Tax changes spur high earners to reconsider pensions

Tax changes for high earners will affect their pension plans and have sparked a search for more tax-efficient investments, says Sarah Coles

According to the Institute for Fiscal Studies, the UK now owes 53.8% of its national income. So it is hardly surprising the former Labour government announced big income tax changes to try to balance the books. The changes mainly affect higher earners and amount to a major attack on pensions for this group.

Conservative/Liberal Democrat’s The coalition: our programme for government, published last month, contained no mention of these issues affecting higher earners. But, it is possible its view of these tax changes could be addressed in the Budget on 22 June.

John Wilson, head of research at JLT Benefit Solutions, says: “The state of the public finances means that the [current] government has higher priorities than pensions. We can expect these pension tax changes to come into effect. It means that employers cannot afford to wait before taking action.”

50% tax rate arrives

The first tax change affecting high earners came into effect in April this year with the introduction of a 50% tax rate for those earning over £150,000, which hit about 300,000 people in the UK. At the same time, there were changes to the personal tax allowance, which is now gradually eroded by £1 for every £2 earned over £100,000.This results in an effective 60% tax charge for earnings between £100,000 and £112,950.

Traditionally, one of the ways higher earners have made their reward package more tax-effective is to transfer some of it into their pension. However, the government has introduced a raft of rules to put a stop to this, known as anti-forestalling legislation.

This applies to staff earning over £50,000, including the value of pension contributions. Anyone earning over £130,000 may also fall under the new rules if their pension contributions are significant. Essentially, the new rules prevent staff from making big changes to the amount they pay into their pension.

Meanwhile, the lifetime allowance has been frozen for six years, and as Nigel Roth, worldwide partner at Mercer, says: “Who knows how many more years it could be frozen for?”

More changes to come

Wilson adds: “This has already had a major effect on higher earners, but there are more changes to come. Most notably, in April 2011 there will be changes to the tax relief on pensions. Those with gross incomes of £180,000 or more will have tax relief restricted to basic rate on all pension contributions. For those with gross incomes of between £150,000 and £180,000, the relief will be tapered.”

This will have a huge effect on pensions for higher earners, who will pay 30% tax on contributions. Then, when they receive the income, they will be taxed again. If they have higher incomes in retirement, they will be taxed at 50% at this stage. Mick Calvert, head of financial planning at Towers Watson, says: “In the case of defined benefit pensions, it is crazy. People will be paying tax on something that may eventually not be paid out.”

In theory, because the changes will largely affect employees, employers do not necessarily need to take any action around them. But Graham Cooke, a senior consultant at JLT Benefit Solutions, says: “These higher-paid employees may be senior, key individuals, and if employers do not act now, they face the potential of those employees opening huge tax bills next April and saying ‘why didn’t you prepare me for this?’. We are finding most employers want to do something for higher earners.”

The question is, what can be done? Calvert says for those earning around £150,000 or just over, the right answer will depend on many things, including their expected marginal rate on pensions in payment. But for the top earners, it will rule pensions out of the running. “For anyone earning over £180,000, pensions will be a non-starter,” he adds.

Pay in cash

The most simple, and common, alternative available to employers is to pay in cash. “A lot of organisations will make available a salary supplement, and individuals will have to weigh up whether they should stay in the pension or take the supplement,” says Mercer’s Roth.

“It is difficult to evaluate because there are so many moving parts and who knows what future taxation will look like?”

In response to the changes, some benefits consultancies and providers, including Mercer and JLT Benefits Solutions, have launched modelling tools.

Another alternative is a mechanism whereby the pension scheme can be used to pay the tax. “Instead of the individual paying the tax bill, where it is over £15,000, they will have the right for the pension scheme to pick up the tab and reduce the benefits, although we await guidance on the terms,” says Roth.

Other options include an unfunded, unapproved promise, which is not caught by the new rules. But Calvert warns:

“There is a covenant issue in terms of the pension promise and how it is covered in future. There are concerns for the financial director as to the liabilities on the balance sheet and the covenant of a 40-year income. The lack of security is a concern.”

Efurbs not covered by rules

Another option is to use employer-financed retirement benefits schemes (Efurbs), which are not covered by the rules. The tax treatment of these is deferred until later, so the longer it stays invested, the more chance there is there will be a change in the economic picture which brings tax rates down. Calvert has a number of clients looking to set up Efurbs. But he points out: “They are expensive to set up and to administer and an individual has to pay administration after retirement. When you talk it through with an individual, they would rather have the cash.”

In April this year, taxation within an Efurb went up from 40% to 50%. This year’s Budget also increased the range of anti-avoidance measures for options that may have provided a solution, such as employee benefit trusts (EBTs) and joint stock ownership plans.

Under the former Labour government, the Treasury announced it intends to take action to tackle tax avoidance through the use of trusts. Roth says: “Many potential solutions are likely to be clobbered by anti-avoidance legislation. The technical guidance indicates that if people look to replace pensions with something else, the government will treat that as taxable. It has not given more detail, but that threat is there if organisations are thinking of a more esoteric solution.

“Some of the bigger accounting firms are banging the drum for things like Efurbs and EBTs, but a lot of companies that invest in them now may find they only work for a year and then they catch a cold, so think before you embark on launching a scheme that may only pay over a limited shelf life.”

Unfunded promise or offshore trust

The fact is, the right solution will differ for each employee. “Employers are looking at offering choice,” says Calvert. “Not just the cash, but also the option of an unfunded promise or an offshore trust. But where a choice is given, individuals need some guidance around those options.”

Staff also require a good understanding of the implications of taking cash alternatives. Cooke says: “Employers should be offering employees assistance in understanding how they can best use that cash to fund their retirement.

But many employers are still nervous about offering advice. “There is an appreciation that people are unaware of what is happening and what they need to do, so employers may need to give education and support in that regard,” says Roth.

Employers and employees need to make preparations, and would be well advised to do so now, Roth says.

“Whereas the standard advice in saving for pensions is to do little and often, the advice now may well to be to go crazy in the years before [employees] become high earners and chuck as much into the pension pot as possible.

[They would then] have a full pension pot by the time they become higher earners, and then they can look to other investments.”

At that point, employers may look at offering employees access to a variety of other products.

Calvert says: “They are talking about a range of products, such as corporate Isas [individual savings accounts]. Some providers are well down the line on that. Some kind of employer-sponsored scheme or negotiated terms might be attractive.”

HMRC-approved share schemes

Others will look to alternative forms of reward. For example, there may be a interest in HM Revenue and Customs-approved share schemes, where the proceeds are taxed at 18% as capital gains. However, this could change as a result of the new government’s programme, which set out its intention to seek a detailed agreement on taxing non-business capital gains at rates similar or close to those applied to income. The government has yet to decide whether shares held through approved plans will be classed as business or non-business assets.

Michael Whitfield, chief executive of Thomsons Online Benefits, adds that there may also be interest in options, such as enterprise management incentives and other investments such as contracts for difference, spread betting and premium bonds, on which there is no tax to pay.

Overall, there are several measures employers can implement for high earners As Roth says: “There is the hope that the carnage affecting high earners this year and next year will blow over in the fullness of time and once the finances improve, the legislation will be less aggressive.”


Salary sacrifice options

  • Those earning (in salary and employer pensions contributions) in excess of £150,000 cannot use salary sacrifice in exchange for greater employer pensions contributions to reduce their salary. HM Revenue and Customs confirmed that when using salary sacrifice to avoid the extra tax, an amount equal to the employer’s pension contribution will count as “relevant income”, which will be taxed.
  • Staff earning over £100,000 affected by removal of the personal tax allowance may find using salary sacrificed pension contributions highly effective. In some cases it will bring their salary down below £100,000 and back into a 40% tax rate. This is particulary useful for those earning between £100k-£112,950 some of whom are paying an effective 60% income tax rate.
  • Salary sacrifice using other tax or NI-free benefits (such as company cars and employee share schemes) still holds some attractions for higher earners because of the potential NI savings.
  • Those selecting tax-efficient benefits (say, through a flexible benefits scheme) will need to carefully check the effect on the taxation of their salary, and their NI contributions.


Is this the end for pensions?

  • There is a question mark over whether pensions will continue to be worthwhile for anyone earning between £150,000 and £180,000.
  • It is generally accepted that for most people earning over £180,000, the perk will cease to hold any attraction.
  • The question is whether, with no benefit to the most senior staff in an organisation, their commitment to a generous pension scheme for other employees will endure.
  • Some predict that a decline in interest in pensions among senior staff will lead to a move down to the lowest common denominator in terms of pensions plan for the wider workforce – to the minimum required under the national employment savings trust [Nest].
  • The National Association of Pension Funds has warned the changes could “destabilise pension saving for lower earners in the company”.