In the Chancellor's Autumn Statement on 5 December 2012, he announced that with effect from the tax year 2014/15 onwards the Annual Allowance and Lifetime Allowance are to be reduced to £40,000 and £1.25m, respectively. He also revealed there will be a consultation by the Department for Work and Pensions in relation to the use of 'smoothing' and considerations of affordability when dealing with defined benefit pension liabilities.

Let's take a look at these in a little more detail.

Annual Allowance to be reduced to £40,000

The reduction in the Annual Allowance was widely predicted in the run up to the Autumn Statement. The proposed further reduction from £50,000 to £40,000 follows the relatively recent reduction in the Annual Allowance from £225,000 to £50,000 made by the Finance Act 2011 (FA 2011). Further details on FA 2011 can be found in our earlier alert on 'The Finance Act 2011, restrictions and flexibilities'.

By way of a very brief reminder, the Annual Allowance Charge applies where the "total pension input amount for a tax year" (TPIA) exceeds the Annual Allowance. The TPIA is the aggregate of an individual's "pension input amount" (PIA) for each arrangement he has in the relevant "pension input period" (PIP). There are different rules for calculating the PIA arising under the different types of arrangement.

Broadly speaking, the PIA for a money purchase scheme is the amount of total contributions paid in the relevant PIP. Again, broadly speaking, for a defined benefit scheme, the PIA is the increase in the value of the individual's rights in the relevant PIP. The increase is the amount "the closing value" of the individual's rights exceeds "the opening value" of those rights, where these values are determined by reference to a formula reflecting the annual rate of pension and lump sum the individual would receive at the start and end of the relevant PIP, uprated by reference to the Consumer Prices Index.

Care does need to be taken in the usual way with PIPs. Even though the further reduced allowance of £40,000 "bites" on 6 April 2014, the individual's PIP may well have started before then. Suppose the PIP matches the calendar year (1 January 2014 to 31 December 2014) rather than the tax year. As the PIP ends on 31 December 2014, it falls in the tax year 2014/15, so any savings from 1 January 2014 to 5 April 2014 are also subject to the reduced allowance.

Legislation will be introduced in the Finance Bill 2013 to make these changes and will be published in draft on 11 December 2012.

What to do in the short-term about the new lower Annual Allowance?

Anyone who is able to increase pension saving to the current limit of £50,000 for the tax years 2012/13 and 2013/14 might wish to do so, given that from the tax year 2014/15, the limit will be reduced to £40,000.

In the slightly longer term, those affected by the reduction in 2014/15 will need to take particular care as the new, even further reduced, Annual Allowance will affect an increasing number of individuals, in particular members of defined benefit schemes.

Many defined benefit schemes have already amended their rules to "target" the current annual allowance of £50,000 introduced by FA 2011 (i.e. to cap accruals such that the Annual Allowance is not exceeded). But where this was achieved by reference to an Annual Allowance of, for example, £50,000 (rather than the Annual Allowance in force from time to time), these schemes should now consider further amendment to reflect the forthcoming reduction.

Where communications to members refer to the Annual Allowance amount, these figures will need to be updated.

An increasing number of employers and employees may find themselves looking at simpler "employment rewards", such as salary increases, rather than making higher, but taxable, pension provision. These rewards might, of course, also be taxable.

Scheme pays and carry forward options

Scheme pays option or, where available, the carry forward facility, might be of some help.

The "Questions and Answers" document produced by HMRC and detailed below contains detailed information on how the further reduced Annual Allowance will interact with "scheme pays" and carry forward.

Basically, there are no proposed changes to the carry forward rules. This means that the amount of any unused allowances arising from tax years 2011/12 to 2013/14, and available to carry forward to 2014/15 and subsequent years, will still be based on the £50,000 limit. But of course, it will only be possible to carry forward up to £40,000 of unused allowances when doing so from the tax year 2014/2015 onwards.

HMRC has also confirmed that the proposals to further reduce the Annual Allowance do not affect the facility for a pension scheme to pay the Annual Allowance charge in return for a reduction in benefits.

Lifetime Allowance

The Lifetime Allowance (LTA) is to be reduced from £1.5 million to £1.25 million and will take effect from the tax year 2014/15 onwards. It doesn't seem long since we were looking at the effect of the reduction in the LTA from £1.8 million to £1.5 million - a change discussed in our alert on "Restricting Pensions Tax Relief - the new regime from April 2011".

Fixed protection 2014

The Government also announced on 5 December 2012 that there will be a "fixed protection" regime for those affected by the further reduction in the LTA.

The "Questions and Answers" document produced by HMRC (see below) also contains further information on how this new "Fixed protection 2014" will work.

The broad outline is that it will work in the same way as the existing fixed protection regime introduced when the LTA was reduced to £1.5 million. Individuals will be able to apply for fixed protection 2014 after the legislation comes into force, which is expected to be in summer 2013.

HMRC's note on tax relief says that anyone with UK tax relieved pension savings can apply for fixed protection 2014; regardless of the current level of their pension savings. This is provided that they do not have one of the existing protections from the LTA (primary, enhanced or fixed protection).

Individuals who successfully apply for "fixed protection 2014" will have the greater LTA of £1.5 million and the standard LTA (£1.25 million from April 2014). But, where it's a money purchase scheme, no further contributions can be made to the scheme. Where it's a defined benefit or cash balance scheme, no further benefits can accrue above the "relevant percentage".

There will be situations where the new fixed protection 2014 can be lost, very broadly, in the same way that the existing fixed protection can be lost.

Personalised protection option

The Government has also stated that there will be discussions with interested parties as to whether to offer a personalised protection regime. This would only be available to those with pension pots over £1.25 million on 5 April 2014.

HMRC anticipate that personalised protection will give individuals an LTA of the greater of the value of their pension rights on 5 April 2014 (up to an overall maximum of £1.5 million) and the standard lifetime allowance (£1.25 million from April 2014). Unlike with fixed protection 2014, the idea is that people with personalised protection will be able to carry on saving in their pension scheme without losing their protection (with any savings above the individual's LTA becoming subject to the LTA charge when benefits are taken).

This still needs to be worked through. For example, will it be possible to have fixed protection 2014 and the personalised protection option? It's a very interesting development!

Lump sum death benefits

It is also proposed that where an individual dies before 6 April 2014, and any lump sum benefits are not paid until on or after that date, the lump sum will be tested against the lifetime allowance at the time of the individual's death. This is instead of at the point the lump sum is paid.

HMRC's "Questions and Answers" document

Further details of what the reductions mean should become clear as and when the draft legislation and supporting regulations are published.

However, in the interim, HMRC has published a summary of the proposed changes on the HMRC website along with some "Questions and Answers" (entitled "Pensions Restriction of pensions tax relief - Overview Note"), to which we have referred above. Both the summary and the overview note prepared by HMRC are available to download from its website.

Drawdown limits

You may recall that the Finance Act 2011 introduced the "drawdown pension" (i.e. whereby the member chooses how much pension they want to be paid each year, while leaving the rest invested). Drawdown pensions replaced the former concepts of "unsecured pensions" and "alternatively secured pensions". Under capped drawdown, there is a limit on the amount of pension an individual may take each year - broadly, the amount which would have been paid under an annuity. Where flexible drawdown applies, there is no such limit - but in these instances, individuals must have a secure pension income of at least £20,000 per year.

In his Autumn Statement this week, the Chancellor said that he wanted to increase the amount of income available under the capped drawdown facility. The amount of income which may be taken from a pension fund that remains invested will increase from 100% to 120% of the rates set by the Government Actuary's Department.

Draft legislation to achieve this will be eagerly awaited.

Single tier pension

The Chancellor also reiterated that the single tier pension is going ahead, however, the finer details are yet to be announced.

Discount rates - movement possible

The industry has been grappling for some time with the effects of the discount rate in defined benefit scheme valuations. When it comes to calculating pension deficits, the current procedure has generally resulted in ballooning deficits. The Government has now announced that it will consult on whether to introduce 'smoothing' when calculating the measure of defined benefit pension liabilities, and on whether to adopt a new objective for the Pensions Regulator that would provide an explicit statutory requirement to take account of affordability issues.

The Pensions Regulator has commented on these proposals on its website - please see the announcement under its "news and updates" section.

We look forward to seeing the draft legislation.