Sweeping changes to pensions are out for consultation from the 55% tax charge on death benefits to a ban on transfers out of unfunded public sector pension schemes. Gareth Rose, pensions expert at Rowanmoor Group, assesses the proposals
Budget 2014 announced significant proposals to change pensions legislation. The government’s intention to increase choice and provide more flexibility for those looking to draw on their pension funds is to be welcomed, however the changes have raised questions over tax implications and the fair treatment of those in defined benefit schemes, particularly public sector members.
Consultation is vital to the success of the proposed changes and the government is keen to engage with interested parties on how best to achieve its policy aims through legislation. It has entered into a consultation period, ending 11 June 2014, and intends to publish draft legislation for a short technical consultation, prior to introduction of the legislation that will enact these changes.
There are several key parts to the consultation; the removal of the minimum income requirement from flexible drawdown, a ban on transfers out of unfunded public sector pension schemes, an increase to the normal minimum pension age, and consultation on the 55% tax charge on death benefits.
Complete flexibility to draw income from defined contribution pension funds from 6 April 2015
At present, there are two forms of income drawdown, flexible and capped, in place.
Prior to the Budget, to qualify for flexible drawdown, an individual must have had at least £20,000 guaranteed income per annum, known as the minimum income requirement, from secured pensions.
Secured pensions include the state pension and any defined benefit pension in payment. Legislation will be brought in so that with effect from 6 April 2015, all limits on the amount of drawdown income which can be paid in any pension year will be removed altogether.
This effectively means that everybody over the age of 55 will automatically qualify for flexible drawdown with no minimum income requirement and can take as much or as little of their fund as they want.
In line with current rules, 25% of the fund will still be paid free of tax as a pension commencement lump sum, and anything else paid will be taxed as income in the hands of the member.
For members aged 55 or older, capped drawdown allows them to draw a variable income from the pension fund but only up to a maximum amount each year. The amount of income allowed depends on fund size, the member’s age and factors prescribed by the Government Actuary’s Department (GAD) to arrive at a figure, known as the ‘basis’ amount.
Changes were announced in Budget 2014 to increase flexibility; the maximum income allowed was increased to 150% of the GAD rate (the basis amount), from its previous level of 120%.
Under flexible drawdown an individual is not limited on how much income they can draw and can take the entire fund should they wish. The cautionary note is that any income drawn is taxable at their marginal rate for income tax in the year of payment and for those considering making large withdrawals, this must be considered carefully.
The government has stated that the entitlement to a tax-free lump sum remains. The balance of the fund remains taxable as and when an income is drawn. For example, an individual has a pension fund worth £300,000 and takes the standard 25% lump sum entitlement of £75,000, leaving £225,000 to be drawn down as income.
Even if that individual had no other taxable income in the year, their income tax bill would be £87,377 (38.8%) if the full £225,000 was drawn in one payment (based on 2014/15 income tax allowances and rules).
This may mean that some individuals will find themselves becoming higher or even additional rate taxpayers for the first time. Options around staggering income withdrawals over a series of tax years could prove more tax effective.
One of the main objections to funding a pension has been the lack of options and flexibility on how to draw the fund at retirement. The overarching objective from the government is to increase flexibility and this should encourage more individuals, both existing and new savers, to fund a pension.
Restrictions on defined benefit schemes
Members of all defined benefit pension schemes have the right to a cash equivalent transfer value. This allows them to transfer their benefits from the defined benefit scheme to a defined contribution scheme.
Historically, this option has rarely been used as the individual would be giving up their secure pension from the defined benefit scheme in exchange for a defined contribution scheme, with its value determined by the cash equivalent transfer value.
The appeal of transferring from defined benefit to defined contribution may increase as a result of the changes to legislation for how defined contribution pension savings can be accessed.
However, as part of the consultation process it is envisaged that a complete restriction on transfers from defined benefit to defined contribution schemes will be introduced. As the majority of public sector defined benefit schemes operate on an unfunded basis, the contributions of members and employers are used to pay for pensions in payment.
It appears likely that this ban on transfers from public sector defined benefit schemes will prevent a ‘run’ on these primarily unfunded arrangements
Should a member of such a scheme decide to take a cash equivalent transfer value the Treasury must bear the upfront cost. More people transferring their rights from unfunded public service defined benefit schemes to defined contribution schemes, to take advantage of the new tax rules, would expose the Treasury to significantly higher costs on a initial basis. Government estimates suggest that the net cost of 1% of public sector workers transferring out of public service schemes each year would be £200m.
It appears likely that this ban on transfers from public sector defined benefit schemes will prevent a ‘run’ on these primarily unfunded arrangements, and a similar ban or other restrictions may be applied to private sector defined benefit schemes.
In most circumstances, the current tax rules allow people to access their pension savings in some form, from age 55. As life expectancy continues to increase the Government is looking at options to increase this minimum age, specifically by looking to introduce a link to the state pension age. It is proposed that it will increase from 55 to 57 in 2028 when the state pension age increases from 65 to 67, and will remain 10 years lower thereafter.
Tax charge on death benefits
Where an individual dies while in income drawdown, the payment of the remaining fund as a lump sum would suffer a 55% tax charge. With the proposed flexibilities on drawing pension income the government is also consulting upon reducing this level of tax charge as they wish to ensure that taxation of pension wealth on death remains fair under the new system.
The proposed changes to pension legislation are seen by many as long overdue and the additional flexibility brought by these new income options is to be welcomed. One way or another the new income flexibility provides a whole host of new tax planning and retirement opportunities.
Gareth Rose is a consultant at pensions expert, Rowanmoor Group plc www.rowanmoor.co.uk