The Government introduced personal pensions in 1988. This allowed the self-employed or employees of companies not offering a pension scheme to have a pension.
They are money purchase schemes where contributions receive tax relief.
Pensions underwent a radical change from 6th April 2006 with the introduction of Pensions Simplification and the March 2014 Budget announced a further sweep of changes which has revolutionised the retirement market.
Tax relief is granted on personal contributions subject to the greater of:
- £3,600 per annum; and
- 100% of relevant earnings (salary, bonuses and benefits in kind).
These limits are subject to the annual allowance detailed further on. To benefit from tax relief on contributions up to age 75, you need to be resident in the UK or be a Crown Servant serving overseas, or their husband, wife or civil partner. Contributions are paid net of basic rate Income Tax with the relief claimed from the Treasury by the pension administrator. Higher rate taxpayers can claim further relief on their contributions through the Self-Assessment process.
Contributions paid by a company on behalf of an individual (employer’s contributions) are tax relievable against the companies’ profits. There are no implications on the individual’s personal income tax. However, the contributions are still subject to annual limits and must be justifiable in accordance with the individual’s income in order to be tax relievable.
- Some of the benefits of contributing to a pension scheme are:
- Capital gains within the fund are tax-free.
- Income generated within the fund is free of tax.
- Currently, 25% of the fund can be taken tax-free on retirement.
- Lump-sum death benefits are normally paid free of Inheritance Tax.
- It is not possible to access the fund before age 55 and it is not suitable for short-term savings or where there may be a need to access the entire fund as a lump sum.
- With a personal pension, you can take benefits without the need to retire from work.
- You can increase contributions (subject to certain limits); add a single contribution or a transfer payment (from a previous pension plan) at any time.
Payment on death
Prior to 6th April 2015, the distinction on death benefits was based on whether the funds were crystallised or not. This distinction has now been removed, and instead, the only difference in benefits is based on the age of the owner at the time of death:
Death before 75 – in this case, the remaining pension funds can be passed to their beneficiaries in full, entirely free of tax. If uncrystallised, the benefits will be tested against the lifetime allowance.
Death after 75 – in this case, the beneficiary will pay tax on withdrawals at their marginal rate of income tax. If the beneficiary does not have a personal tax rate, e.g. a trust or company, then a rate of 45% will apply. It is therefore critical that a nomination of beneficiaries’ form is completed to ensure they pass to the right person.
Prior to the advent of pension simplification, there were many regimes; each with their own rules about how much could be paid into pensions and how they interacted with the other regimes. From 6th April 2006, there is just one set of rules concerning payments to registered pension schemes.
Whilst these new Pension Simplification regulations do increase the ability to fund a pension plan, there are two over-riding limits that must be considered: the annual and lifetime allowances.
The annual allowance
The annual allowance is the amount that can be saved into a pension each year. If the allowance is exceeded (and if carry forward is not used) an individual becomes subject to an income tax charge on the excess. This tax charge is applied to the individual even if it is employer contributions that exceed the allowance.
After a series of changes, it was announced from April 2011 the maximum that can be paid into a pension scheme for an individual was £50,000 and this subsequently dropped to £40,000 from 6th April 2014. For personal payments up to £40,000, income tax relief is available (subject to this not exceeding 100% of relevant earnings); this includes individuals who are taxed at 45%. No income tax relief is available on payments to pension schemes above the £40,000. There is the opportunity to carry forward unused annual allowances from earlier years.
Since 6th April 2016, the annual allowance has been tapered for those with high earnings. The annual allowance will be reduced so that for every £2 of income they have over £240,000, their annual allowance is reduced by £1. The maximum reduction will be £36,000, so anyone with an income of £312,000 or more will have an annual allowance of £4,000.
Money Purchase Annual Allowance (MPAA)
A further reduction to the annual allowance applies and this is targeted at individuals who have flexibly accessed their pension rights. Flexibly accessed includes taking an income under Flexi Access Drawdown or purchase of a Fixed Term Annuity. It does not include taking only the tax-free cash from a pension, purchasing an annuity or putting into payment a Defined Benefit scheme pension. The MPAA restricts future annual contributions to £4,000 gross. It is not possible to carry forward any unused MPAA.
An individual who flexibly accesses their pensions is obligated to tell all other remaining pension providers they are subject to the MPAA within 91 days of accessing benefits flexibility. Failure to notify the other providers in this time can incur a £300 fine and a daily penalty of £60 for every day after the initial 91 days.
The Lifetime Allowance
There is no absolute limit placed on the level of benefits an individual can be provided with under a registered pension scheme. However, every individual has a set level of benefits, which they can draw from all registered pension schemes in their lifetime without triggering certain tax charges. This measure is referred to as the lifetime allowance.
As with the annual allowance, following the initial announcement, there was a raft of changes. The allowance is currently £1,073,100 and will continue to increase each year by the rate of consumer price index (CPI) inflation in the prevailing year.
When a “benefit crystallisation event” occurs, and the individual’s available lifetime allowance is unable to cover the entire crystallised amount, the amount which exceeds the individual’s available lifetime allowance at that point is called the chargeable amount and a lifetime allowance charge arises on this chargeable amount. If the scheme permits all funds above the lifetime allowance to be taken as a lump sum, this will be subject to an immediate lifetime allowance charge of 55% before it is paid out.
Alternatively, a charge of 25% applies if the excess above the lifetime allowance is paid as a pension and this income will additionally be subject to tax at the individual’s highest marginal rate, in payment. The combined effect of the lifetime allowance charge of 25% and income tax at 20% or 40% on pension income is an overall tax charge of 40% or 55%.
Age 75 / Death / Transfer out of the UK
These are the three scenarios where funds are tested against the Lifetime Allowance without any benefits being taken. At age 75, a test is also done on previously crystallised Drawdown funds. Any increase in the value of the crystallised funds compared to the amount originally designated into Drawdown is assessed against the remaining Lifetime Allowance.
Under the age 75 and transfer out of the UK test, the tax charge on any excess is automatically 25% (as no lump sum is being taken) while the structure of death benefits determines whether the charge is 25% or 55%. On death, previously crystallised funds are not tested in terms of growth (as they are under the age 75 test).
Lifetime Allowance Protection
It is possible to have a personal lifetime allowance that exceeds the standard lifetime allowance if protection was applied for at the time available:
|Protection||Lifetime Allowance||Deadline for applying|
|Enhanced Protection||Unlimited||5th April 2009|
|Primary Protection||Lifetime Allowance Factor given||5th April 2009|
|Fixed Protection||£1.8 million||5th April 2012|
|Fixed Protection 2014||£1.5 million||5th April 2014|
|Individual Protection 2014||Up to £1.5 million||5th April 2017|
|Fixed Protection 2016||£1.25 million||None|
|Individual Protection 2016||Up to £1.25 million||None|
Essentially for Fixed Protection applications, contributions need to have ceased, and for Individual Protection applications, your fund value needs to have been above a specified point on a specified date.
State Pension Age
The State Pension Age (SPA) is the earliest age you can draw your State Pension. Your SPA is specific to your date of birth.
Previous changes to the State Pension Age are taking effect with the age in which individuals become entitled to the pension rising to age 66 by October 2020. There is further legislation increasing the age to 67 and this currently affects all those born from 6th March 1961. There are also longer-term plans for the State Pension Age to increase to 68.
Changes to access
Until recently, the two main options for accessing pension benefits from age 55 were annuity purchase and drawdown. For individuals accessing drawdown, the amount they could take from their pension each year was subject to certain limits. From 6th April 2015, the way in which a person can access their pension benefits has been completely revolutionised. The new rules mean that there is no limit to the level of income an individual can take from their pension scheme.
The first 25% will continue to be tax-free; any income taken in addition to that will be added to an individual’s other income in that tax year and income tax charged as appropriate. This is known as flexi access drawdown and once it has been used, an individual’s allowance for contributions drops to £4,000, preventing funds from being reaccumulated within the pension to a significant degree. There is, therefore, much greater flexibility now available for pensions, but with a number of important considerations required.
A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age.
This contrasts with a money purchase pension (such as a personal pension or a stakeholder) in which a fund is built up from contributions and investment growth and that fund is used to provide an income in retirement.
As a defined benefit plan provides a guaranteed income in retirement, and this typically increases each year, this is a very valuable plan type; money purchase pensions do not offer guaranteed income, although they do offer certain options and flexibility, which defined benefits schemes generally do not offer. Additionally, a defined benefit pension entitlement is not dependent on the performance of the stock market and the funds are protected by the Pension Protection Fund, in the event the employer becomes insolvent.
Reviewing the options with regards to a defined benefits plan, in particular considering transferring it to a money purchase plan is therefore not straightforward; the two plans offer very different benefit structures and all the features and options available between them need to be considered carefully
Personal Pension or Self-Invested Personal Pension via a Platform
Personal Pensions and Self-Invested Personal Pensions (SIPPs) can be held and managed on a Platform account. These plans work in the same way in terms of legislation around contributions and tax treatment.
Whether termed by the Platform as a Personal Pension or a SIPP (or a ‘Hybrid’), pensions via a Platform have the general flexibility of SIPPs and typically afford the following features:
- Access to in many cases thousands of investment funds across the market
- Access to alternative investment options such as Exchange Traded Funds (ETFs) and direct equities.
- Full post-retirement flexibility in how benefits are drawn.
- The ability to hold the pension alongside investment wrappers and in some cases, considered alongside other family member’s accounts to determine the charges applied.
These pensions are typically limited in that they do not offer access to all investment options, with notable exclusions being direct commercial property purchase and unlisted equity investments.
A great deal of innovation in the Platform space has occurred over the years’ and this has allowed a number of providers to offer increasingly flexible pensions with the cost being driven down through technology efficiencies and competition.
Platforms and Wraps
Platforms and wraps are Internet-based systems, which allow an adviser to have custody/viewing over a client’s assets so they can view and administer investments. The platforms/wraps provide advisers with tools to analyse a client’s portfolio, choose products for them and arrange transactions. In some cases, the platform/wrap can be used by the client too for viewing holdings. The main benefits of a wrap are:
Ease of transactions
- Reduced administration
- Enhanced fund choice
- Online Access
- Cost and Economies of scale
What are the risks?
There are many risks anyone considering a personal pension needs to think about:
- We base our statements about the tax treatment of products and their benefits on our understanding of current tax law and HMRC practice. Levels and bases of tax relief are subject to change.
- The illustration uses specific assumed rates of growth. The figures used in the illustration are only examples, and neither we nor anyone else can guarantee them.
- The amount the plan will be worth in the future will depend on investments growth, charges and contributions.
- Past performance is no guarantee of future returns.
- If growth is low, charges may eat into the capital invested
- Any employer contribution depends on the continued solvency of the employer.
- Depending on how someone takes it, pension income may depend on interest and annuity rates at the time.
- The current tax treatment and annual contribution limits may change in the future.
- When funds invest in overseas assets, the value will go up and down in line with movements in exchange rates as well as the changes in the value of the fund’s holdings.
- Where a fund invests in emerging markets, its value is likely to move up and down to a higher degree and more often than one that invests in developed markets. These markets may not be as strictly regulated, and securities may be harder to buy and sell than those in more developed markets. These markets may also be politically unstable, which can result in the fund carrying more risk.
- Where a fund invests in fixed interest securities, such as company, government, index-linked or convertible bonds, changes in interest rates or inflation can contribute to the value of the investment going up or down. For example, if interest rates rise, the value is likely to fall.
- Where a fund invests in derivatives as part of its investment strategy, over and above their use for managing the fund more efficiently, under certain circumstances, derivatives can result in large movements in the value of the fund. The fund may also expose itself to the risk of the issuer of the derivative not honouring their obligations, leading to losses.
- Cash/Money Market Funds are different from cash deposit accounts, and their value can fall. Also, in a low-interest-rate environment, the product or fund charges may be higher than the return.
- Where a fund invests in property funds, property shares or direct property, properties are not always readily sellable, which can lead to times when fundholders are unable to ‘cash in’ or switch part or all their holding. Property valuations are made by independent valuers but are ultimately subjective and a matter of judgement Property transaction costs are high due to legal fees, valuations and stamp duty, which will affect the fund’s returns.
- High Yield Bond funds invest in non-investment grade bonds which carry a higher risk that the issuer may not be able to pay interest or return capital. Also, economic conditions and interest rate movements will have a more significant effect on their price. There may be times when these bonds are not easy to buy and sell.
The Financial Services Compensation Scheme
The FSCS exists to protect clients of FCA authorised firms. It covers deposits, insurance, and investments. It compensates individuals who lose money due to their dealings with FCA authorised firms where the firm cannot pay the claims themselves. This is usually because they are insolvent or have stopped trading. The limit of protection varies between assorted products.
A key factor when recommending providers is financial stability. We regularly review this. Any assets they hold for a client are held separately. These assets are ring-fenced from any creditors of the provider.
The same is true for any investment funds we recommend. If the fund manager were to go into default this should not affect the underlying assets of the fund. The FSCS would only come into play if the manager was negligent and could not pay the claims arising from this. The FSCS would cover the outstanding compensation up to £85,000 per person for each fund manager. They do not pay cannot claim compensation just because the value of an investment falls.