Last week, the Treasury confirmed that it is going to restrict the level of pensions tax relief available on contributions made to pension schemes by reducing the Annual Allowance ("AA") for individuals from its current level of £255,000 to £50,000 from the beginning of the next tax year in April 2011. This proposed change will repeal the widely condemned plan to introduce a restriction on tax relief to only those individuals who earned more than £130,000. Pension tax relief will therefore not be restricted up to 40%.

Calculating the Annual Allowance

 Under the current taxation regime, the method of valuing the benefits within Defined Contribution ("DC") and Defined Benefit ("DB") schemes differ. Under DC arrangements the contributions of both the individual and employer are taken into account. This allows a relatively straight forward assessment for the AA and this will not change from next year.

In DB arrangements, however, as a specific amount of pension is promised at a given pension age, a method is required to assess the notional contributions used to provide those benefits. Currently this is based upon a calculation of the amount of any increase in the "closing" value of the individual’s DB rights during the pension input period (a year) as against the "opening" value after indexation has been applied. Both calculations are based upon the pensionable service, accrual rate, pensionable salary and a "flat factor" of 10 times is applied to both "opening" and "closing" values. Under the proposed changes, the method of calculation will remain the same but the "flat factor" will be increased to 16 times the value of the pension benefits (i.e. an increase in annual pension benefits of £1,000 will equate to £16,000 of the reduced AA).

With the reduction of the AA and the increase of the "flat factors", great care will require to be taken to ensure that an increase in pensionable salary (perhaps through a promotion) will not result in a significant tax charge. This has been referred to as "a spike". Pension augmentations on redundancy could equally lead to the AA being exceeded, and a tax charge.

Helpfully the Treasury has proposed that ill health benefits would be exempted from this regime (however further details are awaited). Additionally, where an individual exceeds his or her AA in a specific year, but has any unused AA from the three previous years, he or she may be able to carry forward the balance of such unused AA (which will initially be set at £50,000 per year for each of the last three tax years) to offset against spikes arising in the tax year in question. The Treasury has suggested that pension schemes could be redesigned to smooth away pensionable salary and accrual spikes prior to those pension benefits coming into payment (subject to ensuring that such changes are not seen as tax avoidance). It will also consider whether any tax due could be paid from the pension entitlement rather than current income.

Information to be provided to pension members

The Government will draft regulations which will require pension schemes to provide information to members if the AA has been exceeded. It will also require employers to inform employees of their pensionable pay and benefits, and the length of their service in any DB schemes by 6th July following the end of the tax year in question.

Lifetime Allowance

In conjunction with the AA changes, the total level of pensions tax relief available to an individual before they would trigger a tax charge (the "Lifetime Allowance") will be reduced from £1.8 million to £1.5 million from April 2012.

The above changes are among a number of budget saving measures currently being considered by the Government: they include further reform of pension arrangements for public sector workers (as suggested by the Independent Public Services Pension Commission's interim report).

You can view the announcements on the changes to the AA and Lifetime Allowances by clicking here.