Members leaving early

Before 1975 a scheme member of an occupational pension scheme had no statutory rights to benefits and could loose most or even all benefits that accrued as a result of leaving the scheme early. The introduction of the Social Security Act 1973 (SSA 73) saw a significant improvement in the members retirement benefits within an employers pension scheme by allowing the member a deferred pension on leaving service.

When the Act was introduced on 6 April 1975 it allowed for the preservation of a members pension rights, known as preserved benefits, after 5 years of service and would include both employee and employer contributions. For less than 5 years service the scheme member was entitled to a refund of contributions that they had personally made to the scheme. This duration was reduced in the Social Security Act 1986 to 2 years and a refund of contributions being made with less than 2 years service. However, Tax and a contribution to purchase membership of the state pension scheme will be deducted from the refund before payment.

The Finance Act 1981 introduced the first pension transfer product in the form of section 32 policies, allowing the early leaver an opportunity to transfer out of an occupational pension scheme. Where a final salary pension has contracted out of the state scheme the guaranteed minimum pension (GMP) relates to the earnings component of the State Pension that the member would have earned while in the employer's scheme, had the member not contracted-out. GMPs ceased to accrue after 5 April 1997.

For early leavers from January 1985 the Health and Social Security Act 1984 allowed the revaluation of GMP to be separate from that of preserved benefits. Prior to January 1985 the practice was to absorb GMP into the preserved pension and this was known as franking. As a result, the accrued entitlement to the member increased significantly as this includes the members pension transfer value.

From January 1986 the Social Security Act 1985 allowed the member the right to transfer from an occupational pension scheme rather than leave the preserved benefits. This Act also introduced revaluation of preserved benefits other than the already revalued GMP for leavers from 1986 in line with the retail price index (RPI) to a maximum of 5.0% a year up until retirement age. The Social Security Act 1986 introduced legislation to prevent employers from making membership of their occupational pension scheme compulsory and also approved personal pensions (APP) to receive pension transfers.

The Social Security Act 1990 extended the revaluation of preserved benefits by allowing members leaving service early of final salary schemes from January 1991 to have preserved benefits in addition to GMP to rise by RPI with a ceiling of 5.0% per annum up until retirement age.


Enhancing benefits

The accrual rate is the rate at which future benefits in a defined benefit final salary pension will accumulate, based on a formula linked to the scheme members pensionable earnings. This formula is usually expressed as a fraction of final salary, such as 1/60th or 1/80th and the pension benefits at retirement age will increase as the length of service increases. The Inland Revenue maximum retirement benefits are two thirds of final salary.

This means that for an accrual rate of 1/60th the member will have to work for 40 years to reach the maximum and from this there is the possibility for commutation to a tax free lump sum. For a public service scheme the accrual rate is 1/80th but the member can only work for 40 years giving a maximum pension income of half final salary.

However, the member will receive a tax free lump sum in addition to the income. Where a member needs the maximum pension income it is possible to buy a purchase life annuity with the tax free lump sum. By taking this approach the member will reduce the tax liability because the income is paid as capital and interest. This means that about 2/3rds of the income is deemed by the Inland Revenue to be a return of capital and therefore tax free and the other 1/3rd is interest and taxed at the savings rate of 20%. This advantageous annuity taxation means less tax paid and more income for the rest of the annuitants life.

Although very rarely exercised, an employer may enhance the benefits to employees by offering a scheme with accrual rates of say 1/45th or 1/30th. This means an employee need only work for 30 years or 20 years respectively to retire on the maximum benefits of 2/3rds final salary.

Members of a final salary scheme that will not complete 40 years service by their normal retirement age may be eligible to purchase added years by paying extra contributions to make up some or all of the shortfall. This will apply to pensionable earnings and depending on the scheme rules, may exclude other taxable income and benefits in kind. To make up any shortfall on other taxable income and benefits in kind, the member would have to make contributions to an additional voluntary contributions (AVC) pension.

Due to the impact of inflation during the 1980s and 1990s, the benefits from occupational pension schemes could be easily eroded. The Pension Act 1995 introduced regulations requiring exempt approved schemes to apply indexation to pension benefits in payment by at least the appropriate percentage known as the limited price indexation (LPI), that is the Retail Price Index (RPI) up to a maximum cap of 5.0% per annum. These indexation regulations do not apply to voluntary contributions made by the scheme member such as an AVC, which are excluded.

LPI applies from 6 April 1997 and includes protected rights benefits from contracted out final salary pensions as well as personal pensions in respect of Department of Social Security (DSS) rebates for the 1997/1998 tax year onwards.


Continuous service

A scheme member can qualify for continuous service of an occupational pension scheme such as a final salary pension in respect of pensionable service even though there has been a break of employment or if contributions are made to another scheme of the same employer. Pensionable service can be treated as being continuous if the member is transferred from the employment of one company to another that also participates in the same employers pension scheme, such as is the case with a public service scheme.

Also, continuous service applies if the scheme member was absent from work due to ill health, on maternity leave or taking a sabbatical or if the member has transferred between associated employers. The practice notes issued by the Pension Schemes Office (PSO) define associated employers as a company that is directly or indirectly controlled by the other or both companies are subsidiaries controlled by another company.

For the employee the transfer between associated employers is seen as continuous service in relation to their members pension rights, whether this involves a switch of companies while remaining in an employers pension scheme or leaving pensionable service of one scheme for another within the same employer. The Inland Revenue will establish the employees maximum benefits by combining total benefits from both employers. Whereas post-89 members are subject to the earnings cap on their relevant earnings, pre-87 and pre-89 members with continued rights will be able to maintain their retirement benefits under those advantageous tax regimes.

An occupational pension scheme such as a final salary pension will usually allow an employee to continue as an active scheme member even though he or she is not actively at work due to an illness or taking a sabbatical. The maximum period for such temporary absence is 30 months. During this period retirement benefits continue to accrue and the employee remains covered for death in service benefits.


Salary sacrifice

A scheme member can agree a salary sacrifice with the employer whereby a reduced salary is exchanged for extra pension contributions paid to an occupational pension scheme, such as a final salary pension or money purchase scheme, by the employer. This will save the employer National Insurance (NI) contributions on the salary sacrificed.

The advantage to the scheme member is that for basic rate taxpayers extra contributions of 30% could be made to their pension plan, such as a stakeholder pension, while still taking home the same net pay. This extra contribution would also grow tax free in the fund and would benefit from a commutation to a tax free lump sum at retirement age. At retirement the employee can use the much greater pension fund to purchase an annuity, however before making a decision regarding a pension income, learn more about annuities, compare annuity rates and secure a personalised annuity quote offering guaranteed rates.

However, a salary sacrifice will reduce the members definition of pensionable earnings for maximum retirement benefits, death in service benefits, widows pension and state benefits.