The revised defined contribution tax regime, introduced in April 2001, allows retired clients to contribute £3,600 to a personal pension without reference to earnings and take advantage of tax relief plus the available tax-free sum
The introduction of the tax regime for stakeholder pensions in April 2001 created an attractive opportunity for retired clients seeking ways to generate income.
Now individuals can make modest annual contributions without reference to earnings, and providers and advisers can offer immediate vesting as a tax-efficient retirement income strategy.
Immediate vesting personal pensions allows clients aged 50 or more to pay a pension contribution of up to £3,600 gross, benefit from full tax relief, take the 25% tax-free cash immediately and use the remainder of the contribution to generate a taxable income through a compulsory purchase annuity.
This procedure can be repeated every year, if appropriate, until age 74 ' the last year in which it is possible to make contributions under the personal pension tax regime. The client can also pay this contribution on behalf of others, such as a partner, for example. Where the contribution is paid on behalf of a non-taxpayer, the contributor only benefits from basic rate tax relief, but the annuitant receives the income gross.
It is clearly possible to use immediate vesting for much higher amounts where there are net relevant earnings to justify the contribution. In this case, the maximum personal pension contributions apply.
Stuart Bayliss, director of Annuity Direct, says: 'This can be very attractive for those coming up to retirement, who have not got enough pension and who can take advantage of the higher contribution rates. Through immediate vesting, they can add significant benefits right at the last minute, especially where there is unused relief from the previous tax year. Also, under the new tax rules, clients can continue making contributions for up to five years after earnings cease.'
In this case, the contribution is based on the last year of earning.
'This can be an efficient way of getting into phased retirement without disturbing the main pension plan,' Bayliss argues. 'In some cases, older plans may be tied to a specific normal retirement date (NRD) and it is not in the individual's interests to draw on these benefits earlier as there might be a penalty ' for example, the loss of the guaranteed annuity rate (GAR).'
To help illustrate the way the tax breaks work, in this article we focus on the maximum annual lump sum that can be paid without reference to earnings ' that is, a gross contribution of £3,600.
The provider reclaims basic rate tax relief, so the actual net contribution is £2,808. The immediate tax relief at 22% is worth £792. For a higher rate taxpayer there is a further £648 to reclaim in relief ' an additional 18%, taking the total to 40%. This brings the tax relief up to £1,440. The individual is responsible for reclaiming the higher rate relief through the annual tax return.
The client receives an immediate payment of the tax-free cash, which is calculated as 25% of the gross contribution of £3,600. This is worth £900.
The rest of the gross figure, £2,700, is used to buy an annuity that generates the taxable lifetime income.
The net cost to the client for the annuity purchased with a fund of £2,700 is £1,908 for a basic rate taxpayer and £1,260 for a higher-rate payer. From the tax-efficiency point of view, immediate vesting clearly looks convincing, particularly for the higher rate taxpayer.
Standard Life, one of the major players in this market, provided figures to show how the arrangement works for a male client who pays the gross contribution over 25 years from age 50 to age 74.
In this case, for a total effective outlay of £47,700 for a basic rate taxpayer and £31,500 for the higher rate taxpayer, the total gross income over a 35-year period is £97,910 (not adjusted for inflation). In terms of net income over net investment that is an effective annual return of 7.1% and 8.3% respectively.
Because of the lower annuity rates, the effective annual returns are lower for the female at 6.5% and 7.6%, respectively, although in theory the income would be paid over a longer period because of the greater longevity.
It is important to appreciate that immediate vesting does not follow the usual procedure when a client invests in a personal pension because the contribution is never actually invested.
Instead, the personal pension wrapper is simply used to obtain the tax relief. Advisers tend to use a stakeholder scheme as the basis for immediate vesting as these schemes cannot impose exit penalties.
The Inland Revenue is fully aware of the opportunities for immediate vesting and appears to be taking a neutral stance. The only comment the Revenue spokesman would give is that it is certainly possible to do immediate vesting under the current tax rules.
John Lawson, senior technical manager at Standard Life, says: 'This is a suitable product for those who have failed to make adequate retirement provision by giving them a second bite of the cherry. From the government's perspective it has to be a good thing if pensioners convert capital to a guaranteed lifetime income.'
One of the most important aspects of immediate vesting is to secure an attractive annuity rate and this can be problematic for the client making small annual contributions.
The number of stakeholder providers prepared to annuitise a fund of £2,700 (£3,600 less 25% tax-free cash) is limited. The companies that do operate at this end of the market include Canada Life, Legal & General, and Standard Life. Where a higher contribution is made there is a much wider choice and here the younger client might also consider an investment-linked annuity.
Clients interested in immediate vesting need to understand that what they are buying is an income for life and as such it cannot be compared with the annual return on an equity or bond fund, for example, where there are no such guarantees.
Probably the most appropriate comparison is with a deposit account, where the individual invests a lump sum and then draws a combination of interest and capital over a period of years.
One way to consider this is to assume that an individual pays £1,908 each year to the deposit account. This is the net outlay for a basic rate taxpayer for the £3,600 immediate vesting annuity after allowing for tax-relief and the deduction of the tax-free cash.
The individual then draws the equivalent of the annuity rate from the deposit account. Again using figures from Standard Life, based on a male age 60, the deposit account fund is exhausted after 18 years when the investor is age 78. This is six years less than the average life expectancy of 84. A complicated analogy perhaps but it does demonstrate the potential efficiency of immediate vesting.
While it is unlikely that an individual would contribute each year for the entire 25 years, the serial investor could end up with a portfolio of very small annuities nevertheless. While this may appear complicated from the administration point of view, there are advantages.
Given the uncertainty over annuity rates and investment returns, drip-feeding into the annuity market is as logical for immediate vesting plans as it is for phased retirement.
Legal & General offers index linking and guarantees as options on its immediate vesting personal pension even where the fund size is £2,700 (in fact on any fund from £1,000 upwards).
However, the Standard Life Select product for this particular market is offered on a level basis only.
Mike Connolly, PR manager for stakeholder schemes at Legal & General, stresses that even where contributions are low immediate vesting is a complex product that requires advice. 'This is not something that can be sold on the internet,' he warns.
The commission is modest so the adviser needs to have in place the systems to handle this product on a mass-market basis. Standard Life pays a commission of 2.5% plus uplift to the advisers that sell its Select plan.
This is calculated on the gross fund of £3,600 before the tax-free cash has been paid ' that is, £90 plus whatever uplift the adviser arranges.
Immediate vesting is extremely tax-efficient for retired investors.
Very few stakeholder providers offer annuities for £2,700.
Adviser remuneration is small, therefore firms need to generate a high turnover of these plans and have the right systems in place.
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