 and then be linked to future State Pension Age increases.

For UK resident taxpayers, 25% of this pension pot would be paid tax-free and the balance would be subject to income tax at their marginal rate (the highest tax rate being 45%). As an illustration, assuming that the person had no other taxable income in the year and they took the 25% tax-free lump sum, on a fund of £50,000 the tax on the total fund would work out to be 11%, for a fund of £100,000 it would be 19.63%, for £150,000 it would be 24.75%, for £250,000 it would be 28.2% and for £500,000 it would be 30.98%.

The government suggests that by making available the option to take the full pension pot as a cash sum, this has taken away the need for someone to purchase annuity. This, of course, is referring to a ‘lifetime annuity’, whereby someone gives the insurance company a pot of money in return for a guarantee that the insurance company will pay an annuity to them for the rest of their life. In fact, the requirement to purchase a lifetime annuity had already been abolished in 2011 for Self-Invested Pension Plans (SIPPs), which is one of the types of MPP.

Over the last few years, life-time annuities have not been very popular because the low interest rate environment has had a negative effect on the amount of annuity that someone is able to buy with their pension pot. Therefore, the SIPP has proved to be a popular alternative choice, since the pension pot remains invested and the pension investor can draw an income from the fund. The amount that can be drawn from a SIPP is linked to UK long-term gilt yields, as are insurance company annuities, which implies that there is little difference between the two options.

In fact, the SIPP is more flexible and the amount that can be drawdown can be varied between minimum and maximum amount. In addition, on the person’s death, the remaining fund does not die with the person, unlike a lifetime annuity. So what would make someone chose a lifetime annuity over a SIPP?

Principally, it comes down to attitude to investment risk. If someone is very ‘cautious’ and cannot stand the idea of any volatility in their pension fund and also wants the certainty of a defined amount of income for life, then that person would chose a lifetime annuity, despite the new freedom and choice that they are being offered.

On the other hand, if someone is comfortable with some investment risk and is attracted by the idea of their pension pot passing down to their children, then they are more likely to go down the SIPP route. If they have left the UK, then they may consider transferring the MPP benefits to a Qualifying Recognised Overseas Pension Scheme (QROPS). In effect, a QROPS operates just like a SIPP, but there is some extra flexibility and more potential to mitigate currency risk – very useful if you need your income in a currency other than Sterling – and the fund can pass to your dependants on your death without the UK 55% tax charge.

Generally, the UK pension reform is a welcome improvement, which will provide flexibility that will allow people to make their own choices regarding ‘when to take’ and ‘how to use’ their pension funds, according to their own individual circumstances. For those wishing to make the transition from full employment to full retirement over a number of years – which has become more important due to the increase in the State Pension Age – the reforms will be of enormous benefit. Indirectly, the reforms also have the potential to reduce youth unemployment in the UK, as younger people replace those who are able to retire earlier because it may now be financial viable for them to do so.

However, as in every case of financial planning, everyone’s situation is unique. Therefore, caution will be needed to ensure that people make the right choices, since the decision that they make at retirement will affect them for the rest of their lives. It would be disastrous if the reforms created a scenario that people might unwisely take “too much”, “too early”, out of their pension pots and every effort should be made by those involved in the advice process to avoid that risk.

It follows that it will be essential that people take professional advice, which not only considers the pension assets but also takes into account the person’s total wealth and objectives. Sadly, the government’s proposal that individuals should receive “free”, “face to face”, “impartial advice” as “pensions guidance” is unlikely to be sufficient for this purpose and creates the risk of misleading the person to believe that they do not need any other advice.

 What does it mean for UK non-residents?

The terms of any Double Taxation Treaty (DTT) between the UK and the person’s country of residence will define which country has the right to tax the pension payments of the type that we are discussing here. Usually, it will be the person’s country of residence and not the UK, when the payments are made. Therefore, providing that person has been granted relief from UK income tax – after making application under the terms of the DTT – in theory, they should be able to receive their MPP pension pot without the deduction of UK tax.

However, the practical difficulty will be how the administrator of the MPP will be able to pay the benefit without deducting tax. No doubt HMRC will put in place a prescribed set of rules for calculating and deducting the UK income tax from these ‘cash payments’, for application by pension scheme administrators, as is the case that already exists for these types of payments. If the administrator cannot make the payment gross, this means that you would need to claim the UK tax back from HMRC and HMRC might want evidence that you have declared the amount in your country of residence.

On a final point, there are already tax rules in place in the UK regarding non-residents and ‘flexible drawdown’. The proposed reform is, in effect, ‘flexible drawdown without the Minimum Income Requirement’ (at least from 2015) and so it is reasonable to assume that at least the same tax rules will apply. If so, this could have implications – either when taking the payment or when returning to the UK – if you have not had a sufficient period of UK non-residence. Again, it would be wise to seek advice before making an expensive mistake.

The above outline is provided for information purposes only and does not constitute advice or a recommendation from The Spectrum IFA Group to take any particular action on the subject of investment of financial assets or the mitigation of taxes.