Advisers face a daunting task to determine if an annual allowance tax charge will apply to government superannuation-type schemes, says Moira Warner, who outlines 10 key points advisers should consider.
With an annual allowance threshold of £40,000 and the introduction of tapered annual allowance, many more members of government superannuation type schemes are finding they may now be subject to an annual allowance charge.
Annual allowance used to affect only ‘higher earners’ but can now apply to people not previously effected by issues, such as senior or head teachers and middle managers.
As such, advisers face a daunting task to determine if an annual allowance tax charge will apply or if a client has any additional headroom for further pension contributions. Here are 10 key points that apply to these schemes and which advisers need to consider.
1. Pension input amount (PIA)
For defined benefit arrangements such as public sector final salary or career average schemes, it is the inflation-adjusted increase in the value of the member’s pension rights over the tax year that is tested against the annual allowance, not the amount of the employer/employee contributions.
2. Final salary link
Members who have moved to their scheme’s career average arrangement could still have pension input from their pre-1 April 2015 (pre-1 April 2014 for the LGPS in England & Wales) final salary benefits due to the so-called final salary link.
This is because final salary benefits – unless there has been a break in service of more than five years – will continue to accrue by reference to the salaries the member earns while in pensionable service under the career average scheme.
3. Final salary accrual
The ‘old’ final salary schemes have themselves evolved over time, with changed accrual rates applying to new joiners or future service from specific cut-over dates. An individual member may therefore have final salary benefits at more than one accrual rate. Each of these tranches of benefits may retain the final salary link and cause pension input in any tax year or pension input period (PIP) where the member’s pay increases.
4. Scheme year/Tax year
The scheme year for public sector pensions runs from 1 April to the following 31 March and revaluation of a member’s career average benefits takes place on 1 April. The PIA to be tested against the annual allowance on the other hand is measured over the PIP/tax year.
This mismatch adds an extra layer of complexity to calculation of opening and closing values. A calculation of opening values would therefore typically have to include the following elements for 2016/17:
Final salary pension: Final salary service* pensionable pay/final salary accrual rate PLUS
Career average Pension 1/4/15 – 31/3/16: Pensionable pay/career average accrual rate PLUS
Career average Pension 1/4/16 – 5/4/16: Pensionable pay/career average accrual rate * 5/365 PLUS
Revaluation of accrued career average pension: Accrued career avg benefits to 31/3/16 * relevant revaluation factor PLUS
Final salary lump sum (if any): Final salary service/final salary accrual rate * pensionable pay * 3
A flat factor of 16 must be applied to pension benefits, the lump sum added and the subtotal then uprated for inflation using CPI from September before the start of the tax year. Similarly, closing values will need to take into account revaluation on 1 April 2017 of career average benefits accrued to 31 March 2017 and five days’ benefit accrual between 1 April 2017 and 5 April 2017.
5. Pensionable pay
Individual scheme regulations determine the ‘pay’ to be used when calculating final salary benefit entitlement, but the figure to be used will very rarely be the same as the member’s headline ‘salary’. Indeed, the figure is also unlikely to be the sum of the various elements of the individual’s remuneration, which are identified as pensionable.
The figure used to calculate final salary elements of an individual’s rights is normally a form of average pay, which is designed to prevent retirement scenarios occurring whereby an individual receives a large pay-rise and then immediately retires with benefits calculated on the new pay.
Thus, for example, for an NHS 1995 section member, the pay figure to be used is the pensionable pay earned over the last year, or one of the previous two years, if higher. For a 2008 section member, on the other hand, pension input is to be determined using the average of the best three consecutive years’ pensionable pay in the last 10.
6. Defined benefit top-ups
Across the public sector, pension schemes variously offer members a number of different options to increase their pension benefits on retirement. Where the top-up option provides defined benefits, such as contracts for additional pension or additional scheme membership (sometimes also referred to as added years), then the pension input amount is not the member’s contributions, but the pro rata amount of additional pension or service credited to the member during the relevant tax year.
In such cases it will be important to understand the member’s contract terms – that is, if the contract is unexpired, how much extra pension or service is being purchased each year – in order to factor this into any annual allowance estimate.
Uniquely, the teachers’ schemes offer members the option to accrue benefits at a faster rate for a particular year. In these cases the closing value of benefits should be calculated including career average accrual for that year at the selected rate rather than the standard rate of 1/57.
The NHS and teachers’ schemes also offer career average scheme members the option of paying extra contributions to ‘buy out’ certain actuarial reductions to their pensions that would apply on early retirement before normal retirement where this is higher than age 65. Contracts of this type have no impact on the member’s annual allowance utilisation as there is no increase in the member’s benefits over the year. Contributions will however still qualify for tax relief.
7. Late retirement factors
Individual scheme regulations and statutory guidance determine whether and how benefits taken after normal retirement are uplifted. Typically, however, career average benefits and final salary NPA 60 benefits may be actuarially enhanced if taken late. In circumstances where a member remains in service beyond normal retirement, pension input should include the uplift to benefits as well as the continuing accrual.
8. Transfer club transfers
When an individual transfers benefits between public sector schemes under ‘club transfer’ rules, the years of service they are credited with in the receiving scheme may be adjusted to take into account differences in scheme design. On making such a transfer, however, the individual may enjoy enhancements that are entirely separate to any such actuarial adjustments.
In particular, for members transferring final salary benefits, subject to certain conditions, the transferred benefits will remain linked to the salaries in the new employment. This increases the member’s pension rights and in line with The Finance Act 2004 (Registered Pension Schemes and Annual Allowance Charge)(Amendment) Order 2015, pension input calculations must take into account the value of any such increase in the member’s annual pension due to the salary increase.
Where the transfer is of career average benefits, the transferred rights are ring-fenced by the receiving public sector scheme and enjoy the same revaluation rate as the member would have enjoyed under the sending scheme as long as the individual remains in active service.
This enhanced revaluation of the ring-fenced portion of benefits must be factored into a PIA calculation. Additionally, where the revaluation is applied on re-employment following a break in service of not more than five years, the in-service rate will be retrospectively applied by the sending scheme to cover the period of the break and this should also be included in the closing values for the final input period in the sending scheme.
9. LGPS – There’s always an exception to the rules
The LGPS comprises three separately registered schemes covering England & Wales, Scotland and Northern Ireland. It is administered on a regional basis by 99 separate administering authorities and members leaving pensionable service will be entitled to a deferred benefit with their former administering authority unless benefits are aggregated with those accruing in the new employment.
This structure has implications for the operation of the final salary link and hence annual allowance calculations since deferred benefits are likely to be held in the same registered scheme.
Where an LGPS member does not aggregate deferred benefits with their active membership within the same LGPS Scheme, and this includes final salary benefits, the deferred final salary benefits will not benefit from the ongoing final salary link and hence does not need to be factored into annual allowance calculations as described under point 4. Conversely, where the deferred final salary benefits are combined, the member’s salary in their new employment will be used to calculate the final salary benefits accrued in their former employment.
10. And finally…
Due to their forward-looking nature, pension input estimates for members of defined benefit schemes expose an adviser to risk. Even if the member has a clear idea of their likely pay progression over the year, translating this to the pay figure to be used to calculate closing values is unlikely to be straightforward.
For public sector pension scheme members, add to this the risk attached to identifying pension input arising from linked final salary accrual, defined benefit top-up contributions, actuarial adjustments and any club transfers and it’s not difficult to see why many scheme members are struggling to find professional help with pro-active retirement planning.
In view of the risks, for those souls brave enough to venture into this territory, it would be advisable not to attempt any form of calculation or estimate without sight of the member’s most recent Annual Benefit Statement so there is a clear and accurate line of sight of the member’s scheme profile.
Where the member may need to use carry forward, the most recent Pension Savings Statement(s) should be obtained. It is worth bearing in mind that advisers may need to ask for this in respect of both the final salary scheme and the career average scheme where an individual has accrued rights in both.
Last, and perhaps most important, any calculation should be positioned as an estimate since advisers are unlikely to have all the pay and other data available in order to perform an accurate calculation with confidence.
Moira Warner is a technical manager at Prudential
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