The new defined contribution pension has a schizophrenic character, warns Margaret Craig
It seems that the new defined contribution pension regime may turn out to have something of a split personality. On the one hand, we have the concept of stakeholder. It was originally intended as a cheap, simple and flexible arrangement to be offered via employers with the aim of extending funded pensions provision to more people, particularly the significant number of people in this country who are not saving for their own retirement.
The other face of the new regime is very different. The new regime (and that means both stakeholder and personal pensions) offers new opportunities that will bring pensions planning and tax planning even closer together, particularly for the better-off customer. These new opportunities are a direct result of the new regulations under the defined contribution regime.
Crucial to the new regime is the change in eligibility criteria. Until April this year, anyone wanting to take out a personal pension had to have UK net relevant earnings in order to be eligible. Eligibility now requires only that the individual be under age 75 and UK resident (or be a Crown servant or the spouse of a Crown servant). This clearly opens up pension planning, with its attractive tax advantages, to new markets.
Put simply, even those who have no earnings can now have pensions. The catch, of course, is that they have to be able to afford the contributions. And if those contributions are not to be financed from earnings, they still need to come from somewhere ' perhaps from savings or from a partner's earnings.
That is not to say that these opportunities are restricted to the rich. Even modest levels of contribution can build into an attractive retirement nest egg, particularly if those contributions are started early and regularly maintained. But, being realistic, it is more likely to be the better off customer who can afford to take full advantage of the new rules. And these customers are also likely to be the ones to whom the tax planning advantages will most appeal.
Pensions and tax
In practice then, how might pension planning and tax planning combine in the new regime?
There is a very good argument for saying that pension planning will now be much more of a joint exercise between husband and wife than in the past. Where there is one high-earning partner and one who is not paying tax, the most obvious route is to pay the absolute maximum possible contribution possible for the high earner and then contribute to the other partner's pensions.
However, the less obvious route should not be ignored. If the higher earner is heading towards being a high-rate taxpayer in retirement, it may make sense not to use his or her full potential contribution, but to divert funding to the non taxpayer, who will, in all likelihood, only pay basic rate tax in retirement
While we are on the subject of maximum potential contributions, it is worth looking at the practicalities of the new earnings certification rules. Where individuals want to base contributions on earnings, they certify the figure on which they wish to base contributions. This then becomes the basis year and they can continue to base contributions on this earnings figure for up to the next five years, even if their earnings reduce.
Consider the case of a self-employed customer with fluctuating earnings and look at the maximum potential contribution figures that could apply (see table). If earnings rise and he wants to increase contributions above the level that could be supported by the currently certified figure, he simply re-certifies, thereby creating a new basis year and the whole process starts again.
So if, instead of the scenario outlined above, his business had improved in 2005 and earnings had gone up to, say, £70,000, he could have created a new basis year in 2005 and based contributions on the higher figure. That would have made the year 2005, his new 'year one' and he could use that £70,000 earnings figure for the five years following 2005, that is up until 2011.
Alternatively, let us revert to the first scenario and assume his earnings had dipped again in 2007 and reduced to £35,000. He could choose to re-certify on the basis of his 2006 earnings of £50,000. That would then make 2006 his basis year and he could base contributions on those earnings until 2012.
At the risk of stating the obvious, where earnings are falling it may be difficult to pay maximum contributions. But the point of the example is to illustrate the considerable flexibility that this rule offers. It may be particularly useful where the individual wants to wind down their involvement in the business as they ease into retirement but still wants to continue making high contributions to their pension.
If the plan is to ease into retirement, it may make sense to combine the earnings certification rule with the earnings cessation rule. Under the new regime, contributions may continue to be based on earnings for up to five years after earnings stop. Not only that but it is also possible to combine these two rules, allowing contributions to be based on an earnings figure from 11 years previously.
After the five-year period has finished, contributions revert to the straightforward £3,600 a year figure. This can continue right through to age 75, even if the person has retired. Individuals that have high levels of annuity or drawdown income may want to recycle their pension for more tax-free cash from a new personal pension or stakeholder contract.
Pensions for children
Having taken care of the adults' pension planning, we can now consider pensions for children. The DSS regulations governing the new regime specifically permit third-party contracts. Where the contract is for a minor child, it must be taken out by the child's legal guardian, which will, in the vast majority of cases, mean that the contract will be set up by the child's mother or father. But although the contract is taken out by one of the parents, others could actually pay contributions, with the most likely candidates being the grandparents.
Contributions would be paid net of basic rate tax and build up with all the usual tax advantages enjoyed by pension contracts. The question of any potential inheritance tax liability clearly has to be thought through. Opinion on whether or not contributions made by grandparents would be a Potential Exempt Transfer (PET) seems to be shifting around at the moment and it may be that we will need clarification from the Revenue on this point.
However, leaving aside the PET question for the moment, there are other avenues to consider. In many cases, it will be possible to use the annual exemption for gifts. Very conveniently, the current figure for annual gift exemptions is £3,000 per donor, while the net equivalent of the £3,600 maximum pension contribution is £2808.
One concern that has been raised in this context is whether the net figure of £2,808 is the relevant figure or whether the gift should be counted as £3,600. It seems clear that as far as the annual gift exemption figure is concerned, the relevant figure is £2,808 since that is the loss to the grandparent's estate.
Another possible route may be for grandparents to pay contributions regularly out of income. For this to work, it would have to be clearly demonstrated and documented that contributions were being made from income. There would also have to be a clearly documented commitment to making regular payments into the child's pension, which might prove tricky if payments were made by single premium, for example.
Whatever the appropriate method, the key is that pension planning for grandchildren can carry tax advantages for grandparents and provides a welcome starter fund for the young person's own retirement planning in later years.
All in all, this face of the new regime is very different from its stakeholder persona. In the wider defined contribution regime, there are clearly many areas where the tax planning aspects of pension planning will be crucial. It follows that the need for advice in the new environment will be at least as important as it was in the days before April 2001.
l New regime offers opportunities that will bring pensions and tax planning closer together.
l Change in eligibility criteria is crucial to the new regime.
l Even those with no earnings can now have pensions.
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