Lower tax allowances for pension savings

Almost as soon as it came into power, the coalition Government announced that it would be changing the tax-relief rules on pension savings and benefits. Working to a tight deadline, the Government included the changes in the Finance Act 2011, which has now received royal assent. We examine how the revised tax allowances will work.

On this page:
Reduced annual allowance
Box 1: Example of DB member tested against annual allowance
Pension input periods
Straddling PIPs
Box 2: Example of "straddling PIP" calculation for DB scheme member
Carry-forward rule
Box 3: Example of the carry-forward calculation
"Scheme pays"
Other pension tax changes
Likely impact on pension schemes.

Within weeks of the 2010 general election, the coalition Government announced that it would scrap arrangements introduced by the Labour Government in the Finance Act 2010 to restrict pension tax relief for those on high incomes and approach the issue in a different way. The result was a Finance Bill that, among other matters, reduced the annual allowance for tax-relieved pension savings substantially with retrospective effect from April 2011. The Finance Act 2011 received royal assent on 19 July 2011. At the same time a number of Regulations were made to fill out and implement the Act's provisions.

Other related pension tax changes included in the Act were the reduction in the lifetime allowance from April 2012, new rules relating to pension input periods, and the introduction of a method of paying tax on benefits accrued in excess of the annual allowance, known as "scheme pays". In addition, the Act offers new flexibility to the members of defined-contribution (DC) schemes on when and how their benefits come into payment.

Reduced annual allowance

The main change to the tax reliefs given to pension savings introduced by the 2011 Act is the reduction in the annual allowance from £255,000 for the 2010/11 tax year to £50,000 for tax years from 2011/12 onwards. There is no provision in the Act for any regular indexation of this figure. The annual allowance is the maximum amount of pension savings in each year on which an individual is entitled to tax relief. Any pension savings above this level attract the annual allowance charge. This charge is calculated by adding the excess pension savings (that is above the level of the annual allowance) to the individual's taxable income and then applying that individual's highest (ie marginal) rate of tax to the resulting figure.

There are three main situations when the annual allowance charge will not be applied to amounts in excess of the annual allowance in a particular tax year, namely:

• if the pension scheme member dies during the year;
• if members suffer from such severe ill health that a medical practitioner decides they will be unlikely to work before state pension age, so that their benefits become payable immediately, or the pension is paid as a serious-ill-health lump sum because the individual is expected to live for less than 12 months; and
• if the member is a deferred pensioner whose benefits do not increase by more than the revaluation rate set out in legislation or in accordance with the scheme rules in force on 14 October 2010.

It is straightforward to value annual pension savings under DC schemes as it consists of the total member and employer contributions paid during the pension input period (PIP). To value benefits accrued under defined-benefit (DB) schemes during the PIP, the increase in the member's annual pension over this period is multiplied by a factor of 16. Prior to the 2011 Act, the conversion factor was 10. However, members will still be able to disregard any increase to DB pension resulting from inflation as measured by the consumer prices index.

The reduced annual allowance will not only affect those on high earnings. Individuals in DB schemes who experience a large increase in earnings, possibly due to promotion, and who have long pensionable service may also breach the allowance limit. In the example in box 1, an employee with pensionable earnings of £70,000 and with 30 years' pensionable service would breach the limit if awarded a 10% pay increase.

Pension input periods

While the pension industry broadly welcomed the reductions in the annual and lifetime allowances as being a preferable means of achieving the same increase in tax revenue as the previous Government's arrangements, changes to the rules concerning PIPs have caused some additional complications.

The PIP is the reference period for calculating increases to a member's benefits to see if they exceed the tax relief limits. The previous position was that, if no other date had been nominated, the PIP ended on 6 April each year for an individual who was a member of a DB scheme on A-day (6 April 2006) and, as Norton Rose points out, such a PIP does not align with the tax year. Under DC schemes, either the scheme or the member could nominate an end date for the PIP. If no date was nominated, then the default date was different for each member and depended on the anniversary of when the benefits started to accrue or when the first contribution was made prior to 6 April 2011.

The 2011 Act now provides that for new members or arrangements the default PIP is aligned with tax years and will end on 5 April. The Act also permits schemes to change their PIP if they have already made a nomination so that it aligns with the tax year. However, a PIP cannot be less than 12 months and, where the PIP is greater than that period, the same annual allowance will apply to the longer period. So if the PIP were 14 months, in order to align it with the next tax year, members would still only receive tax relief on £50,000 of pension savings during that longer period.

Straddling PIPs

The change in the PIP rules led to a transitional problem known as "straddling PIPs". These occurred when a PIP commenced before 6 April 2011 and ended on or after that date. This could lead to a situation where the increase in a member's pension savings during the PIP did not breach the annual allowance in force at the start of the PIP, but could exceed the lower allowance in force at the end of the PIP because the new annual allowance applies retrospectively from the beginning of the 2011/12 tax year.

In order to get round this problem the Government introduced two concessions. The first is that schemes that had been using the default date were able to retrospectively nominate their PIPs back to A-day, provided they did so before the Act received royal assent.

The second was to introduce transitional provisions. Under these, the straddling PIP is divided into two parts: the first runs from the commencement of the PIP to 13 October 2010; and the second runs from 14 October 2010, when the Government announced the reduction in the amount of the annual allowance, to the end of the PIP. Pension inputs made during the first period are tested against the £255,000 allowance and those made during the second period are tested against the new annual allowance. A worked example is set out in box 2.

Carry-forward rule

Following the reduction in the annual allowance to £50,000, the 2011 Act introduces a facility to carry forward unused allowances for three years, which also took effect from 6 April 2011. Under this, members can carry forward any annual allowance not used from the previous three tax years to the current tax year and add it to the current year's allowance. Because the concession takes effect from the start of the 2011/12 tax year, members can carry forward unused annual allowance (using the £50,000 allowance) from the 2008/09 tax year onwards.

In order to benefit from this facility the member must have:

• been a member of a UK-registered pension scheme during the tax year; and
• utilised their maximum allowance in the PIP during the current tax year.

Once a member has used up the current year's annual allowance, they can then start using up unused allowances from earlier years. However, this has to be done in strict order, with unused allowance from the earliest tax year being used first. The worked example in box 3 illustrates how carry forward will operate in practice.

Any unused allowance may be carried forward automatically and used without reference to HM Revenue & Customs (HMRC).

"Scheme pays"

If, even after making use of any unused allowance from previous tax years, the member still has pension savings in excess of the annual allowance, the excess amount has to be reported to HMRC under the self-assessment regime and the member has to pay tax on the amount at their highest (ie marginal) rate. However, provided certain conditions are met, the member may be able to elect for some or all of the tax liability to be met out of their pension savings under the so-called "scheme pays" provisions.

HMRC consulted on this idea at some length before it finalised its rules. It has now published guidance for members and administrators (external website) setting out details of the facility. This confirms a number of points that the Treasury had already revealed in its response to its consultation on its easement, but still leaves some matters unresolved.

Schemes have a legal obligation to pay the annual allowance charge on the member's behalf if given notice by the member within the requisite period where:

• the member's annual allowance charge exceeds £2,000 (from all schemes); and
• the total amount of the member's pension savings in relation to the particular scheme exceeds the annual allowance for the tax year to which the charge relates.

Once the system is fully operational, members must give notice to their scheme that they wish to use "scheme pays" by 31 July in the year following the tax year in which the charge becomes due. For the tax year 2011/12 only, the deadline is extended to 31 December 2013. If a member's benefits are due to be paid, the notice must be given before payment commences.

The guidance makes it clear that only the member's benefits can be reduced in this way, not any death benefit or dependants' pensions (although there may be reductions in these benefits as a consequence of the member's benefits being reduced).

However, actuarial consultancy Lane Clark & Peacock (LCP) points out that the guidance makes no mention of the option for DB scheme trustees to choose to recoup tax from a member's DC additional voluntary contributions, although it seems this is permissible. LCP believes this approach will be popular because it is simple.

The consultation paper asserted that schemes could choose how they wish to reduce benefits. However, HMRC's guidance states that reductions under DB schemes must be on a "whole of life" basis, ie a member cannot have a reduction for just a few years.

According to LCP, there are particular problem areas regarding how the "scheme pays" rules impact on the amount of tax-free lump sum that may be taken at retirement and on the lifetime allowance charge. Difficulties from the member's point of view may arise when the member's benefits from a number of schemes exceed the total annual allowance but the charge does not exceed £2,000 under any one of the schemes. A scheme cannot be made liable for an amount of annual allowance charge that is not attributable to that particular scheme, so the only thing the member can hope for in these circumstances is that one of the schemes will meet the annual allowance charge relating to the other schemes on a voluntary basis.

Once the charge has been paid by the scheme, the administrator must account for it on an accounting for tax form. Members liable to a charge will also have to include the amount of the charge and the amount the scheme has paid (or will pay) on their behalf on their self-assessment form.

Other pension tax changes

The lifetime allowance will be reduced from £1.8 million to £1.5 million in April 2012. Members can opt for "fixed protection", which will allow them to protect benefits up to the previous allowance that have already accrued provided they do not have enhanced or primary protection under the 2006 regime, and that no further benefits accrue. Applications for fixed protection must be received by HMRC by 5 April 2012. Law firm Eversheds points out that there is no exception to the rule that further benefits cannot accrue, so if someone is automatically enrolled in a scheme they will lose the protection.

As a consequence of the new allowance, HMRC has introduced a number of changes to the information that must be provided. The Registered Pension Schemes (Provision of Information) (Amendment) (No.2) Regulations 2011 (SI 2011/1797) and the Registered Pension Schemes (Notice of Joint Liability for the Annual Allowance Charge) Regulations 2011 (SI 2011/1793) contain details of its new requirements. In particular, SI 2011/1797 provides that, where a scheme identifies that a member's pension savings are likely to exceed the annual allowance during the PIP, it must issue a "pension savings statement" that contains sufficient information to enable the member to work out whether or not the annual allowance charge will be payable and, if so, the amount of the charge. In addition, employers must supply the administrator with sufficient information to enable the scheme to calculate the pension input amount relating to an employee for a tax year. Several commentators have noted that the successful operation of the system relies on schemes and employers establishing good lines of communication.

Likely impact on pension schemes

Just before the 2011 Act received royal assent, actuarial consultancy Punter Southall published a short survey (external website) examining the attitudes of about 130 schemes to the new tax rules. This reveals that 55% of respondents are against the "scheme pays" rules and 37% believe that the threshold should be higher than £2,000.

Nearly 45% of participants think that senior management will become less engaged with their pension scheme as a result of the changes. However, nearly 90% of schemes had already identified members who may be affected by the changes and communicated with them.

To help schemes come to grips with the changes, HMRC published its newsletter no.48 (PDF format, 65K) (external website), which highlights the main changes, gives details of the Regulations and contains links to the main parts of its guidance. However, some of this is described as "draft" and the newsletter reveals that the final version of the guidance will not be available until later in the year. Several pension advisers have expressed concern that this does not give schemes much time to sort out all the fine detail of the new limits, especially as questions remain concerning some aspects of their application.

This feature is based on the Finance Act 2011, the accompanying Regulations, and HMRC guidance and its newsletter on the topic. We have also referred to client newsletters produced by a number of actuarial consultants and law firms, including Burges Salmon, Eversheds, Lane Clark & Peacock, Norton Rose, Punter Southall and Towers Watson. We are grateful to Towers Watson for checking and adding to our example in box 1.