Pensions update

As anyone who has spent even just a few hours involved in pension arrangements will know, the pensions system in the UK is constantly being reformed. No government of whatever hue can seem to resist meddling, usually to no great ultimate improvement, save for those who enjoy unravelling complex puzzles.

Prior to 2004, we had layer upon layer of tax rules, each one more opaque than the last that had built up over the years. The system was simplified with the Finance Act 2004 with the so called 'A-Day Simplifications' which introduced one simple and understandable tax regime. Within two years however, we were already seeing a retreat from simplification which has only gathered pace as the years have gone on.

Major changes occurred following the Pensions Act 2008 and Finance Act 2011, and this government, and no doubt the next, have many more reforms in mind. It is difficult to determine the government's real intentions when mismatches of policies are being implemented.

Automatic enrolment

On one side, the Department for Work and Pensions is encouraging people to save for a pension. 1 October 2012 saw the phased introduction of possibly the most significant reform in workplace pensions for many a year: the automatic enrolment scheme (AE). This imposed a duty on every employer whether large or small, to automatically enrol most of their workers in a pension scheme who are not already active members of the employer's qualifying scheme.

The AE regime only applies to employees classified as a jobholder, [an employee who works in the UK under a contract aged between 16 and 74 and who is paid qualifying earnings, (the threshold for 2013/14 tax year is annual earnings between £5,668 and £41,450), by an employer in a pay reference period]. All jobholders have the right to opt out of this scheme although they will still be re-enrolled every three years whether they want to be or not.

With the AE system, employers face the obligation to pay a minimum pension contribution on behalf of their employees who join the workplace pension scheme. The plan is to ensure that employers who sponsor a defined contribution scheme make contributions of at l'¨east 3 per cent of employees' qualifying earnings. With this type of scheme the eventual benefits are unknown to the employee until retirement. Between the employer and employee a total amount of 8 per cent of the earnings will have to '¨be contributed.

Poor implementation

The biggest problem with AE as I see it is essentially twofold. First, the administration surrounding the opt-out process, and in fact the whole process, is unnecessarily onerous and complex. Just calculating band earnings to work out eligibility requires a degree in higher computing. The number of notices that are required to be given as employees, particularly those on short time or unusual working pattern contracts is a nightmare as they may fall into and out of eligible bands several times in the space of one year.

Secondly, if anyone thinks that an 8 per cent contribution going into a defined contribution pension scheme is going to provide a decent pension at retirement, then I'm afraid they are sadly mistaken and there are going to be an awful lot of disappointed people in a few years' time when this realisation hits public awareness.

I'm not sure I would like to be in the government when that happens. But, and it's a big but, before my dear readers think I'm being unduly negative, let me say that the idea and principle of AE is absolutely right. It's just the implementation that is horribly wrong.

Harvesting tax relief

Outside the AE regime, on the other side, HM Treasury is reducing the incentives to get people saving for their retirement pension by reducing the tax breaks. Even though the government offers generous tax advantages to incentivise employers and employees to join registered pension schemes; For example, the contributions made are tax deductible; contributions made by employers to an employees registered pension scheme are not liable to income tax or NIC; on retirement, part of the employee's benefits may normally be taken as a tax-free lump sum; these forms of tax relief have been targeted as ripe for some harvesting by successive chancellors.

As we know, the A-Day simplifications set up both an annual and lifetime allowance which enabled tax advantaged savings. Originally, the lifetime allowance was set at £1.8 million and was reduced in 2012 to £1.5 million. Consultation currently going through suggests that this will be further reduced to £1.25 million.

This may seem like a lot, but Skandia the insurer has estimated that if someone starts contributing to their pension at age 25, with a retirement age of 65, that's 40 years' worth of contributions. If they invest £509 gross, which equates to just £363 net for a higher rate tax payer, their pension savings could breach the current £1.5m lifetime allowance threshold by the time they reach retirement.

If the limit is reduced even further then the likelihood of this is even greater. "So what?" I hear you ask. What are the consequences if I breach the limits? Actually, the consequences are quite scary. The saver will be penalised with a tax charge of up to 55 per cent on any excess above the limit and that could amount to a very large windfall to '¨the exchequer indeed, which was probably not what was intended after all that careful tax planning advice.

Just to complete the picture, since 6 April 2006, individuals have been able to contribute the amounts they wish to pension schemes. However, personal tax relief can only be claimed on employees' contributions up to the higher of £3,600 or 100 per cent of their UK earnings. Tax relief on the contributions employers make is currently limited to £50,000 in the year which they are made. This annual allowance, which is an annual limit on the increase in value of a person's pension savings in any registered pension scheme, will be reduced to £40,000.

Ugly scheme

Further, unregistered pension schemes are less attractive as the tax advantages have been removed. For example, under the "disguised remuneration" provisions, contributions to an employer-financed retirement benefit are now liable to an income tax charge as deemed employment income and employers cannot claim relief from corporation tax on those contributions. In addition, employers may have to pay NIC's to the benefits paid from this scheme.

Employees will be balancing out the benefits of a pension scheme and the tax benefits to determine whether to stay in an auto enrolment scheme or opt out. Certainly any employee with some form of 'tax protection', often called primary or enhanced protection, should seriously consider getting proper advice before remaining in an AE scheme.

Mixed messages

My message then is perhaps not very attractive. These mixed messages need to be clarified and dealt with. The government must do better to ensure that its departments implement policies which are coherent; if they are intended to benefit society on one hand they cannot then be disadvantageous on the other.

It's not just the DWP and the Treasury of course that are often in conflict. The Treasury is usually at the bottom of most of them to some extent as inevitably the age of austerity butts up against the desire to do better, particularly for the disadvantaged. While policy continues to be driven based on advice from the same 'usual suspects' there will always be a balance to be struck.

The trick will be to get that balance right and to try to avoid the obvious pitfalls that anyone with a couple of adjacent brain cells can see is a mistake. But that's just common sense. Clearly, I'll never make a politician. SJ