BACKGROUND
On 8 July 2015, the Chancellor of the Exchequer reduced the level of benefit that a member of a pension scheme could accrue in any year before a tax charge would apply. Any “excess” benefit would be taxed at an individual’s marginal rate, in a similar manner to a “benefit in kind”. The excess level of benefit is to be tapered from £40,000 to £10,000 as an individual’s earnings (note all earnings are assessed, not just remuneration from the relevant employment) increase from £150,000 per annum to £210,000 per annum. The methodology is very similar to the tapering of the “Personal Allowance” for higher earners.
CALCULATION
The value that is assessed against a member’s Annual Allowance Charge limit is as follows;
- Increase in the accrued defined benefit (in excess of statutory revaluation) over the year multiplied by 16
Plus
- The total money purchase[1] contributions paid to registered pension arrangements during the year.
POSSIBLE REMEDIES
The payment of this tax is required to be made on an annual basis in line with the payment of tax as part of the individual’s self-assessment tax form completion. Clearly, these changes will make the accrual of defined benefits less attractive for relatively high earners, but there are a number of approaches that can be undertaken to reduce, if not remove the liability for this tax. These include;
- Restructuring of the benefits – greater pension increases in payment
The annual allowance test does not distinguish between pensions that increase in payment at different rates. Consequently, it is possible to provide a member with a lower initial pension that increases at a higher rate. This would mean that the member is expected to receive a benefit of a similar overall value to the original pension, however, the level of tax paid is reduced/removed.
- Restructuring of the benefits – a higher spouse’s pension
In a similar manner to the previous point, the member’s pension could be reduced to provide a higher spouse’s pension. This will help the member to receive a benefit of similar value overall, but with a lower level of initial pension.
- Restructuring of the benefits – alternative remuneration
The member may prefer to have their benefits restricted to an amount equal to the annual allowance and receive additional remuneration in a different form, typically cash. A potential problem with this is that the payment of additional remuneration may further reduce the level of the member’s Annual Allowance…remember that there is a taper in the Annual Allowance as remuneration increases from £150,000 pa to £210,000 pa.
The efficacy of these options depends on the specific circumstances of each particular member as well as the existing benefit structure of the relevant scheme. These options may present the Company and the member with sufficient scope to change the shape of the benefits to remove any liability to pay the Annual Allowance charge. However, if this is unavoidable then there are a number of approaches that can reduce the impact of paying the charge.
TAX PAYMENT
The last option above can be used and will provide the member with limited pension accrual, but in the absence of providing the member with alternative remuneration, this is akin to “throwing the baby out with the bathwater”. A member might as well receive a benefit after the payment of the Annual Allowance tax charge rather than no benefit at all.
There are essentially two approaches that can be adopted to the payment of the Annual Allowance charge;
- Member Pays. The calculation previously summarised is carried out and the member adds the excess amount to their self-assessment tax return. This is then taxed in the same manner as other remuneration.
- Scheme Pays. There are certain rules regarding this approach, but essentially the member can insist that the Scheme Pays the Annual Allowance Charge and makes a commensurate reduction to the benefits that are paid from the Scheme. This reduction can be carried out on as “as you go” basis, whereby explicit reductions are made to the member’s benefits each year. Alternatively, the member can build up a notional (negative) defined contribution account which is used to offset any future transfer value or converted at retirement to a negative pension.
A further variant of the Scheme Pays option is that the member can elect to have their tax-free cash reduced instead of their pension benefit. This point highlights an important tax consideration for the member. The tax free cash is not currently subject to tax. Alternatively, the member’s pension income will be subject to income tax. Further the element of the pension sacrificed to pay the Annual Allowance Charge would have been taxed at the highest rate the member pays. This provides a strong argument for members to elect to reduce pension benefit rather than tax free cash. Further, this example also provides a clear bias away from “Member Pays” towards “Scheme Pays”.
Clearly, the specific circumstances of each member needs to be considered when companies are deciding how to approach this issue. Further as the calculation depends crucially on information that is not necessarily available to the Company (e.g. private rental income) early engagement is required with individual members to arrive at an appropriate solution.
Please contact your usual Quantum Advisory contact, if you would like to discuss this further.
Robert Palmer
Partner
robert.palmer@quantumadvisory.co.uk
[1] This includes contributions paid to trust based and contract based defined contribution arrangements, as well as additional voluntary contributions paid to a defined benefit arrangement on a defined contribution basis.