Government changes to the annual allowance and lifetime allowance for pensions: practical advice

3 November 2010

What is changing?
The government announced in October 2010 that, from 6 April 2011, the annual allowance ("AA") for tax-privileged pension saving will be reduced from £255,000 to £50,000 and that from April 2012 the lifetime allowance ("LTA") will be reduced from £1.8million to £1.5million. The reduced AA applies to defined benefit ("DB") and defined contribution schemes.

DB accruals will be valued by a flat-rate factor of 16, after being indexed according to the rise in the consumer prices index ("CPI") the previous September. The use of the single factor means that the AA as applied to DB members effectively becomes a limit on the annual amount of the new tax-privileged pension which a member can accrue per year. It will mean that older workers will be able to accrue more valuable benefits than younger workers. Whether this will be challenged as discriminatory practice under the Equality Act 2010 is something we will be monitoring.

From 6 April 2011, tax relief on pension saving will continue to be available at a taxpayer's marginal rate, including in relation to income taxed at the additional rate of 50%. But the annual allowance tax charge on pension saving that exceeds the reduced annual allowance (currently set at 40%) will be tailored to recoup the relief given.

There is a three year "carry forward period" for the AA and an exemption from the AA test for ill-health early retirement and for deferred members. This means that deferred members will be exempt from tests against the annual allowance (to the extent revaluation of their benefits does not exceed CPI inflation), as will individuals with less than 12 months to live who commute their benefits in full.

To prevent individuals who would typically have pension contributions below the AA, but who exceed it in a single year ("accrual spike"), from facing a tax charge as a result, the government has decided that individuals will be able to carry-forward unused annual allowance from up to three previous years, to offset against contributions in excess of the AA in a single year. This facility will be automatic, so individuals on incomes below £100,000 who are not already within self-assessment will not have to complete a tax return to benefit from it. Carry-forward will be available against an assumed AA of £50,000 (with revaluation of DB accruals to reflect the new factor 16 and uplifts of opening value) for the tax years 2008-09, 2009-10 and 2010-11 to enable individuals affected in the first years of the regime to benefit from it.

Why is the government making these changes?
The cost of tax relief net of income tax paid on pensions doubled under the last Government to around £19 billion per annum by 2008-9. These proposals will save the Government having to pay income tax relief amounting to £4 billion per annum. The proposals are also less complex. The reforms are a departure from the previous government’s pension plans which would have involved a high income excess relief charge applying to contributions or accruals by individuals with annual incomes exceeding £150,000.

Government Actuary’s Department ("GAD") advice
The GAD recently issued a technical bulletin which provides practical advice on what DB scheme managers, employers and individuals should consider doing in order to prepare for the changes, including:

Scheme managers

• Consider the merits of amending aspects of scheme design by deed of amendment or otherwise. This may be necessary in order to deal with necessary changes to the definitions of final pensionable pay, caps on accrual and so forth. Many schemes have already incorporated effective limits into their governing rules. But the government warns it will take steps to counter avoidance activity such as extending a "smoothing period" past the date on which an individual's employment ends;
• Inform members about the changes to LTA and AA. Schemes will be obliged to provide members whose pension saving exceeds the annual allowance with a "pension savings statement" showing their pension input amount within six months after the end of the tax year. But if a member requests this information, the scheme will have to provide the statement by the later of three months from the request or six months from the end of the relevant tax year;
• Examine new processes that will calculate members’ Pension Input Amounts ("PIA" – the deemed value of the new pension earned during the year, for AA purposes);
• Ensure that there will be a communication process in place that will effectively communicate details of PIAs to members within the prescribed deadline, including retrospective figures back to 2008/9;
• Check to make sure that there is a process in place that will identify those early retirements which qualify for exemption from the AA on grounds of ill-health.

Employers

• 
  Consider which employees might be directly affected by the changes to AA and LTA and any alteration to their remuneration strategy that may be necessary, plus the impact of the changes on the wider pension strategy of the organisation;
• Reconsider the use of Employee Benefit Trusts and Employer-Financed Retirement Benefit Schemes;
• Review processes to provide pension administrators with critical member data to the new deadlines. Employers will be required to provide information to schemes about employees' pensionable pay and benefits and length of service in a DB scheme by 6 July each year;
• Along with the scheme managers, consider amending aspects of scheme design. In the employer’s case, this will be in order to help minimise he risk of individuals facing large one-off increases in pension accrual;
• Consider impact of changes on redundancy terms.

Employees or workers

• Consider the current level of pension savings and the impact of the reduced AA on regular pension saving, especially for individuals who are saving in multiple schemes;
• Consider impact of reduced LTA;
• Consider the need (if any) to complete self-assessment returns from 2011/12, if exceeding AA, and claiming the benefit of carry forward provisions.