Pensions: Time to simplify … again?
Pension simplification was originally brought about due to the complex patchwork of legislation that existed prior to A-Day, which had been fixed together by successive administrations and was seen as an obstacle for pension members to access their benefits.
The only reasonable solution, therefore, was to remove said obstacles and allow people to access their pension(s) without having to navigate what had developed into a minefield of pension legislation.
As it stands, we are dangerously close to reaching a point again where pension legislation is overwhelmingly complex. I can’t help but conclude that this has arisen as a result of politicians not being able to resist raiding the pension tax relief piggy bank to shore up public finances. This narrow- minded approach for short-term gain is causing agonising long-term legislative pain.
There are more than a few suggestions I could mention but for the purpose of this article I have focused potential solutions specifically on how the Annual Allowance (AA) and the Lifetime Allowance (LTA) could be used to restrict tax relief depending on the type of pension scheme, rather than a combination of the two on all schemes.
Annual Allowance vs Lifetime Allowance
Simply put, the AA restricts the amount of pension input whereas the LTA limits pension output. They both started life with a clear purpose and were relatively easy to understand. With many recent Budgets and subsequent tax years, each has become progressively more complex with: reductions in limits, transitional periods, LTA protections, carry forward, AA taper and the money purchase annual allowance. It appears as though the concept of simplification has already fallen apart at the seams.
There are now seven different forms of protection from the LTA tax charge. These were introduced at four different points including the original A-Day protections. The consequence of this is far from straightforward for both scheme members and scheme administrators.
Take Owen as an example: he has Primary Protection with an LTA enhancement factor (LAEF) of 0.5. When calculating the amount of LTA he has utilised his adviser needs to consider three different LTA figures. So in the current tax year (2018/19), the following considerations would be required:
- The amount of fund that can be crystallised without a tax charge.
- This is based on an underpinned LTA of £1.8m and the LAEF of 0.5 in this instance.
- The calculation is (SLA x LAEF) + SLA = (£1.8m x 0.5) + £1.8m = £2.7m.
- The remaining PCLS entitlement is based on an underpinned LTA of £1.5m.
- The amount of LTA deemed to have been used at each Benefit Crystallisation Event (BCE) is calculated and reported to Owen based on the standard LTA at the time of the BCE, £1.03m in this case.
To complicate matters even further, from the 2018/19 tax year onwards the LTA increases annually by the Consumer Price Index (CPI). As a result it is impossible to predict with any certainty what the standard LTA is going to be in any given tax year in the future. CPI used in the 2018/19 tax year was 3.00%, I have assumed this figure going forward in the calculations that follow.
Protections already in place will become obsolete when the standard LTA is equal to or greater than the protected LTA value it serves to protect. Based on the above assumption, the standard LTA will be greater than £1.25m, £1.5m and £1.8m in 7, 14 and 20 years respectively.
Both Defined Benefit (DB) and Defined Contribution (DC) schemes currently have a limit of relevant benefit accrual that can be added to the pension environment and still be eligible for tax relief. They also have a ‘check’ on the way back out in the form of the LTA. Ergo, two different types of schemes are subject to both the AA and LTA. The problem is compounded by the fact that there is a perception that DB schemes are treated more favourably for LTA purposes.
Implementing a tailored solution
Improved simplicity could be achieved by disentangling the rules for DB and DC schemes. Clearly the main concern for the Government when it comes to restricting inputs and outputs from pension schemes is the amount of tax relief that an individual can benefit from (i.e. the cost to the revenue per pension scheme member).
The cost of each scheme could be controlled by the level of benefits (LTA) for DB schemes and the level of contributions (AA) for DC schemes.
The legislation to bridge the gap between the two types of scheme will unquestionably be complex but the result will be much simpler and understandable for the end users – pension scheme members.
Advantages of this solution are that it still gives the Government two levers to pull to restrict the cost of pension benefits as they deem appropriate, and it is much easier for the schemes to administer and for scheme members to understand.
Trying to apply a complicated one-size-fits-all approach to two separate types of regime has clearly sent the movement towards simplified pensions heading well and truly away from the desired destination. The ideal outcome from all the suggestions that I have mentioned is to get pension simplification back on track, or at least moving in the right direction.