Next April’s £1.5m pensions cap has put the spotlight on how executives top up their pensions, Sue Ward picks through the most tax-efficient alternatives
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With the new pensions tax regime coming into force in April 2006, the rules for unapproved arrangements for highly-paid executives will be replaced by those for non-registered employer-financed retirement benefit schemes (EFRBs). Companies are having to decide how to react to this, and so far at least, cash is king.
However, the amount on offer may not compensate fully for the cost of what employees are giving up. Some people will prefer to stay in their employer’s registered pension scheme and pay the tax penalty.
From April 2006, the current pensionable earnings cap will be replaced by a new lifetime tax allowance (LTA) for an individual’s pension fund, which will be set at £1.5m for the first year and will increase thereafter. Because this is an allowance rather than a limit, staff can build up funds above that if they want, but will then incur high tax charges on the excess. That means a 55% charge if they take the benefits as a lump sum at retirement or 25% if taken as income.
Those whose pension funds are at or above the LTA already, can take out primary or enhanced protection against the new requirements. Primary protection increases the LTA in proportion to the pre-commencement pension rights of the individual, but they may still have to pay tax above that level. Enhanced protection ring-fences the pension fund the individual has built up pre-A-Day completely, but at the price of not allowing any further post A-Day accrual.
Tax approval for pension schemes is also to be replaced by registration. Peter Tompkins, partner at consultants Pricewaterhouse Coopers (PwC), says: “Funded unapproved retirement benefits (Furbs) are going to become very tax inefficient. They will just wither on the vine.”
This means a rethink of top executives’ remuneration packages. Sue Bartlett, senior consultant at Watson Wyatt, who has been advising companies on their strategy, explains: “The company’s role is to decide what to offer senior people, and the individuals’ role is to think about it and act following financial advice.” She has one client that has decided that “the pension is such a small part of senior executives’ total pay, that paying 55% tax on it is no big deal, so it is not going to do anything. But that is the exception.”
More generally, she has found that two strategies are coming out way ahead of anything else. “One is cash; people can come out of the pension scheme and take a percentage of salary as cash. Around two-thirds of [organisations] are offering this. The other third are saying they will offer unfunded pension promises, which are likely to be used by more organisations rather than fewer. They may only make these available, though, to certain people such as existing directors who have a problem with the LTA at A-Day, so the population covered will gradually dwindle.”
After A-Day, the tax implications of unfunded unapproved retirement benefits (Uurbs) are not so different from now. “Nor are unfunded unapproved benefits terribly complicated in concept. One thing companies are looking at, however, is providing some kind of security for the pension promise. It may have to endure 20 or 30 years, and how many organisations would be recognisable now from 30 years ago? So there is the concept of a secured Uurb, which means that the company grants legal charge over an asset to a trustee who is acting for the individual. If the company defaults on its promise, the trustee would spring into action and take over the asset.”
However, creating or continuing an Uurb means facing down the corporate governance activists, particularly the Association of British Insurers (ABI). The ABI’s principles on remuneration state that “companies are not responsible for compensating individuals for changes in personal tax liabilities. With impending changes to pensions taxation, remuneration committees should carefully consider what role will be continued to be played by additional pension accrual as against other forms of remuneration that might more clearly align with shareholder value creation”. The ABI’s investment team has recently been reinforcing this message in their contact with benefits consultants.
PwC recently carried out a telephone survey of its own clients and found three-quarters of them were likely to take the cash route. Robert Ivey, principal at Mercer HR Consulting, however, sees a slightly more varied picture. “What [firms] are doing for the future appears to be driven quite heavily by what they have done in the past in relation to the earnings cap. Those who were capped before might have had a salary supplement, a Furb or an Uurb. Uurbs are popular with those who have had them before, but those who have not are more likely to go for cash. Some organisations are using this as a good opportunity to get out of either Furbs or Uurbs, which can be messy to run. They are planning to make a clean break and so coming up with a salary supplement,” he explains.
But setting the level of this can be a problem. “If you look at each individual and calculate the true cost of providing, for example, thirtieths or forty-fifths of final salary, and turn that into a supplement; then given the age of these guys this creates big figures which look frightening. There are also concerns about disclosing such large numbers as cash. The other thing is that the nature of the deal has changed. Pensions are long-term deferred remuneration, while the supplements are immediate, and so they don’t have [the same] retention advantages,” says Ivey.
Companies therefore are often taking a broad brush approach, asking their advisers to come up with average figures with which they can be comfortable in terms of disclosure, and offering this average amount to anyone who wants to come out of the scheme because they are affected by the LTA. “The figure might be 30%, whereas the true cost for someone in their 50s or 60s might be 50-60%. The company is then telling people they are offering cash, but are not saying it’s a comparable amount, and are explaining that if they want to stay in the scheme and pay tax at the end, it is up to them,” Ivey adds.
As for existing Furbs, Bartlett thinks that generally they will be frozen. “No contributions will be paid in after A-Day, because if you make contributions you risk tainting the pre-A-Day money. Some may simply be cashed out and benefits paid.” According to PWC’s Tompkins, there are some question marks over HM Revenue & Custom’s attitude to this, at least where it would involve altering the retirement age within the terms of the trust. “There is a tendency for organisations not to like paying out something early in the career of an executive, because they want to maintain their retention arrangements,” he warns.
Retirement benefit schemes
These are funded and unfunded, unapproved retirement benefit schemes. Introduced in 1989, such schemes are perfectly legitimate, but do not have the same tax advantages as ordinary approved pension plans. These will typically be designed to sit on top of the approved scheme that covers senior management, replicating the benefits package (still usually on a final salary basis) for the slice of salary that can no longer be treated as pensionable because of the earnings cap. This currently means any salary over £105,600 for 2005-2006, the last year in which it will operate.
HM Revenue & Customs has provided some transitional arrangements for existing Furbs and Uurbs, under Schedule 36 of the Finance Act 2004. Where an employee has been taxed on employer contributions to a Furbs before April 2006, these contributions can continue to be made and the tax-free element of any lump sum will be adjusted when it is paid out. This will take account of any employee contributions and the proportion of the fund taxed under the old rules. Money already in the Furbs at 6 April 2006 will retain its pre-April 2006 inheritance tax treatment, and funds will be apportioned where later contributions are made. There will, however, be no transitional arrangements for Furbs where employees were not taxed on contributions as they were made. Uurbs can be rolled into registered schemes at any time, but if this is done within three months of A-Day, the increase in value of the registered scheme benefits will count only against the lifetime limit, and not the annual allowance.
EFRBs after 6 April 2006
New employer-funded retirement benefits (EFRBs) will be treated like any other taxable benefit. Payments are taxable on the employee on receipt, so employers can only deduct contribution costs against profits when benefits are paid and are chargeable to tax. There is no shelter from inheritance tax. There is no national insurance on payouts, provided these are limited to those that could be paid out of a registered scheme, and so long as employment has ceased. In a funded scheme, investment income and capital gains are taxed at the rate applicable to trusts, which could mean 32.5% or 40% tax. For unfunded EFRBs, firms can provide suitable underwriting for funds and staff pay a benefit-in-kind charge.