Saving for tomorrow

Observers of the chancellor's recent autumn statement will have noticed that he touched only briefly on pensions. However what he said, as always, was of interest - majoring as he did on the somewhat interconnected issues of the tax treatment of pension related death benefits and ISAs. He then followed up with a further announcement on 12 December 2014 about the mechanics of the pensioner bonds which he initially announced in the 2014 budget.

The headline news is that from April 2015 the 55 per cent 'death tax' on defined contribution pension savings will be abolished. The tax on annuity payments to a partner where an individual has died before age 75 will also be removed, and from April 2015, savers will be allowed an additional ISA investment allowance on the death of their spouse or civil partner. Additionally, pensioner bonds are to have very attractive rates of return, perhaps a concession in recognition of the poor rates of interest given by other products for cash savings.

Death and no taxes?

In September 2014, the government announced that from April 2015 the current 55 per cent special lump sum death benefits charge on benefits paid by a registered pension scheme on an individual's death will be abolished.

The new rules have just a single distinction between deaths pre and post age 75:

• If an individual dies before age 75, payments to the individual's nominated beneficiary are free of all tax whether taken as a lump sum or as income. Annuity payments and guarantee payments to a beneficiary on the death of the annuitant are paid tax-free (they are currently subject to income tax at the beneficiary's marginal rate). If an individual dies after age 75, drawdown income payments to a nominated beneficiary are subject to income tax at the beneficiary's marginal rate. Benefits taken as a lump sum will be taxed at 45 per cent in the tax year 2015/2016, but then at the recipient's marginal tax rate (as opposed to the fixed 45 per cent rate) from the tax year 2016/2017 onwards. Similar treatment applies to annuities where the original annuitant dies after the age of 75.

• If an individual dies after age 75, drawdown income payments to a nominated beneficiary are subject to income tax at the beneficiary’s marginal rate. Benefits taken as a lump sum will be taxed at 45 per cent in the tax year 2015/2016, but then at the recipient’s marginal tax rate (as opposed to the fixed 45 per cent rate) from the tax year 2016/2017 onwards. Similar treatment applies to annuities where the original annuitant dies after the age of 75.

If benefits are crystallised or uncrystallised, or paid to a dependant or non-dependant, there is no difference in treatment (in respect of either pre or post age 75 deaths). There are also no restrictions on the level of withdrawals.

These rules apply to all such payments made post April 2015, so they can apply even if the individual died some time before April 2015. However, if the member died before age 75, lump sum payments must be made within two years of the scheme administrator being notified of the death. In addition, unused drawdown funds can be passed down the family. The nominated beneficiary can pass any unused drawdown funds onto a successor on his or her death. The same tax treatment will then apply depending on the age of the first beneficiary at the date of his or her death.

The impact of this on an individual’s lifetime allowance is still unclear.

A new anti-avoidance measure

To prevent abuse of the new flexibilities in drawing pension, a new anti-avoidance measure will be introduced; the Money Purchase Annual Allowance (MPAA). This is designed to prevent widespread recycling once income has been drawn down from the pension. It is relevant to defined contribution or 'money purchase' schemes only. With the various changes and proposed changes in the definition of what a money purchase scheme is, care will need to be taken to check that the scheme is actually a true money purchase scheme.

The MPAA will be set at £10,000 per year from 6 April 2015, and unused MPAA cannot be carried forward. The MPAA will apply to those already in flexible drawdown who currently have no (or very limited) annual allowance. The new annual allowance rules will distinguish between money purchase and defined benefit (DB) accrual. Contributions to a money purchase scheme will be limited to £10,000 but a member may also be able to accrue benefits on a DB basis. This is obviously only beneficial to individuals who still have access to a scheme that provides DB accrual, like a small self-administered scheme (SSAS) or perhaps if there is a public sector connection.

More specifically, the MPAA applies:

• when income is taken from flexi-access drawdown (FAD). All new drawdown plans taken out from 6 April 2015 will be FAD, and all pre-April 2015 flexible drawdown will automatically become FAD. There will be no limits on income levels from a FAD, but only 25 per cent of it will be tax-free, subject to the lifetime allowance. The balance can remain invested, be paid as a lump sum, or used to provide flexible income, and the marginal rate of income tax applies. Once any income has been taken, the£10,000 money purchase annual allowance applies (see below);

• when income above certain limits set by the Government Actuary’s Department (GAD) is taken post April 2015 from a capped drawdown fund(CDF). No new capped drawdown arrangements can be set up post April 2015, but existing plans can remain in place. A capped drawdown fund will automatically convert to FAD if an individual’s income exceeds 150 per cent of the limits set by GAD. It will however be possible to transfer existing capped drawdown plans from one provider to another;

• when an uncrystallised funds pension lump sum (UFPLS) is received. This is a new concept; a lump sum drawn directly from uncrystallised pension funds. The term ‘uncrystallised’ means the funds have not yet been put into payment. 25 per cent of each lump sum in this type of arrangement is paid tax-free, and the balance of the lump sum is taxed at the individual’s marginal rate of income tax. Once an UFPLS is taken, the £10,000 money purchase annual allowance applies. Unlike FAD, it isn’t possible to access all of the available tax-free amount in one go and then take flexible income from the rest of the pot. Some restrictions apply to individuals with primary protection, enhanced protection or lifetime allowance enhancement factors affecting their tax-free cash entitlement; and

• when a payment from a reducible lifetime annuity (RLA) (another new flexible option) is taken. It is unclear quite how these annuities will work in practice, but the main principle appears to be an annuity structure that allows an individual to take a greater proportion of income earlier on in retirement, and less in the later stages of retirement. We await further news of when such annuities will be offered to the market. 

The MPAA does not apply in the following circumstances:

• where an individual commences FAD, but doesn’t receive any income, i.e. just takes tax-free cash;

• where an individual is in capped drawdown before 6 April 2015 and does not receive income above 150 per cent GAD after 5 April 2015; or

• when small pots (i.e. below £10,000) are accessed.

ISA tax changes

From the tax year 2015-16, savers will be allowed an additional ISA investment allowance if their spouse or civil partner dies on or after 3 December 2014. This allowance will be set at the value held in the deceased person's ISA on their date of death. The surviving spouse or civil partner will therefore be able to use the additional allowance in relation to their own ISAs, regardless of whether they have actually inherited the funds in the deceased's ISAs. Draft secondary legislation for this change is due to be published shortly.

The government has stated it will continue to consider the taxation of former ISA assets during the administration of the deceased person's estate, and will look to legislate in the next parliament to extend the current ISA tax advantages into this administration period. We wait to see what further changes may then occur.

Pension and ISAs - is there a narrowing gap?

Both ISAs and pensions are tax advantaged savings vehicles, with pensions getting tax relief on the way in and being taxed, to some extent, on the way out, while ISA contributions are made out of taxed income but the benefit is not taxed when withdrawn.

Now there is no requirement to buy an annuity on retirement, defined contribution pension funds are being billed as giving 'instant access' to savings in a similar way to savings vehicles such as ISAs. Given this, we wonder whether the chancellor's announcements on ISAs could indicate a possible future move to amalgamate, or at least further link up these two main tax relieved savings vehicles. One approach would be for there to be a single annual savings allowance that could potentially be spread over both, thereby allowing taxpayers to choose how much they allocate to each.

One of the key differences between ISAs and defined contribution pension arrangements is, of course, that individuals have to be aged 55 or over to access their pension fund, whereas ISAs can be accessed at any time, putting aside the issue of incurring any financial penalties for so doing.

There are already products available in other countries, such as the USA, where the lines between traditional defined contribution pension funds and products analogous to ISAs have been blurred. One example is the American 'IRA' which has several different saving structures within one overall limit.

The fact that tax breaks on pension contributions are given up front can be particularly advantageous for high rate taxpayers. This partly depends on their tax band in retirement, when (aside from the 25 per cent tax-free lump sum, subject to the lifetime allowance) they will pay income tax on their pension at their marginal rate, which may well be lower than the applicable tax relief.

Pensioner bonds

The announcement on pensioner bonds shows there could, in the future, be even more flexibility around pensions, with these bonds appealing to individuals who want to use the cash from their pension savings as constructively as possible. More cynically perhaps, it's just an attempt to win over the powerful grey vote at the next election.

A one-year bond will pay an annual interest rate of 2.8 per cent, and the three-year bonds will pay 4 per cent. Only those aged 65 and over are eligible to invest in the bonds, which are scheduled to be launched in January 2015. Investment will be limited to £10,000 in each bond, making a maximum of £20,000 per individual. These so called 'market-beating' rates are designed to protect pensioners' savings from erosion by inflation (the UK's consumer prices index inflation is currently at a twelve year low) and record low interest rates, and so the rates are, in this sense, a very real reflection of the times.

The government has limited the issue to £10bn, and expects one million pensioners to buy them. They will be sold on a first-come, first-served basis, so it is likely that many pensioners will be disappointed. It is unclear whether these bonds will be on offer longer term (if and when interest rates are again allowed to rise) but their existence may well pave the way for similar offerings from the private sector as the uptake in annuities continues to fall and pensioners look for a variety of financial products that will suit their financial needs throughout the different stages of their retirement.

Post election

With less than 5 months to go until the general election, we did not expect the chancellor to reduce the 40 or 45 per cent tax relief that higher paid individuals enjoy on their pension savings. This type of policy change would have a direct impact on those same middle income earners that the Conservatives will need to win over to remain in government after the election.

That said, who knows what changes there might be to this after the election. There has already been some speculation that the government plans to remove this higher rate tax relief and replace it with a flat tax rate of 30 per cent for all, making pensions less attractive to high earners.

This would; (a) provide a much needed boost to lower income pension savers, many approaching pension savings for the first time through automatic enrolment; (b) restrict the potential impact upon middle and higher income pension savers by not completely abolishing the tax relief they currently enjoy through the 40 and 45 per cent rates; and (c) boost tax reliefs by restricting the amounts of tax currently lost through higher rate tax relief. It would, however, require a complete overhaul of the current legislation and systems, and should not be rushed into.

Whether such a proposal would be implemented will very much depend on who wins the next election, as Labour and the Liberal Democrats are likely to make more radical changes, all of which hinge on the state of the nation's finances.

A last plea

Regardless of which party wins the next election, it's clear we're only just embarking on a series of reforms to our pension and savings system. However, please, could whoever does become in charge, change some of the new pension acronyms to more memorable and meaningful ones? It is hard enough to explain pensions to the educated man or woman in the street (let alone anyone else) without having to talk about MPAAs, FADs, CDFs, UFPLS, RLAs or even the GAD.

Penny Cogher is a partner at
Charles Russell Speechlys