After two consultation papers, the final Personal Pension Schemes (Transfer Payments) Regulations 20...
After two consultation papers, the final Personal Pension Schemes (Transfer Payments) Regulations 2000 were issued at the end of January 2001. The implementation date for the majority of the provisions in the regulations is April 2001.
This Ritchie Paper considers the implications of these regulations for transfers from occupational schemes and what action IFAs should take now and in the future to ensure their clients' best interests are served.
The regulations cover four main areas:
l The certification of transfers from occupational schemes to personal pensions.
l The certification of tax-free cash on these transfers.
l The treatment of the post-transfer fund in a personal pension on death before vesting.
l Transfers while in personal pension drawdown.
Below, I will expand on the first three areas. The ability to transfer while in personal pension drawdown was introduced from 14 February and covered in the last Ritchie Paper, as printed in the 12 and 19 March issues of Investment Week.
Individuals in a specific category must get a certificate to be able to transfer from an occupational scheme to a personal pension. A transfer certificate will be given where an individual's fund passes a check to ensure that it is not excessive.
So, who falls into this 'excessive' category? At present, it is individuals who, in the past 10 years, have been either a controlling director or have earned over the earnings cap, current at the time of transfer, in relation to the employment to which the transfer relates.
The new regulations change the definition of this category to include anyone who has been a controlling director in the past 10 years, or anyone aged 45 or over at the time of transfer who has earned above the full earnings cap, current at the time of transfer, or in any of the past six years.
The draft regulations proposed that individuals earning more than 50% of the earnings cap would be subject to the new test, so the final regulations represent a significant improvement to what was proposed.
The new criteria will reduce the number of people who have to undertake a funding check on transfer. For example, non-controlling directors under the age of 45 will escape any check, however high their earnings, whereas under the current rules, they are subject to a check if they earn above the earnings cap. Individuals who fall into this category are definitely advised to wait until the new rules are implemented before transferring.
Because even individuals who fail the test may still be able to transfer part of their funds (see below), the new regulations may effectively mean now that anyone subject to certain conditions can transfer to a personal pension, although we need further clarification on this point.
The second big change to the certification process relates to the calculation basis used. At present, actuaries determine the maximum allowable transfer, based on Actuarial Guidance Note 11 the funding check is commonly known as the GN11 test. Although the basis gives guidelines, it allows actuaries some discretion about the assumptions they can use in the calculation. In particular, actuaries are allowed to reflect current market conditions and their views on likely future investment returns.
The GN11 test is based on the Inland Revenue maximum benefit calculation for early leavers. Within GN11, the actuary must then make certain assumptions, such as the annuity rate on the individual's retirement and the rate of investment return likely to be achievable between now and normal retirement date.
What are the changes?
The new test will no longer give actuaries any discretion on the basis to use. It will be in accordance with a prescribed formula and it will also be more stringent compared with what most actuaries would regard as reasonable under GN11 in current market conditions.
The new basis is similar to the basis currently used for executive pension plan (EPP) maximum funding calculations (in other words, the calculation used to set the maximum amount that can be paid into an EPP each year for an individual). The EPP maximum funding basis has been designed to prevent individuals from paying in too much and, therefore, not surprisingly, errs on the side of caution.
However, there are strong logical reasons for setting the basis to calculate the maximum allowed for transfer at a less stringent level. Surely where an individual has been funding for their pension in good faith and within Inland Revenue funding limits, the Revenue should only stop transfers going ahead where there is a clear case of overfunding. Otherwise, individuals could end up being penalised for better-than-expected investment performance.
Another problem with having a prescribed set of assumptions is that they are not responsive to changes in market conditions. Comparison between the new and GN11 typical bases indicate that the maximum amount allowable under the new basis could easily be 20% to 30% less than the amount actuaries would regard as reasonable in current market conditions.
I believe the new basis is too cautious in three key areas. The first is the mortality assumption. The Government has proposed that we use set mortality rates, which are heavier (assuming shorter life expectancy) than the rates currently being used by most actuaries. The calculation will underestimate the cost of the annuity, and so reduce the maximum fund value allowed on transfer.
The second is the annuity interest rate. This has been set assuming a long yield gilts rate of 8.5% a year, which is excessively high compared with current market conditions (the current long yield gilt rate is about 4.7%). This assumption again understates the cost of buying an annuity and pushes down the fund that can be transferred. However, the assumed post-retirement increases of 5.3% do help to mitigate the effect of the annuity interest rate.
The final one is the assumption that if the individual is unattached (not married and with no adult financial dependants) at date of transfer, he or she will be single at the date of retirement. However, it is not difficult to come up with examples of individuals who remarry or marry for the first time at a relatively advanced age. The cost of buying a joint annuity is more than the cost of buying a single annuity, and so basing the maximum transferable amount on a single life annuity penalises those who subsequently marry. This particular assumption is also especially harsh on those who are bereaved or divorced at point of transfer. Table 1 highlights the main changes proposed to the calculation bases.
The 'Regulatory Impact Assessment', published by the Inland Revenue to accompany the regulations, admits that some of those who responded to the draft regulations viewed the actuarial factors as out of date. Scottish Equitable was one of those. However, the Inland Revenue did not feel it was appropriate to review these factors in isolation and has suggested that any review would have to form part of a wider general review of actuarial factors prescribed for other purposes. I would welcome such a review at the earliest opportunity.
If an individual is transferring from a defined benefit scheme that is subject to the minimum funding requirement (MFR), then the trustees must pay a transfer of not less than the statutory minimum determined under the MFR basis.
If the statutory minimum MFR transfer is higher than the maximum allowed under the transfer regulation basis, then the MFR transfer can still be paid.
This situation could feasibly arise as the MFR calculation basis reflects current market conditions, whereas the prescribed basis does not.
Because many schemes adopt the statutory minimum MFR basis as their transfer basis, this is likely to mean that the majority of transfers from defined benefits schemes will not be restricted. However, where the transfer is from a money purchase arrangement an EPP, for example there is no equivalent relaxation, and the transfer value will not reflect current market conditions.
If the transfer fails the funding check, no certificate will be given and the individual will be unable to transfer to the personal pension.
However, Appendix XI to the Pension Schemes Office (PSO) Practice Notes (IR12) suggests that in the future, if the member fails the funding check, it may be possible in some circumstances for the maximum certifiable amount still to be transferred. Before concluding if this is a useful relaxation however, we need a better understanding of what the circumstances might be, and whether they are achievable in practice. We also need to understand the interaction between this and the preservation rules.
On transferring to a personal pension, as well as the individuals who have to obtain a transfer certificate, there is another group who are required to obtain a certificate regarding the maximum allowable tax-free cash that can be taken from an occupational scheme. In such cases, on vesting his or her personal pension benefits, an individual is restricted to taking the lower of 25% of the value of the fund or certified tax-free cash increased for price inflation.
At the moment, tax-free cash certification applies to anyone who is a controlling director, earning above the earnings cap, or is over the age of 45. The regulations change this so that only transfers that have to have a funding certificate will also have to obtain tax-free cash certification. This again reduces the number of people who will have to have a tax-free cash certificate. Two main categories benefit. First, high earners who are under the age of 45, and, second, anyone who is 45 or over will not have their tax-free cash automatically certified. This is positive news for those who have funded carefully throughout their working life and now want to transfer to a personal pension, perhaps to take advantage of drawdown as an alternative to annuity purchase.
The regulations also change the rules governing death benefits post-transfer.
At present, on transfer from an occupational scheme to a personal pension the transfer fund must remain clearly separate from any other monies and, on death before vesting, up to 25% of the transfer fund can be paid in lump sum format on a discretionary basis.
The remainder has to be used to buy a pension for any surviving husband or wife only where there is no surviving spouse can the full fund value be paid in lump sum form. This applies to all individuals who transfer.
In future, if a certificate is not needed to transfer, then the whole of the transfer fund can be taken as a lump sum. This removes the need to keep the transferred fund separate. The treatment of benefits on death before vesting has always been a consideration when choosing between a personal pension or S32 buyout plan (which mirrors the occupational regime) on transferring from an occupational scheme.
This change, to allow many individuals to take the full fund in lump sum form, will greatly improve the death benefits situation for individuals who are not certified. For some, it will provide an incentive for choosing not to vest fully if there is no real need and consider other phasing options instead. It may also mean that fewer people choose a S32 buyout plan.
The changes to the transfer rules will mean that, overall, fewer transfers from an occupational scheme to a personal pension will need a funding check. This in itself is a welcome change from the proposed regulations, which, if carried through, would have increased this number quite considerably. However, the more adverse calculation conditions (controlling directors and individuals aged 45 or above earning above the earnings cap) will be more likely not to receive a certificate.
As a result, these individuals will have to give up the idea of transferring or, alternatively, look into sacrificing a proportion of their fund by leaving it within the original scheme. However, we still require further clarification about this.
The introduction of a prescribed basis will have a number of implications. The maximum amount will no longer be based on market conditions, which means there will be a difference between what pension can actually be bought and what pension the regulations assume can be bought. This difference will be more pronounced if annuity rates continue at their present level, as they are expected to do.
However, the details of the prescribed format for the test are contained in Appendix XI (to the PSO Practice Notes), and as the Appendix is not part of the legislation, hopefully it can be changed quickly to reflect changes in market conditions.
Individuals who are unattached at date of transfer but expect to marry later will also lose out. The difference between the funds needed to buy a joint pension and a single pension can be quite marked, and for some, will mean the difference between transferring or not transferring.
On the plus side, that a prescribed basis is being introduced should mean that it will be easier for IFAs to determine when a client should consider transferring to a personal pension, and to plan accordingly. Non-controlling directors under the age of 45 will not have to get a transfer certificate, whatever the value of their pension plan or their earnings. This will be a very welcome move for some individuals.
However, it should be remembered that even if a certificate is not needed to transfer, there is still a requirement for transfers from occupational schemes to be checked to ensure that they are not excessive in relation to the benefits being given up. In the case of money purchase schemes, only a small minority of cases will have to be restricted on this account. Fewer individuals will require tax-free cash certification a welcome escape from the automatic requirement that everyone over age 45 runs the risk of being restricted for tax-free cash, even if they are on very modest earnings and do not expect a large pension.
There are clearly winners and losers as a result of these new regulations and IFAs would be well advised to consider the current position of their EPP and other occupational clients in the run up to April 2001.
The regulations will mean that a number of transfers from occupational schemes to personal pensions will escape certification. Certain employees should consider deferring pension transfers until after the regulations are implemented. This includes individuals who have earned more than the full earnings cap (over the past six years) but who are under age 45.
However, controlling directors or older high earners who will be caught by the test, whether they transfer before or after April, should strongly consider taking action now. This means individuals who have well-funded occupational money purchase policies, particularly if they are single. The highest priority will be individuals who may consider transfers to personal pensions in the next few years maybe to take advantage of the additional flexibility of personal pension drawdown or who have left service.
Over the longer term, the approach of a client's 45th birthday will become a significant trigger for IFAs to carry out a fundamental review of their occupational clients' pension planning.
Stewart Ritchie is pensions development director at Scottish Equitable
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