The last few months have seen a plethora of announcements, consultations, draft legislation and of course plenty of speculation. The pensions industry has been pressing the Government to try and resolve the important issues – but some remain unresolved. In this Review we aim to identify priorities for action, and show where you can start spring cleaning your pension scheme.
In the style of “good housekeeping magazines”1 we are also offering some top tips for adding a perfect polish to your pensions policies. So, scheme rules and elbow grease at the ready…
PENSION INPUT PERIODS – IN NEED OF IRONING OUT
A Pension Input Period (PIP) is the period over which a member tests his or her pension savings against the Annual Allowance (AA) for the purpose of assessing whether or not s/he is subject to a tax charge. Testing against the AA in any tax year is by reference to an individual’s PIP that ends in that tax year. This is a key part of the pensions tax regime introduced from 6 April 2006. The AA has been set at a high level since its introduction (currently £255,000) – hence it, and the period over which it is tested, has until now had no real relevance to most members.
The reduction of the AA to £50,000 from 6 April 2011 has brought this issue under the microscope, as there will be a far greater number of pension savers at or close to the new AA who will have to monitor the level of their savings. That scrutiny has revealed that the legislation on PIPs, which was far from ideal even when it only affected a small number of people, may be much more problematic for scheme administration when it affects a larger number.
This is broadly how PIPs work…
- Trustees can nominate a scheme’s PIP by determining a date and notifying this to members. Some schemes chose sensibly to align their PIP with the Scheme Year or tax year. Members of DC schemes can nominate their own personal PIP in certain circumstances.
- Where no nomination has been made, members have a default PIP which normally starts from the first day of membership of a DB scheme or from the date that the first contribution is made to a DC scheme.
- For members of schemes as at 6 April 2006 different default PIPs apply. Members of DB schemes will have a default PIP of 7 April to 6 April. Members of DC schemes will have a default PIP starting with the date of the first contribution made after 6 April 2006.
- There is an added complexity in that each ‘arrangement’ within a pension scheme has its own PIP – so a DB scheme that offers money purchase AVCs, or has different sections of benefits, may operate different PIPs for each ‘arrangement’ within the same scheme.
Even from this broad summary, it is apparent that the situation is something of a mess. There are some particular points of concern, including the following:
- Where a default PIP of 7 April to 6 April applies, this straddles two tax years by just one day. The Government has proposed transitional measures for “straddling PIPs” which include testing members’ pension savings built up from the date of the Government announcement on 14 October 2010 against the lower AA of £50,000. This will come as a shock to those high earners affected by the reduction of the AA to £50,000 earlier than expected.
- Future member communications may be problematic where members do not have a common PIP. From 6 April 2011 the Government is proposing to allow taxpayers to carry forward any unused AA from up to three previous tax years (using an assumed AA of £50,000 for the years prior to 2011/12 and the actual AA of £50,000 for 2011/12 and subsequent years). Schemes will need to provide members with details of their pension accrual in the current and each of the three previous PIPs, which will be administratively complex.
Where a PIP has not been previously nominated and a default applies, it is possible for trustees to elect to change the PIP retrospectively before the provisions of the Finance Bill 2011 have effect (the timing is yet to be confirmed). This simply involves making a decision and notifying members, and no consultation is required. However a retrospective nomination of a PIP will have effect from 2006, and may cause a problem for high earners who have already accounted for tax on the basis of the default PIP. Also, as savings from all registered pension schemes count towards the AA, individual members may have savings of which the trustees/employer have no knowledge – so the assessment regarding who is affected by a retrospective nomination is not an easy one.
We are aware that industry bodies are challenging HMRC and pressing for a more workable system, but time is running out for trustees to retrospectively alter their scheme’s PIP.
Trustees and employers should identify the PIPs applying to their schemes and assess the pros and cons of making a retrospective change (including who may be affected). Trustees will then be able to act quickly if no helpful amendments to the relevant legislation are forthcoming.
RPI/CPI – GET YOUR HOUSE IN ORDER
Pensions Minister Steve Webb’s announcement that the Consumer Prices Index rather than the Retail Prices Index would be used to set minimum statutory rates of increases to DB pension benefits from 2011 caused widespread confusion and controversy within the pensions industry and beyond. His announcement has been followed by statements from the Pensions Regulator and Department for Work and Pensions, a DWP consultation and draft amending legislation in the Pensions Bill. However, many issues remain unresolved and we are still waiting for the response to the DWP consultation and final amending legislation.
Despite this uncertainty – the switch to CPI is already effective! The Revaluation Order for 2011, which sets the minimum percentages for revaluation and indexation, came into force on 1 January and incorporates the increase in CPI over the 12 months to September 2010.
- Check the scheme’s deed and rules now (if you haven’t already done so) to establish whether the changes to the calculation of statutory minimum increases will automatically impact on scheme benefits. Don’t forget to look at the power of amendment: some schemes are able to make formal rule changes other than by deed.
- Look beyond the current trust deed and rules. Historic scheme documentation is likely to be relevant, as rules governing pension increases typically change over time. Prior leavers generally have their benefits determined by the rules in force when they left. It may be the case that different rules apply to different tranches of pensionable service within the scheme. Check that your scheme administrator actually applies any historic variations correctly.
- Review what members have been told in the past about indexation and revaluation, for example in scheme booklets, benefit statements and leaving and joining information. Ensuring that booklets and standard member communications are updated to take account of the switch to CPI will help minimise member complaints about misleading information.
- If an employer wants to change the basis of revaluation or indexation, from an express or “hardwired” reference to RPI, to CPI for future service benefits, under current proposals it will have to consult with affected members for 60 days before any change can be formally made.
- As a general rule, members should be notified of any automatic switch to CPI.
DEFAULT RETIREMENT AGE – FRAGILE! HANDLE WITH CARE
The phasing out of the default retirement age from April 2011 will have widespread implications for employers, who will have no choice but to focus on pension provision for the over-65s.
Up until now employers may have avoided giving proper consideration to flexible retirement and late retirement options provided by their pension schemes, relying on their ability to prevent a scheme member from remaining in employment after age 65. Scheme rules which disadvantage older employees may breach age discrimination legislation unless objectively justifiable, and will come under greater scrutiny with an increase in the number of over-65s remaining employed.
In response to concerns about the cost of insurance cover the Government has proposed an exemption, to the requirement for equal treatment on the grounds of age, where group risk insured benefits (including death in service cover), are not offered to employees aged 65 or over. This age limit is intended to rise in due course in line with the State Pension Age.
Trustees and employers will need to tidy up scheme rules and retirement policies to ensure that they meet legal requirements. Consider what provision the scheme makes for late retirees (for example use of late retirement factors or allowing continued accrual) and those members who wish to start drawing their pension whilst remaining in employment.
FLEXIBILITY IN DC SCHEMES – DUST DOWN YOUR DRAWDOWN OPTIONS
The Government has confirmed that the requirement to purchase an annuity under a DC scheme at age 75 is to be abolished from 6 April 2011. This is potentially one of the most radical developments in terms of pension benefit design for decades. Legislation preventing certain lump sums being paid to over-75s from registered pension schemes will also be amended.
In addition, the rules governing how and when an individual can leave his or her pension funds invested in a registered pension scheme, but make withdrawals from those funds as income, will change. The maximum withdrawal that most eligible individuals will be able to make will be capped at 100% of the equivalent annuity that could have been bought with the value of the fund.
For those with sources of pension income which support a lifetime pension income of at least £20,000 a year, even greater freedom will be provided in the form of “flexible drawdown”, which allows withdrawals from pension savings without any annual cap applying.
The existing regime for tax-free lump sums taken in conjunction with a pension or annuity will remain; but, in another radical development, there will be freedom to pass on any unused capital on death without a charge to inheritance tax. However, in certain circumstances, a tax charge of 55% will be levied on certain lump sum payments.
Very few occupational DC schemes currently allow drawdown in any form, because of the complexities of the current system. Any trustees of schemes which do allow drawdown, should review their scheme rules and processes and, where necessary, update them in line with the new legislative limits and requirements. For the majority of employers and trustees who do not currently provide for drawdown, consider the merits of introducing this option for members who wish to take advantage of the greater flexibility afforded by the new legislation.
Scheme rules should also be reviewed to ensure that any out-of-date age 75 restrictions on the payment of lump sums, or requirements to purchase an annuity by this age, are amended.
PAYMENTS TO EMPLOYERS – NO NEED TO CRY OVER SPILT MILK
In previous communications we have addressed the legislative quirk (section 251 of the Pensions Act 2004) that requires trustees to pass a resolution in order to preserve existing powers in their scheme to make payments to employers. This requirement covers not only payments to employers connected with a surplus in an ongoing scheme but also routine administrative payments and payments from schemes in wind up.
In order to preserve their powers to make employer payments, trustees need to give three months’ notice to scheme members and employers and then pass a resolution before 6 April 2011.
Those schemes that will miss the 5 April 2011 deadline need not panic. Draft legislation is contained in the Pensions Bill 2011 to extend the date by which resolutions must be passed to 5 April 2016. The amendments are also intended to reduce the scope of this legislation by excluding schemes in wind-up, most DC schemes, and some routine administrative payments. This will help to reduce the ambiguity of the current legislation and buy trustess time to pass the necessary resolutions. We do not know yet when this legislation will come into force.
Trustees who pass a resolution before 6 April 2011 do not need to take any further action and the resolution will remain valid notwithstanding the proposed change to legislation outlined above. Trustees who do not complete this process before 6 April 2011 should consider whether they need to take action once the new legislation is in place to ensure that they have the power to make future payments to an employer.
HMRC APPROVAL IN AMENDMENT POWERS – SOMETHING TO MOP UP
Many pension schemes contain a provision in their amendment power that the scheme rules cannot be amended without Inland Revenue/HMRC agreement, consent, approval or confirmation (or similar wording). Such provisions stem from the tax regime which applied before 6 April 2006 when this requirement was a necessary part of preserving a pension scheme’s tax approved status.
However, since April 2006, it has not been possible to comply with this requirement, as HMRC no longer gives such approval/consent. Transitional regulations allow such provisions to be disregarded until April 2011.
After this date, to avoid any questions concerning this restriction on the power of amendment, trustees of affected schemes should pass a resolution to remove the requirement from their rules before any further rule amendment is made. However, trustees who are passing a resolution for another purpose before April 2011 could deal with this issue at the same time in order to avoid having to revisit it at a later date.
Trustees should check whether their scheme amendment power contains the wording described above and liaise with their legal advisers regarding a trustee resolution to remove the wording.
EXPIRY OF INLAND REVENUE LIMITS – DON’T SWEEP THIS UNDER THE CARPET
Where pension scheme rules have not been amended in order to retain features of the tax regime that existed before 6 April 2006 this should be dealt with before 6 April 2011 or schemes may face a significant increase in liabilities. Currently, pension schemes are subject to overriding legislation which means that features such as the earnings cap, limits on benefits, and the provision for trustees not to have to pay ‘unauthorised’ benefits, still apply. This will cease to be the case on 6 April 2011 when the transitional legislation will no longer have effect.
Employers and trustees should check whether their schemes have been amended to retain features of the old tax regime that existed before 6 April 2006, and take action before 6 April 2011 to retain the relevant provisions expressly if necessary.
HOW CLEAN IS YOUR SCHEME?
Clearly there is a lot for trustees and employers to do. The scale of the clean-up required will depend on provisions in scheme rules, trustees’ and employers’ objectives, and the needs of the workforce; but no scheme will be unaffected by the issues covered in this Review.