PENSIONS - 13.11.2018

Pension pitfalls

Different types of scheme

Not all pension schemes were created equal, so it’s important to understand what sits behind some baffling titles. An occupational pension scheme is one set up under a trust deed and rules.

The means it is run for the benefit of the employees by the trustees, with the employer signing a covenant (a legally binding document) to fund the scheme with the contributions agreed with the trustees. Historically, it was only large employers in the public and private sector who had trust-based pension schemes because of the costs involved, but since 2012 88 master trusts have been created.

A master trust allows multiple employers to share in the cost of one overarching trustee board, so is a much cheaper option for a small employer. The other type of pension offered by employers is contract-based . This refers to an individual insurance contract, so these are personal pensions not occupational pensions even if bundled together as group personal pensions.

Tax relief

Even more baffling is the way that tax relief is delivered by different pension schemes. Relief at source (RAS) schemes have employee pension contributions taken from net pay, net of the standard 20% tax relief that the provider can claim from HMRC for all pension scheme members regardless of their earnings.

Higher and additional rate taxpayers can get the extra tax relief at 40% or 45% via their self-assessment return and an amended tax code.

Net pay arrangement (NPA) schemes, on the other hand, have nothing to do with net pay and everything to do with gross.

The gross taxable pay is reduced by the employee’s pension contribution, so this gives them immediate tax relief through the payroll as it top slices their gross pay. They get automatic relief at their highest tax rate so 45% for some employees (or even 46% for some Scottish taxpayers). However, at the other end of the earnings spectrum NPA schemes deny any tax relief to employees.

Example 1. Jane earns £11,000 per year as a part-time teaching assistant so has been auto-enrolled into the Teachers’ Pension Scheme as she earns over £10,000 p.a. She doesn’t pay tax as the personal allowance is £11,850 so she loses the 20% tax relief.

Example 2. Ian works as a part-time barman, he also earns £11,000 per year and is a member of the National Employment Savings Trust.

This operates RAS, so he doesn’t need to pay the 3% employee contribution that is the statutory minimum for 2018/19; he only needs to pay 2.4%. NEST will claim the 0.6% relief direct from HMRC and invest it in his fund.

Pro advice. Never choose a pension scheme that operates NPA tax relief if you have low earning employees as you’ll be denying them much needed tax relief. Some schemes offer the choice of NPA or RAS, so choose wisely.

DB or DC?

DB stands for defined benefit . The pension benefit is defined by the person’s salary when they retire so they’re also called final salary schemes. They are very costly for employers as they have to pay the pension for as long as the individual lives so that open-ended promise is damaging to the balance sheet.

For this reason most DB schemes in the private sector have now closed and they’re really only a feature in the public sector. To try to share the cost burden employee contributions are much higher in the remaining DB schemes, so Jane in our case study will be paying much higher contributions making the loss of 20% relief more noticeable.

DC stands for defined contribution , the defined bit here is the amount paid in. But there is no definite amount to get out, it all depends on the investment return the fund has made at the point of retirement and if the employee chooses just to live off that capital or de-risk by buying an annuity - a guaranteed pension via an insurance company with the fund amassed.

DC schemes are sometimes called money purchase schemes as the investor is purchasing their pension with their own money.

Pro advice. The choice of what to do with a DB or DC fund on retirement is complex as there can be tax implications (both good and bad). Employees can withdraw £500 tax-free three times from their fund ahead of retirement to pay for financial advice. If you as an employer want to fund the advice, you can pay up to £500 p.a. per employee tax free, i.e. it’s not a benefit in kind.

Allowances

Tax relief on pensions costs the government around £25bn p.a. so naturally some controls are needed, and these are the annual and lifetime allowances, which it’s fair to say are catching out more than a few taxpayers.

Lifetime allowance

The lifetime allowance is currently £1.03m, that’s how much a total pension fund can be before tax is paid on extra employer and employee contributions. It sounds a huge amount of money, and it is for those in a DC scheme, but for those in DB schemes it’s much easier to get there as a final pension is multiplied by 20 to see if the limit is reached, so a pension of £50,000 means there is a £1m fund.

Once the fund is going to exceed the limit, the sensible thing to do is to opt for lifetime allowance protection. This means the fund is safe from HMRC as long as the person is never a pension scheme member again, and that’s where employers have to be careful.

Pro advice. Ask all new starters if they have protection, they’ll know if they have and you need the registration number to hold on your records. This will be your audit trail to exclude them from being auto-enrolled in your pension scheme. Make sure you don’t auto-enrol or re-enrol them as if you do, they’ll lose their tax protection.

Annual allowance

The annual allowance controls the amount of tax relief that can be offered in a tax year and ranges from £4,000 to £40,000 depending on the employee’s personal circumstances. If the combined employee and employer contributions exceed their personalised allowance, they will get a nasty tax bill from HMRC when they do their tax return.

Pro advice. You might want to make employees aware of the AA as they can carry forward any unused allowance from prior tax years. But if they’re struggling to understand the implications, they really need a pensions expert, that’s not your job.

Goodbye to lots of master trusts?

In a case of “you reap what you sow” the government chose not to regulate master trusts as it wanted lots of pension providers to be available to small employers when they had to stage for auto- enrolment. Sadly, that means many providers came to the market who weren’t commercially viable, as anyone could set up a master trust.

From 1 October 2018 new regulations have come into force as part of the Pension Schemes Act 2017 . All master trusts now have to prove that they are viable and pay a hefty registration fee to The Pensions Regulator. It has said that it believes 30 out of 88 master trusts will not register so will exit the market.

Pro advice. If you’re not sure whether you’re using a master trust see Follow up . But if you are, ask if and when it plans to register. If it doesn’t plan to, you will have to move all your employees’ pensions to a new provider with not a day’s membership gap between the old and new provider.

Master trust registration