On 17 December 2002, the UK government published its Green Paper entitled "Simplicity, security and choice: Working and saving for retirement." At the same time, the Inland Revenue and the Treasury issued a separate but allied consultation document entitled "Simplifying the taxation of pensions: Increasing choice and flexibility for all." The deadline for comments on the Green Paper is 28 March 2003 and for the Inland Revenue consultation document the deadline is 11 April 2003.
With pension fund values so low and an aging population, pensions are a political hot potato. The government’s response, which has been largely to deny the widespread perception that there is a crisis which requires a revolution in pension provision in the United Kingdom, has been seen in many corners as somewhat inadequate. However, it is difficult to see what the government could have proposed. Forcing people to save for their retirement, which many have been suggested as the only sensible solution, would no doubt prove to be, at the very least, a politically courageous decision.
There is very little that is radical in the Green Paper itself, but the Inland Revenue document contains a number of interesting proposals. In particular, the new limits would be of great value to high earners. The earnings cap (of £97,200) on which the limits are currently based for the majority of high earners prevents them from making contributions as much as they would like, especially later on in their careers. The new annual limit allows for relatively large cash injections. Against this, however, the imposition of a total lifetime limit on pensions saving would have to be set which may prove to be too low.
Informed Choice, Not Compulsion (Yet)
The government currently has no plans to require compulsory contributions on the part of either employees or employers in the provision of pensions. It has merely proposed that it will enable employers to make scheme membership a condition of employment, subject to certain exceptions, for example, where the employee is already contributing to a personal or stakeholder pension.
The Green Paper acknowledges that the voluntary approach to saving will need to be kept under review and provides for the establishment of an independent pensions commission to report regularly on trends in long-term saving and make recommendations on whether a case emerges for introducing compulsion.
The Inland Revenue consultation document proposes a wholesale simplification of the current tax treatment of pensions by replacing the existing eight regimes with a single set of rules, which would apply to all types of schemes: occupational, personal and stakeholder. These new rules would come into effect on "A-day," which is currently (rather optimistically) proposed as 5 April 2004, and all pension savings after this day would be subject to the new limits. Pension savings and rights accrued before A-day would be valued and protected with indexation, but not aggregated with post A-day accruals. Contributions to schemes after A-day within the new limits will benefit from full tax relief, including relief from national insurance.
An important implication of the introduction of the lifetime and annual limits is that a person will be able to contribute to more than one pension arrangement simultaneously after A-day, provided that he or she stays within the overall limits. This is a welcome relaxation because, currently, this is only permitted in certain circumstances.
Lifetime Limit (Fund Value)
The current limits on annual pension contributions and final benefits (including the earnings cap) are to be replaced by a single lifetime limit on the total amount of pension savings on which tax relief will be granted. It is suggested that this limit will initially be set at £1.4 million and, thereafter, indexed to keep pace with inflation. The real value of the £1.4 million limit will be, therefore, gradually eroded if salaries continue to increase faster than inflation (as has always been the case historically). Any pension savings over the lifetime limit will be subject to tax at a standard 331/3 per cent rate. The pension scheme will be responsible for policing the lifetime limit. This might be extremely difficult if individuals have multiple arrangements.
Annual Limit (Contributions and Growth)
In addition, there will be an annual limit of £200,000 on the value of inflows to each person’s pension savings, again indexed to inflation not salary growth. This annual limit will be enforced through the existing self-assessment system so income tax will be charged at an individual’s marginal rate on any employer or employee contributions made (in the case of a money purchase arrangement) or on any increase in value in the defined benefit (in the case of a final salary arrangement) in excess of the annual limit in any given year. Actuarial tables will be published to allow the valuation of increases in defined benefit pension rights.
Policing and Regulation
The existing requirement to obtain Inland Revenue approval to occupational schemes will no longer be necessary because the "policing" under the simplified tax regime will be done through the self assessment system, i.e., in individuals’ tax returns. Instead of approval, it is proposed that a system of registration be introduced, similar to that used for ISAs. This is a major change.
The Green Paper acknowledges that the Occupational Pensions Regulatory Authority (OPRA) is given only a reactive role under the current legislation and, therefore, proposes setting up a new regulator to act alongside the Financial Services Authority (FSA). Like OPRA, the new regulator would be funded by a levy on schemes. Unlike OPRA, it would be a proactive body and its investigative effort would focus on schemes in which there is a higher risk of fraud, bad governance or maladministration. It would, therefore, have powers enabling it to anticipate problems, rather than only to respond to them after the event.
Retirement Lump Sum
The ability to take a tax-free lump sum on retirement will be retained and, in the case of members of an occupational pension scheme, there could be a significant improvement in that the maximum amount of the lump sum will be increased to 25 per cent of the value of that person’s pension fund (under current rules, the limit is 3/80ths of final remuneration for each year of service up to 40 years or 2.25 times the initial pension). This new rule would more effectively reflect the current rate of employee mobility.
Normal Retirement and Minimum Benefit Age
The minimum benefit age (i.e., the age at which a person may start drawing retirement benefits) is to be raised from 50 to 55 by 2010. The government is open as to whether this change is implemented under scheme-specific arrangements put in place by schemes themselves or by a prescribed phased rise in the age from A-day to 2010. The concept of a normal retirement age is also to be abandoned for the new tax regime. This is, however, (with some regret) subject to the retention of the rule which obliges a person to purchase an annuity with his pension savings or draw on benefits under a defined benefit scheme by age 75. It is hoped that this rule will be removed or at least relaxed after consultation.
Scheme-Specific Funding Standard
The minimum funding requirement (MFR) introduced in 1997 has now been largely discredited, and the government announced in 2000 that it would be abolished. The Green Paper sets out the proposals for its replacement by a long-term, scheme-specific funding standard. Under this new regime, trustees and their advisers would need to take a view on the proper funding and investment strategies of the scheme in light of the scheme’s own circumstances and those of the sponsoring employer. There are several key points.
A full actuarial valuation would be required at least every three years, using a funding method decided by the trustees with the agreement of the employer and based on the advice of the scheme actuary. This broadly presents a return to the pre-MFR practice. Trustees would be required to agree to a statement of funding principles with the employer, based on the scheme actuary’s advice. This would set out the scheme’s strategy for funding its pension commitments and for correcting any deficits and would have to be made available to members. This is not very different from what happens under MFR.
The schedule of contributions would set a contribution rate determined partly by the actuary’s findings as to the scheme’s funding position, partly by the scheme’s valuation method and partly by the new statement of funding principles.
The scheme actuary’s duty of care to scheme members would be clarified in a new actuarial guidance note, with statutory backing. There is a risk here that actuaries may become over-cautious and force schemes to wind up in order to protect themselves from claims when this is not absolutely necessary.
If the trustees and the employer were unable to agree a statement of funding principles or if the employer were to fail to pay the sums specified in the schedule of contributions, then the trustees would have power either to freeze the scheme or to wind it up altogether, which is exactly what the government is trying to prevent. In addition, like OPRA, the new regulator would also have extensive powers to impose sanctions for noncompliance, including fining the employer, appointing an independent trustee, removing trustees or freezing or winding up the scheme.
The drastic powers which these proposals give to trustees could in some cases put trustees, employers and actuaries in a difficult, and often polarised, position (for example, where the employer has real financial difficulties in being able to agree to the proposed statement of funding principles advised by the actuary). The replacement of the MFR is to be welcomed, but the enforcement of the scheme specific funding requirement needs more consideration.
The government wants to increase members’ confidence in the security of their benefits if their scheme is wound up and, therefore, proposes in the Green Paper a number of changes in the regulations applying both to solvent and insolvent employers who wind up their pension schemes.
Where an insolvent employer owes a statutory debt to the scheme as a consequence of its underfunding, the debt ranks as unsecured and will, therefore, rarely be recovered in full, since preferential and secured debts owed by the employer will have priority. The Green Paper invites views on possible changes here, recognising that there is a careful balance to be struck between the potential impact on business and the need to protect employees, since, for example, companies would no doubt find it more expensive to raise capital were secured creditors to lose their priority over pension liabilities.
The Green Paper also suggests the following possibilities for the "pooling" of risk in addition to strengthening the existing statutory compensation scheme, which covers cases of fraud or dishonesty: a centralised arrangement or "clearing house" into which members could transfer the funds attributable to them on winding up. Economies of scale might then enable the clearing house to buy a more favourable annuity on their behalf than would otherwise have been possible or an insurance scheme (such as a central discontinuance fund) enabling members to be confident of receiving their benefits should their employer become insolvent with the scheme in deficit.
Changes were recently introduced to the method of calculating an employer’s statutory debt to an underfunded scheme when it is being wound up, so where the employer is solvent the debt must cover the full buyout costs in relation to pensions in payment and pension increases. The Green Paper invites comments on proposals to extend this requirement, either to also cover the buyout costs for those nearing retirement or, alternatively, to enable a full buyout for all members.
The present statutory order of priorities, which governs the distribution of scheme assets on a winding up makes no distinction between the scheme’s young active members and those on the verge of retirement. The Green Paper suggests upgrading the statutory priority level of those approaching retirement age or basing the level of protection on the number of years that the individual has been contributing, regardless of his age.
Another issue is that younger members can presently "jump the queue" ahead of older members by opting for early retirement shortly before winding up starts. This will often be a well-paid senior employee, whose higher pension entitlement could have a significant impact on the benefits eventually received by other members. The Green Paper invites views on proposals that pensioners who have retired during the 12 months before winding up should only have priority in relation to their first £30,000 of annual pension or that the principle be extended to all pensioners (not just those who have recently retired), so it becomes a matter of members with smaller pensions being better protected than those with larger benefits, regardless of whether the better-off pensioners have jumped the queue.
Immediate Vesting and Small Transfers
Pension schemes are currently required to provide pension benefits for early leavers only if they have completed at least two years of qualifying service. Schemes have the option to allow vesting at an earlier stage; however, this is not a mandatory requirement. The introduction of compulsory "immediate vesting" proposed in the Green Paper would require schemes to provide pension benefits for all early leavers, regardless of length of service.
The disadvantage of immediate vesting is that some schemes would have to administer many more small deferred pensions for early leavers than they do at present. To ease this burden, certain stakeholder schemes would be established as "safe harbour" products to which these small benefits could be transferred. Members would need to be advised of the proposed transfer before leaving pensionable service and given six months in which to object. The Green Paper suggests a maximum of either £7,000 or the benefits arising from five years’ pensionable service for such "small transfers."
Section 67 of the Pensions Act 1995 protects accrued rights by requiring an actuary to certify formally that any proposed amendment to a scheme would not adversely affect any member in respect of those accrued rights, unless the members have consented to the amendment. The wording of Section 67, however, is unnecessarily restrictive and produces some surprising anomalies. It can even prevent amendments which are really in the members’ interests.
The Green Paper proposes that the wording of Section 67 should be clarified and schemes should be allowed to make changes provided that this does not affect more than a certain percentage limit (say 5 per cent) of member’s accrued rights. And if there is a reduction in accrued rights, the rights removed must be replaced by something of actuarially equivalent value.
The government is considering the imposition of a formal requirement on employers to consult their employees or employee representatives (or both) before making changes which might affect benefits relating to future service. Although an additional restriction for employers on the basis of current law, this move would represent a codification of best practice.
Because the requirements of Transfer of Undertakings Protection of Employment (TUPE) do not generally apply to occupational pension schemes, business transfers in the private sector (as opposed to share sales) often result in employees having a different type of pension arrangement for service following transfer from that which they had beforehand. Most controversial are those circumstances where employees are transferred from a final salary scheme to a money purchase arrangement in respect of their future service.
The Green Paper suggests that the new employer might be required to pay a particular level of contribution for future service and invites comments on what this level should be where the new employer provides a group personal pension or stakeholder scheme. Where the new employer provides a money purchase occupational scheme, the Green Paper suggests that the contributions be comparable to those paid by the old employer. It is not clear why there should be such a difference in treatment between occupational and other types of money purchase arrangement.
It would remain open to the new employer to later change its pension arrangements, including its own contributions to them, if this became necessary for reasons unrelated to the transfer itself. This issue is not new; the government has consulted on TUPE before but has not found any clear solution because of the wide variety of circumstances of business transfers. It is not anticipated that there will be any move forward on TUPE at this time.
New Reference Scheme Test
A new, simpler reference scheme test is proposed for contracted-out defined benefit schemes, which would set an annual accrual rate of 1 per cent of pensionable salary (instead of the current 1/80th), change the earnings calculations from average qualifying earnings in the last three years to average career earnings, use the pension age that is stated in the scheme rules (but no later than 65) and reduce from 90 to 80 per cent the proportion of pensions that must be expected to be as good as the reference scheme benefits in order for a scheme to pass the test.
The Green Paper also invites views on the possibility of converting past service reference scheme test benefits into actuarially equivalent benefits under the new test; ways of easing the complexities of administering pre-6 April 1997 guaranteed minimum pensions; easing the rules relating to the transfer of contracted-out rights between schemes; introducing more freedom as to the date when contracted-out benefits become payable; and removing the rules preventing payment of a lump sum from contracted-out benefits.
Real simplification would come in the form of the abolition of the entire contracting-out regime. However, the government has not at this stage had the courage to take such a radical step.
It is proposed that all schemes should be required to have one-third of their trustees nominated and selected by members (except those types of scheme which are exempt under the present legislation), but with no provision for the employer to opt out. This requirement would be backed up with guidance issued by the new regulator on good practice for nomination and selection arrangements. These requirements may be subject to a further condition that the nomination and selection arrangements be "fair and open." The new regulator would have a role in deciding whether this future condition was satisfied.