Background

In late 2002, the government published a consultation paper containing some very radical changes to the taxation of pensions. These were further refined a year later in a second paper. The tax proposals were legislated for in the Finance Act 2004 and Finance Act 2005 and a raft of subsequent regulations. Although further legislation was contained in the Finance Bill 2006, the new regime took effect from 6 April 2006, a date usually called ‘A-Day’.

The main elements of the new regime are:

• Lifetime allowance Every individual has a maximum permitted tax-exempt fund of £1.5m in 2006–07, which will rise to £1.8m by 2010–11 and then be regularly reviewed. Any excess over the lifetime allowance when benefits are drawn is subject to a 55% lifetime allowance charge if taken as a lump sum or 25% if the excess is used to provide taxable pension benefits. Benefits accrued before the new regime started (pre-A-Day) can be protected in one of two ways:
  
  
  • Primary protection Under primary protection the value of retirement and death benefits at 5 April 2006 is protected from a lifetime allowance charge to the extent that they increase no faster than the rise in the lifetime allowance. Primary protection is only available as an option if the value of benefits at 5 April 2006 exceeded £1,500,000.
    
    
  • Enhanced protection Under enhanced protection the lifetime allowance charge is generally avoided, provided that after 5 April 2006 no further pension benefits accrue or contributions are made (other than to certain pension life cover arrangements in force on 5 April 2006). Enhanced protection is available to all and, if the value of benefits at 5 April 2006 exceeds £1,500,000, can be elected for alongside primary protection.

The latest date for an election for primary protection and/or enhanced protection is 5 April 2009.

• Annual allowance In addition to the lifetime allowance, there is an annual allowance of £215,000 in 2006–07, rising by £10,000 a year until 2010–11. This represents the maximum contribution (or increase in value of benefits for a final salary scheme) during a tax year. An individual cannot personally contribute more than the greater of £3,600 or 100% of their earnings and receive tax relief. In nearly all instances, the £215,000 allowance is much higher than applied under the previous rules, but for very high earners it can be more restrictive. Any contribution above the allowance attracts a 40% tax charge on the individual, cancelling the tax relief given. However, the annual allowance does not apply in the final year in which all benefits are drawn from a scheme.
  
  
• Tax-free cash sum As a general rule, this is simply 25% of the value of any pension arrangement. If at 5 April 2006, the accrued lump sum benefit under an occupational pension scheme was greater than 25%, then at retirement special transitional protection rules apply to determine the lump sum. No election is required to gain this treatment. There are other complex transitional rules for those who opt for enhanced and/or primary protection.

Most occupational pension scheme members previously subject to the 1989 tax regime and former retirement annuity contract owners benefit from this change, but there are some losers, mainly among pre-1989 members and those occupational scheme members with low rates of benefit accrual.

• Retirement age The concept of a normal retirement age has disappeared, as have constraints on drawing occupational benefits while still employed by the scheme sponsor, although many schemes may not take advantage of all the extra flexibility. The minimum age for drawing benefits will increase from 50 to 55 from 6 April 2010. Benefits no longer have to be drawn by age 75, but once this age is reached, the opportunity to take tax-free cash is lost.
  
  
• Death benefits before retirement The maximum death benefit is simply a lump sum equal to the individual’s remaining lifetime allowance, ie usually £1.5m if death occurs before retirement benefits are taken. Any excess paid as a lump sum is subject to a 55% tax charge unless transitional protection applies. Survivors’ pensions can be provided in lieu of a lump sum, but for tax reasons most people will choose cash unless forced to take a pension, eg by contracting out requirements or to avoid the 55% tax charge.
  
  
• Income in retirement The new rules split pension income in retirement into four categories:
  • Scheme pensions (which can be provided by any pension arrangement, but will normally be from final salary pension schemes);
  • Lifetime annuities;
  • Unsecured pension (pension fund withdrawals and short term annuities);
  • Alternatively secured pension (a restricted form of pension fund withdrawal introduced primarily for certain religious groups).

Annual income under the unsecured option can be drawn at any level from nil to approximately 120% of what could be provided by an open market annuity. Reviews will normally be five-yearly and by age 75 income must be provided as a scheme pension or lifetime annuity unless at that age the alternatively secured pension route is selected. Under this latter option, pension fund withdrawals can continue at a maximum level of 70% of the open market annuity based on age 75 and reviews are annual.

If a lifetime annuity or scheme pension is selected, death in retirement benefits (other than dependants’ pensions) can take the form of either traditional guaranteed payment periods of up to 10 years or ‘value protection’. Under value protection, the maximum lump sum payment on death before age 75 is the original annuity purchase price less income payments made. The lump sum is normally subject to a 35% tax charge unless the pension arose from a final salary scheme.

The unsecured pension option will provide death benefits on the same basis as the previous pension fund withdrawals regime, ie on death before age 75 a return of the remaining fund subject to a 35% tax charge. If the alternatively secured pension route is adopted, funds remaining on death will be applied to provide dependants’ pensions. If there are no dependants, the fund will revert to the scheme where it could be reallocated for the benefit of other members nominated by the deceased member or paid to a charity nominated by the member. The inheritance tax position is that on death before age 75 there will normally be no liability, but from age 75 there will be a tax charge if funds are reallocated.

• SSASs and SIPPs – Member-directed pensions There is one set of investment rules for all pension schemes which, after a dramatic U-turn in December 2005, are now similar to the pre A-Day rules. There are new restrictions on the amount schemes can borrow or lend to sponsoring employers. However, pre-A-Day investments and borrowing are protected.

• FURBS and UURBS Under the new regime, any contributions made by employers to FURBS are not tax relievable when they are made, nor do they give rise to any income tax or NIC liability for an employee. Contribution tax relief is only granted when benefits are drawn by the member. Investment income and gains are taxable within the FURBS at the trust tax rate of 40% (32.5% for dividends). When benefits are drawn from a FURBS or UURBS, they are subject to income tax but usually not NIC, provided employment has ceased. Up to 25% of the FURBS fund may be drawn as a taxable lump sum. There are transitional rules to allow FURBS benefits accrued before A-Day to be drawn as tax-free cash where the contributions have been subject to income tax for the member.