This article was first published on Lexis®PSL Pensions on 11 September 2014.

Pensions analysis: Why have senior executives started to favour cash payments over pension contributions when agreeing their remuneration package? Symon Rowley, a director with Pitmans LLP, looks at the trends in executive pension arrangements and benefits.

Original news

Directors choosing cash over pension contributions, LNB News 02/09/2014 142

Changes to tax rules affecting the annual and lifetime allowances for company pensions have led to more directors receiving cash payments in lieu of contributions to pension schemes, according to the Trade Unions Congress' latest annual PensionsWatch survey. Three in five of the UK's top directors are now reportedly receiving cash payments, up from 29% in 2011. The cash payments totalled around £33m in 2013. The typical cash amount received by senior directors is 17% of their salary, rising to 24.5% of salary for chief executives.

Why have cash payments become more popular than pension contributions to pension schemes as a means of remunerating directors and senior executives?

The cut in pensions tax relief in recent years is the main reason why senior executives have started to favour cash payments over pension contributions when agreeing their remuneration package.

The annual allowance was slashed from £255,000 to £50,000 in 2011, and this reduced again to £40,000 from 6 April 2014. The annual allowance represents the maximum annual amount that can be contributed to the tax approved pension schemes of an individual with the benefit of tax relief. Any contributions above that limit are subject to a tax charge, usually at the individual's margin rate for income tax.

'Contributions' include defined contribution (DC) contributions by both the executive and their employer, and, for benefits in a defined benefit (DB) scheme, the increase in value of those benefits.

In addition, the lifetime allowance on tax approved pension savings was reduced from £1.8m to £1.5m in 2012, and was further reduced to £1.25m in 2014.

Breaching the annual allowance means that executives would be taxed twice--once when they accrue benefits during service, and again when they receive benefits at retirement. Employers have therefore looked for ways to mitigate the impact of the reduced annual allowance. One option is to cap executives' pension benefits and offer alternative compensation such as a cash payment in lieu of pension provision.

What are the most common forms of retirement benefits for executives? And what are the main differences between them?

Pension benefits for executives continue to be DB or DC provision depending on the type of pension scheme currently operated by the employer. However, in line with the general market trend for employers to close DB schemes to all employees, DB pension provision for executives also continues to decline because of the significant costs in funding open-ended pension promises based on final pensionable salary.

DC is therefore the most common form of pension provision for executives. The pension contribution they receive will usually be a fixed percentage of their salary in the usual way, but it may be payable in three ways:

  • contributions to a DC pension scheme
  • cash only payment which is taxable
  • a combination of cash and DC contributions

The reduction to the annual allowance in 2011 from £255,000 to £50,000 had a big impact on these options. The number of executives choosing to receive remuneration in the form of traditional DC pension provision reduced considerably as their remuneration was reshaped to fit the lower annual allowance for tax relievable pension contributions. Executives are now taking a higher proportion of their overall remuneration from cash and DC contributions. This trend is likely to continue with the annual allowance further reduced to £40,000 in April 2014.

What kind of issues do executive pension arrangements raise for pensions lawyers and practitioners who advise on them?

Pensions lawyers and practitioners have had to consider new ways to assist the employer in adapting to the tax changes.

An alternative to the cash supplement option is for the employer to amend its pension arrangements so that no tax charges arise in respect of pension accrued by executive members. This may be achieved by the use of employer financed retirement benefit schemes (EFRBS) so that executives receive part of their pension from the employer's standard DB or DC scheme and the remainder via an EFRBS.

An EFRBS is not registered with HMRC and does not have the same tax advantages as HMRC registered schemes. But an EFRBS can provide benefits that are not subject to the annual allowance and the lifetime allowance if established properly and unfunded.

Under this arrangement, executives accrue pension in the employer's registered pension scheme (used for all employees), but their pension is limited so that the annual allowance is not exceeded. The remainder of the executives' pensions are provided from an EFRBS.

Some employers also provide security to back up the pension promise from the EFRBS in case the employer were to get into financial difficulties. This is known as a secured EFRBS and the unfunded pension promise is backed up security, eg a charge over a company asset.

On a general level, all practitioners need to keep a watchful eye on legal and tax developments as the rules governing the annual allowance and the lifetime allowance are subject to change.

How has the legal market for executive pension benefits changed over the past 10-15 years?

The A-Day reforms in 2006 which limited tax relief on large pensions and subsequent changes from 2011 have had the most impact on executive pensions. Under the previous tax regime, executives would often accrue a large proportion of their pension benefits in the employer's company-wide DB or DC scheme in the same way as other employees.

The reduction to the annual allowance in particular has meant cash supplements are now a common method of providing executive retirement benefits. The result is that retirement provision for executives is increasing-ly bespoke so that benefits are tailored to match the financial circumstances of each executive. For high earning executives whose pension benefits would otherwise far exceed the annual allowance, it means that retirement benefits are seen as cash top-ups to salary and overall benefit packages rather than traditional pension payable from a pension scheme.

What are your predictions for future developments?

The scrapping of the requirement to buy an annuity at retirement with DC pensions in the March 2014 Budget may encourage everyone, including executives, to maximise DC pension benefits.
However, the taxation of pensions may be subject to further changes in the near future, especially with a general election due in 2015.

Further reductions to the annual allowance or the lifetime allowance cannot be ruled out.

More radical changes are also possible. The upfront cost of tax relief to the Treasury is substantial (£28bn in 2012/13) and this cost will increase if the scrapping of the annuity requirement means greater contributions are made to DC schemes. Following the 2014 Budget in March, Pensions Minister Steve Webb suggested that the lifetime allowance should be removed, along with the introduction of a flat tax relief rate of 30% for all. This would give less tax relief to higher rate payers.

Any reduction to tax relief enjoyed by high earners may well increase the current trend for executives to take retirement benefits in the form of cash supplements rather than traditional pension.