The Inland Revenue's proposed pre-retirement tax regime is to be welcomed for its simplicity but the details of how tax limits are to be calculated need to be handled with care
There are far too few 'real change' opportunities that can fundamentally change people's lives. The stunning simplicity of the Inland Revenue's proposed pre-retirement tax regime concept is a once in a generation opportunity which must be grasped.
We strongly support the key principle that people should enjoy tax relief to build up a fund to deliver their income needs in retirement, and accept there should be a maximum fund, with tax claw-back where this is exceeded.
The idea of having a maximum tax relieved fund is not new. Individual's funding on a money purchase basis, for example in an executive pension plan (EPP), already operate on this basis. They are not able currently to benefit from a higher pension than the Inland Revenue maximum, and need to manage their fund at retirement to mitigate any excess (although any such excess will then be reapplied within the scheme or returned to the employer after tax as appropriate).
The advantages of the new approach are very beneficial. For example:
• Defined benefit (DB) and defined contribution (DC) schemes can be brought within the same rules, avoiding complex interfaces between them.
• The main compliance check will be carried out once only ' at the point of taking benefits under any scheme.
• Full concurrency is available.
• Only minimal checks against contributions are needed.
• A number of detailed regulations can be consigned to the dustbin.
Simplification will help administrators reduce costs and will streamline the advice process. But the real winners from simplification are consumers. Many people who are put off making pension provision because of the impenetrable maze of pensions legislation will see that barrier removed ' an invaluable step towards reducing the savings gap, though insufficient on its own.
Although we strongly endorse the principle behind the Revenue's proposals, we believe there are areas which can be improved.
The key point, which we believe should be enshrined in primary legislation, is the principle that underlies the limit. We believe that the primary objective should be to deliver a specified maximum target income, which should be indexed in line with average earnings to ensure that the scope for pension planning does not diminish with time. The next question is what fund is needed to deliver that target income. We propose that it should be determined by investment and mortality considerations ' essentially by using annuity rates. A key advantage of establishing these principles in legislation would be in guiding future reviews of the limit, since an income-driven fund limit would not change in the same way as a simple cash-based limit.
An income-driven approach is consistent with the Green Paper's assertion that the lifetime limit is designed to deliver the current maximum Inland Revenue pension for a man aged 60 on capped earnings. However, it is not clear how this generates a life time limit of £1.4m, as £1.8m would be needed in current investment conditions.
It is in the nature of a 'one-size-fits-all' approach that there will be rough edges but these should be smoothed as far as possible. We therefore advocate that the limit is reviewed actively ' certainly annually ' and perhaps also if there is a significant change in investment conditions. The same principle would apply to the factors used to convert defined benefits to defined contributions for testing against the limit.
We accept the concept of a recovery charge which seeks to claw back the tax benefit enjoyed by funds in excess of the lifetime limit. However, the recovery charge must be fair to those who have, for example, experienced higher than expected investment performance in a DC scheme. Estimates of the charges needed to remove the impact of preferential tax treatment on investment growth are shown in the table below, for different investment periods and for regular and single contributions separately. The figures are based on reducing a gross return of 8% to 6%, to reflect the removal of preferential tax treatment.
There is an implicit assumption that higher rate tax relief on contributions is balanced by higher rate tax on the cash sum and pension payable from the excess over the lifetime limit.
In practice, this balance may not be the case. In particular, contributions from employers would enjoy a higher rate of relief if National Insurance savings are allowed for and the recovery charge would have to be set to take account of this. Given that contributions normally increase with age, we believe that a lower rate of 15% to 20% should apply.
It may also be appropriate to set the rate low initially since unintended excesses as a result of investment performance will relate primarily to earlier contributions. However, the charge would need to be set sufficiently high to avoid people gaining tax advantage by paying contributions and immediately taking benefits.
Allowing for the possibility that the contribution would be paid by the employer, National Insurance contributions of 6.3% would be saved (including the 1% employee contribution) so the initial rate would have to be set greater than this. That benefits had to be taken partly in income form would also act as a disincentive to deliberate overpayments.
Setting the rate at a lower level initially would also allow further work to be done to assess the way in which funds in excess of the lifetime limit build up. This information would provide a better basis on which to set a level of recovery charge based on the average period funds are invested for people who reach the lifetime limit.
A lower initial recovery charge could form part of the improved transitional arrangements which we believe are needed for people with funds close to or above the limit at A-day.
The key aspect of any improvement must be that the essential simplicity of the proposals is not destroyed. We advocate in principle two ideas, both of which could apply:
l The amount registered at A-day could be higher than the fund at that date with the increase providing a margin if investment performance is greater than that assumed in the ongoing reviews of the lifetime limit.
l Schemes should be able to opt to provide additional protection against a recovery charge applying. In a DC scheme actual investment growth on the fund at A-day would not be liable for a recovery charge. In a DB scheme, accrued benefit at A-day, indexed to retirement, would be protected. This additional protection would be lost on transfer to another scheme to prevent complication of the general tax regime by introducing, for example, certification of ring-fenced funds.
We have concentrated here on the changes we believe are needed to improve the lifetime limit. Other changes are also needed. In particular, the Department for Work and Pensions and financial regulators need to buy into the concept of simplicity too. But there is no doubt that the Inland Revenue's ideas can be a foundation for reinventing pensions with a new and elegant simplicity. The real prize will be removing complexity as a real and perceived barrier which discourages people from making provision for a happy retirement.
The principle of a tax relief fund for pre-retirement planning purposes is to be welcomed.
Simplification will help to reduce costs and streamline the advice process, making pensions easier for consumers to understand.
The limit on the size of the fund should be determined by a target income based on annuity rates and this should be written into legislation.
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