Pension tax changes

1. Pension tax changes • What are the new rules? • Is there anything which high earners can do to protect themselves from the impact of the changes?

2. Two major changes to tax-privileged pension contributions • Annual Allowance (i.e. the amount of additional pension you can accrue each year) is reduced from April 2011 • Lifetime Allowance (i.e. total aggregate value of your tax-privileged pension pot) is reduced from April 2012

3. Annual Allowance from 6 April 2011 • Annual Allowance is currently £255,000 • Frozen until at least • Looks back (see below) Will be reduced to £50,000 2015/16 3 years

4. Annual Allowances: tax due on the excess • Taxed at your highest rate of marginal income tax • Collected through self-assessment, rather than PAYE, or by an adjustment to the pension when it becomes payable • Liability measured over the pension scheme year (“pension input period”) • For USS and NHS schemes this is identical to the tax year (April to March), but necessarily co-incident with the tax year for other schemes

5. Calculating the annual pension accrual (1) Defined Contribution schemes: including money purchase employer’s schemes, (e.g. Friends Provident scheme for IC Consultants), Self-invested Personal Pensions (SIPPs) and money purchase Additional Voluntary Contributions (AVCs) eg through Prudential • Actual Employer contributions during the year [=nil for AVCs] + • Actual Employee contributions during the year • Any increase in the value of the underlying investments is disregarded for these purposes

6. Calculating the annual pension accrual(2) Defined Benefit schemes: (e.g. final salary) such as USS and NHS • Calculate the increase in pension over the year, i.e value at end, minus value at start • If you make “added-years” additional voluntary contributions, these should be included in the above calculation (as an increase in the pension value, not the cash cost to you) • Index the opening value (start of year) using Consumer Prices Index (CPI) • Multiply the increase in pension by 16 • Ignore deferred pensions (eg frozen pensions accrued under former employers to which no further contributions are being made)

7. What is the resultant tax liability? • Defined Benefit pension accrual (above) • + • Defined Contribution (money purchase) cost (above) • Less: annual allowance of £50,000

8. Tax payable on the excess • The excess is taxable at your highest marginal rate • But liability is substantially mitigated by the three-year carry back rule (see below)

9. Worked example : DB scheme • Member of USS final salary scheme, accruing 1/80th for each year of service • 30 years service at start of the year • Salary of £150,000 at start of the year • Receives a salary increase to £160,000 during the year • Inflation (CPI) of 2% • No AVCs or other pension accruals during the year • For simplicity, the lump sum of three-times annual pension has been ignored

10. Calculation • Start year : 30/80 x £150,000 = £56,250 • Start year indexed : £56,250 x 1.02 = £57,375 • End of year: 31/80 x £160,000 = £62,000 • Pension increase : £62,000 - £57,375 = £4,625 pa • Value of increase for HMRC purposes: • 16 x £4,625 = £74,000 • Taxable benefit : £74,000 - £50,000 = £24,000 • Tax at 50% = £12,000 • However, the employee received no inflation-busting pay increases in the previous three years, so has unused allowances to offset. May be able to reduce tax to zero. An online modeller has been promised by USS

11. Who will be affected by the reduced Annual Allowance? • Employees with long service who receive pay increases greater than the cost of living are likely to breach the Annual Allowance

12. Breach of Annual Allowance - assumptions The above graph assumes:- • a final salary scheme with an accrual rate of one eightieth for each year of service • a lump sum equivalent to 3 times pension • No money purchase AVCs, SIPPs or other pension arrangements outside the main scheme

13. Annual Allowance mitigation – the three year rule • Employees who breach the Annual Allowance in any given year may utilise unused allowances for up to three previous years • At April 2011, employees are deemed to have allowances of £50k a year for 3 prior years

15. Deferral of the excess tax on Annual Allowances • Out to consultation (ended 7 January – outcome not yet published) • Proposed that the initial element is taxed immediately – perhaps £2k to £6k

16. Deferral process • Tax payer can apply to HMRC on the self-assessment return to defer the remainder • The deferred tax is collected by the pension scheme at the time of pension payment

17. Lifetime Allowance • Reduced to £1.5m from April 2012 (currently £1.8m) • Frozen until at least 2015/16 • Crystallised at point of retirement • Protection for individuals whose pension pot already exceeds £1.5m at April 2011. • Special rules for partial retirements and early drawdown of pension benefits (see below)

18. Tax payable on excess over Lifetime Allowance • Paid by employee on draw-down of benefits • Rate of tax on the excess (this has not changed): • Lump sums: 55% • Income: 25% on top of the individual’s marginal income tax rate

19. How to calculate your Lifetime Allowance • 20 times the actual pension payable on retirement under Defined Benefit schemes (eg USS or NHS) • Plus the value of the tax-free lump sum • Plus the actual accumulated monetary value of any money purchase (defined contribution) scheme, including AVCs and SIPPs [this value includes increases in the values of the underlying investments after you have made your contributions] • This calculation also needs to be done for any deferred pensions from former employers, and the whole lot summed together

20. Taxation of lump sums on death in service, and dependants’ pensions • Maximum tax-free cash of £1.5m (as for Lifetime Allowance) • Any excess taxed at 55% • Dependants’ pensions not affected

21. Who will be affected by the Lifetime Allowance change?

22. Lifetime Allowance limit will potentially impact • Long serving employees earning more than £130k • But until 2006, for many members the pension contributions were capped, so pension pots may not be as large as is suggested by the graph above

23. What if I’m already over the Lifetime Allowance? • Apply to HMRC for personal protection • If your pension savings will be above £1.5m by April 2012; or • If you expect investment growth will cause them to exceed that limit thereafter without any further contributions • Written application to HMRC on the prescribed form by 5 April 2012 • The excess tax charges on the Lifetime Allowance will not apply • But you will then be de-barred from making any further tax-privileged pension contributions • (There is a complex issue surrounding continuing with non tax-privileged contributions, which depends upon which scheme you belong to. Please take advice if you are in this situation.)

24. Special rules for partial draw-down • From April 2011, USS members over 55 will be allowed to draw between 20% and 80% of their pensions whilst continuing in pensionable employment, provided they reduce their hours by between 20% and 80%. • Maximum of two flexible retirements before drawing the entirety of benefits on the third occasion • Actuarial reduction will apply to partial draw-down • Each draw-down will be expressed as utilising a percentage of your Lifetime Allowance, and when the total of these exceeds 100% the excess tax charge will kick in

25. How will career average pension accrual affect things (i.e. the new “CARE” proposal for new joiners to USS)? • It will tend to make it less likely that the Lifetime Allowance limit is breached, because the pension payable will tend to be lower • It will tend to make it less likely that the Annual Allowance is exceeded when significant pay increases are awarded later in the employee’s career • It will make the calculations harder

26. Special cases • The Government intends to exempt ill-health retirements from the Annual Allowance regime. If retirement on grounds of serious ill health occurs, any increase in pension arising in the year of retirement will fall outside the Annual Allowance • No exemptions will be made for redundancy. If part of a redundancy payment is commuted into a pension contribution exceeding £50k, the Annual Allowance excess charge will potentially be triggered, unless it is possible to use the three year carry forward rule to utilise unused allowances from prior years.

27. What is the overall effect of the new arrangements • Maximum tax-free lump sum on retirement remains at 25% of the pension pot • The Government has effectively limited the size of tax-privileged pensions to • An annual pension of £75k; or • An annual pension of £56k plus a lump sum of £325,000 • The annual allowance regime is intended to encourage steady accumulation of pension savings throughout an employee’s working life, rather than a sudden rush for the finishing line at the end of their career.

28. Is there anything that Imperial can do? • Until we have guidance from USS and NHS it is difficult to offer clear advice to senior staff • Options might include:- • For employees due to receive pay awards greater than CPI which would result in breach the Lifetime Allowance, we could consider paying in the form of non-pensionable annual bonuses • For employees receiving substantial pay increases late in their career, it might be possible to spread the increase over several years in order to avoid breaching the Annual Allowance

29. Is there anything which individuals should consider doing? • You should review AVCs, SIPPs and any other private arrangements which you might have. • If:- • your earnings are between £50k and £255k and • your pension pot is currently well short of the lifetime allowance (and is unlikely to hit it through normal contributions before you retire) there is now a final opportunity to make substantial AVCs before 5 April 2011

30. AVCs and SIPPs review – part 2 • Conversely:- • if you are already making regular AVCs, and your total pension pot is growing on a trajectory which will exceed the lifetime allowance by the time you retire, you should consider suspending your AVCs. The excess tax you will pay at retirement will probably exceed any tax savings you can make now.

31. Should I leave the pension scheme? • Almost certainly not • The leverage provided by the employer’s contribution (£2 for every £1 you paying yourself) makes it worth staying, even at the cost of an extra tax bill

32. How is HMRC notified? • Primary responsibility is with the employee, via their self-assessment return • No need to tell HMRC if an employee’s pension savings are • Below the £50k annual allowance; or • Above the £50k allowance, but covered by unutilised allowances from previous years • From April 2013, pension schemes will be obliged to send a statement to any member whose savings exceed the annual allowance • However, you may be a member of more than one scheme, or have AVCs outside the main scheme, so the responsibility to sum up all pension accruals, and report to HMRC is yours

33. Sources of further information • The Government’s consultation document and summary of responses is at:- http://www.hm-treasury.gov.uk/consult_pensionsrelief.htm • HMRC’s web-site contains draft guidance:- http://www.hmrc.gov.uk/pensionschemes/annual-allowance/index.htm on the assumption that the Government’s proposals pass into law.