Introduction

Individuals that do not have access to an employers pension must establish their own private pensions where the contributions will be made from their income only. Employer pensions such as final salary offer valuable benefits, having evolved significantly since 1975 when there were no statutory rights afforded to the a member on leaving early.

The Social Security Act 1973 (SSA 73) brought in major improvements and this Act continues to make additions on a regular basis. The Pension Schemes Act 1993 (PSA 93) and the Pensions Act 1995 added further protection, the latter introducing the Occupational Pensions Regulatory Authority (OPRA) to regulate employer

The employer can offer an occupational pension scheme, such as final salary pensions where the benefits are related to the member's earnings at retirement and length of service and this is known as a defined benefit scheme. Alternatively, an employers occupational money purchase scheme gives a pension income linked to the fund value, this being dependent upon the contributions made, retirement age and investment return and is known as a defined contribution scheme.

These are usually contributory schemes but occasionally the employer offers the scheme member a non contributory scheme where the member is not required to make personal contributions, but will still accumulate retirement benefits over time. If the employer has a group personal pension or stakeholder pensions often the employer will match the employees contributions up to a certain percentage.

Since the introduction of stakeholder pensions from 6 April 2001, all companies with five or more permanent employees that do not have an existing pension arrangement must have establish either a group personal pension (GPP) or group stakeholder pensions.

All these schemes are subject to the Pension Simplification regulations, introduced on 6 April 2006 and referred to as A-Day, that have established limits on the annual allowance of contributions to a pension fund and lifetime allowance of the size of the fund at retirement.


Scheme contributions

Any pension scheme, whether an employers pension scheme or private pension scheme, where the member is required to contribute is known as a contributory scheme. For an employers pension scheme, the employer will make a contribution to the scheme if required to meet the scheme funding objective.

The employer may be required not to make contributions to the scheme if it is in surplus but this will not affect the members pension rights at retirement age. In extreme circumstances even the members may not be required to make payments until the scheme is in balance, creating a non contributory scheme for a period of time. A private pension scheme will always be contributory as the onus is on the member to make payments if he or she wishes to accrue a sufficient fund value to deliver their desired retirement benefits.

Any employer pension scheme where the members are not required to make contributions and where the employer is responsible for funding the members pension rights is referred to as a non contributory scheme. The majority of employers operate contributory schemes as non contributory schemes have high operating costs. If an employer pension scheme is non contributory, they will typically be associated with a defined benefit final salary pension.

A public service scheme may also be non contributory, such as the civil service, and although this scheme will also be unfunded, the members pension rights at retirement age are guaranteed by statute. For an early leaver, there is a risk to the scheme member leaving within two years, as the employer can apply a refund of contributions made by the member. This means that in a non contributory scheme no contributions are made so the member will have no accrued pension benefits on leaving service.

Contribution limits

Since 6 April 2006, Pension Simplification has set a limit of the annual allowance at £215,000 for 2006/07 tax year rising to £255,000 in 2010/11 tax year and reducing to £40,000 for the 2014/15 tax year onwards. These limits are for payments to a defined contribution scheme or as accrued benefits within a defined benefit scheme.

This has allowed individuals of an occupational money purchase scheme to make contributions subject to the annual allowance and this gives them the opportunity to contribute considerably more to their retirement planning.

For members of a defined benefit final salary pension scheme the value is calculated as the increase in value of the employees' pension benefits accrued during the year using a valuation factor of 10:1, as opposed to the factor 20:1 used at retirement to determine the lifetime allowance.

Prior to A-Day the contribution maxima for an occupational pension scheme was limited to 15.0% of relevant earnings, irrespective of age by the Inland Revenue, now HM Revenue & Customs (HMRC). This could be different to the schemes pensionable earnings where usually only the basic salary is used to determine an employers contribution to the members pension and the benefits at retirement age. A member could enhance benefits where there was a shortfall by purchasing added years or making contributions to an additional voluntary contribution scheme (AVC).

Similarly, Prior to A-Day a free standing additional voluntary contribution (FSAVC) scheme linked to an occupational pension regime limited the member's contributions to 15.0% of pensionable earnings. For a group personal pension the Inland Revenue maxima varied with the members age from 17.5% below 36 years of age to 40.0% above 61 years of age, being scaled between these figures.


Scheme benefits

A pension scheme where the rules specify the benefits to be paid to the scheme members at retirement is known as a defined benefit scheme. Both the employer and member can finance the scheme to meet the benefit obligations in the future from the contributions. Where the contributions are made to a pension fund without specifying the benefits, such as an AVC scheme, stakeholder pension or money purchase scheme, are known as defined contribution schemes.

With the development of low cost employer sponsored stakeholder schemes that every employer must offer if they have 5 or more full time employees, effective from 8 October 2001, many employers with final salary pensions are closing these schemes to new entrants due to the high operating cost. These defined benefit schemes offer valuable defined benefits at retirement age based on a scheme members salary at that time where the risk of providing the benefits is with the employer. The maximum benefits that can be taken from a defined benefits scheme are 2/3rds of final salary subject to the lifetime allowance.

The total benefits a member will accrue will depend in part on the eligibility rules as set out by the scheme. This could include a waiting period before joining, indicate the type of employees that can join the scheme, the accrual rate applied, the level of benefits, retirement age and whether it is non contributory or contributory and if so the level of personal contributions.

Although a group scheme may be established by the employer, they really represent a collection of individual policies owned by the member and operated by a provider. When the member leaves the company all the contributions accrued by the member and the employer, belong to the member. The contributions can be left in the group scheme or a pension transfer made to another provider.

All schemes can pay a tax free lump sum of up to 25.0% of the fund value and to a maximum of 25% of the lifetime allowance irrespective of the type of pension. This includes protected rights portion of a pension, AVC, FSAVC's and transfers received from occupational pension schemes.


Benefit limits

Both defined benefit and defined contribution schemes are subject to the Pension Simplification regulations introduced from 6 April 2006. The standard lifetime allowance is the maximum amount of pension savings that can benefit from tax relief and has been initially set at £1.5 million in 2006 rising to £1.8 million in 2010. The allowance is based on the approximate amount of money that would be needed to purchase a pension equal to the maximum the HMRC would permit under the tax regime.

In terms of occupational scheme benefits the HMRC have determined that the lifetime allowance of £1.5 million is broadly the amount required to provide maximum benefits for a 60 year old with earnings at the earnings cap of £105,600 in 2005/06. The HMRC are using a valuation factor of 20:1 for converting a defined benefit scheme to a cash equivalent. Therefore the £1.5 million lifetime allowance represents a gross income of £75,000 per annum.

All schemes are able to pay a tax free lump sum limited to 25.0% of the fund value up to the lifetime allowance. For defined benefit schemes such as final salary pensions the scheme must calculate the value of the pension to determine the maximum tax free cash. The calculation used by the HMRC is a 20:1 value for converting a defined benefit scheme to cash. Therefore assuming a pension accrued of £15,000 per annum, this would represent a cash value of £300,000 which would produce a tax free cash sum of £75,000. If the tax free lump sum in total exceeds 25.0% or more than £375,000 (25% of the £1.5 million lifetime allowance for 2006/07) a tax charge would be made.

Prior to A-Day the defined benefit tax free lump sum was calculated by multiplying 3/80ths of final pensionable earnings for each year pensionable service. For example, for someone retiring with earnings of £20,000 a year, after 40 years of service the tax free lump sum will be 40 x 3/80ths or 120/80ths or one-and-a-half times pensionable earnings, providing a sum of £30,000. Alternatively, if it produces a larger lump sum the member could take up to two-and-a-quarter times the full initial pension before commutation.

In contrast, before A-Day a money purchase scheme had no limit on the amount of benefit that could be taken at retirement age, but the member was limited by the contributions made and the earnings cap. The scheme member was able to take a fixed 25.0% tax free lump sum from the fund value irrespective of the number of years service or members retirement age.


Earnings and taxation

Since 6 April 2006, Pension Simplification has replaced the differing contribution levels of defined benefit and defined contribution schemes with a lifetime and annual allowance. In terms of the annual allowance this is £215,000 in 2006 rising to £255,000 in 2010 with tax relief on the contributions limited to 100% of relevant earnings.

As defined in the Income and Corporation Taxes Act 1988 (ICTA 88) any income that is chargeable to UK tax is considered relevant earnings include the following:

Where funding exceeds the annual allowance an annual allowance charge of 40% is levied on the excess in contributions. Any investment growth or loss in the value of the fund for all money purchase schemes, whether private pensions or occupational pensions, are not included in the annual allowance.

The lifetime allowance was initially set at £1.5 million in 2006 rising to £1.8 million in 2010. Funds that exceed the lifetime allowance can be taken as a lump sum and in this case the lifetime allowance charge would be at 55%. There is a charge of 25% on pension funds that exceed the lifetime allowance and are used to provide a pension income. The income would also be subject to income tax at the individuals marginal rate and probably this would be a 40% higher rate tax, therefore the likely overall effect would be a tax rate of 55%.

Prior to A-Day the Finance Act 1989 imposed limits for any post-89 pension scheme members pension arrangement by the earnings cap. The earnings cap limited the taxable earnings of a member that could have been used for pension planning, latterly £105,600 for the 2005/2006 tax year before pension simplification was introduced. A pre-89 pension scheme member was not limited to the earnings cap and for an occupational pension scheme could retire on two thirds of their final remuneration with no upper limit.

Although the scheme member can commute part of their retirement benefits to a tax free lump sum, the pension income is taxable as earned income at a basic rate of 20% for the 2009/10 tax year. This means that the normal tax rules apply to this income after deductions for personal allowances. For a couple on divorce where the scheme member is a higher rate taxpayer while in retirement, a pension sharing order could actually mean both parties will become basic rate taxpayers after the pension income is divided.

Where a member needs the maximum pension income it is possible to buy a purchase life annuity with the tax free lump sum. By doing this the member will reduce the tax liability because the income is paid as capital and interest. This means that, say for a 65 year old, about 4/5ths of the income is deemed by HM Revenue & Customs to be a return of capital and therefore tax free and the other 1/5th is interest and taxed at the savings rate of 20%. This advantageous annuity taxation results in less tax paid and more income for the rest of the annuitants life.