From 6 April 2015, the pensions landscape will be altered radically. The changes will apply to defined contribution/money purchase arrangements, but they are likely to have a significant impact on defined benefit arrangements (such as final salary or career average schemes) as well.
While there are, of course, some very large DB schemes in the UK’s TMT sector (and the telecoms sector in particular), the advent of auto-enrolment means that even the smallest employers are now enrolling employees into – and contributing to – a workplace pension arrangement (which, in most cases, means a DC scheme). The April reforms are therefore relevant to virtually every employer in the UK.
The essence of the April reforms is a set of changes to the pensions tax regime that will remove the current de facto requirement for members of DC arrangements to purchase an annuity with the proceeds of their DC pot by age 75. Instead individuals will, from 6 April, be able to access their savings in a much more flexible way which does not necessarily have to include purchasing an annuity.
The new pensions tax rules are complex but, in broad terms, the additional flexibilities will allow members of a DC scheme to:
- take their pension savings as cash, either in one go or in instalments – if this option is taken, the first 25% of each payment will be tax-free and the remainder will be taxed at the individual’s marginal rate (this contrasts with the current, more penal tax treatment); and
- convert their savings into what is called a “drawdown” facility, under which the member will be able to keep their pot invested and draw down from it from time to time, depending on their requirements – under this option, 25% of an individual’s savings can be taken as tax-free cash when the initial conversion is made (this option is currently available only in much more limited circumstances).
Importantly, the April reforms will not prevent individuals from purchasing an annuity if they wish to do so – and it is expected that a substantial number of people will still find an annuity attractive. The difference is that the individual annuity market will be materially smaller than it is today.
Another key feature of the new regime is that DC savers will be able to combine all or some of the flexibilities referred to above. So, for example, an individual will be able to purchase an annuity from an insurance company with, say, 25% of their funds and then transfer 50% into a drawdown arrangement, taking the remainder as a tax-free lump sum. This ability to blend options is expected to be very attractive to those who currently regard the annuity market as offering poor value for money.
While these changes will apply in the DC environment, they will be open to members of DB arrangements as well – but only if they decide to transfer the value of their benefits out of their DB arrangement and into a suitable DC arrangement (which, as a point of detail, could sit alongside a DB arrangement in the same (hybrid) scheme).
A separate element of the reforms is that “total commutation” will be permitted in more cases. This will allow people with a DC pot of up to £10,000 (rather than £2,000, which is the current limit) to convert the whole of their pot to cash and to do this in respect of up to three (rather than, currently, two) separate pots. This will mean that more members with relatively small pots will be able to take all of their savings as cash, subject to much lower (non-penal) rates of tax.
For all TMT businesses, including those sponsoring a DB scheme, the April reforms are a watershed development between the current more restricted system (which some say discourages pension saving) and a new era of choice and flexibility. This, coupled with the introduction of auto-enrolment, can be expected to increase the general level of participation and engagement in DC pension saving in the years to come. All of this is a consideration for employers at a time when it is no longer lawful to operate a default retirement age.
However, with choice and flexibility comes responsibility and, while most of this will ultimately rest with the individual saver, none of the options described above will be available unless they are permitted by the relevant DC scheme and there will be a requirement for those using the new freedoms to be directed towards “Pension Wise” (HM Treasury’s “guidance guarantee”). In addition, for DB members wanting to transfer out of their DB scheme in search of the benefits of the new DC world, independent financial advice will be required if the cash equivalent value of their benefits exceeds £30,000.
For those preparing for April, we would suggest forming a view on the following:
- how much flexibility you want your scheme to adopt – in this regard, it is worth considering not only best practice but also whether your pension offering will be consistent with what is likely to be attractive in the recruitment and retention market once the reforms are in place;
- what you want the features of your default fund to be in the new DC environment – whether, for example, it will target a particular cash amount or a particular annuity value (or perhaps both, depending on the size of the member’s pot); and
- the communications you will be issuing to your workforce and other members to inform them about the new options – remembering, however, to take special care when writing to DB members to avoid any suggestion of inducing a transfer out.