Contracting out

The State Earnings Related Pension Scheme (SERPS) and State Second Pension (S2P) included provisions allowing members to contract out. That means that they may take the additional contributions which would have gone to SERPS or S2P and invest them instead into an appropriate Personal Pension Plan or an Employer’s Scheme – which could be a Money Purchase Scheme or a Final Salary Scheme.

The employer and the employee pay lower National Insurance contributions, but the amount by which their contributions decrease goes instead into the contracted out scheme.

Contracted Out Final Salary Schemes (COFSS)

To contract out via this route, the member has to be a member of an employer’s Final Salary Scheme. The contributions to COFSS built up an entitlement to Guaranteed Minimum Pension (GMP) which was broadly the same as the SERPS entitlement on the same contributions. This was available from 1978 to 1997.

This arrangement continued until 1997. From that date, the scheme must demonstrate that its benefits satisfy a quality comparison, showing that they are at least equal to, or better than, a series of test benefits known as the Notional Reference Scheme (NRS). The NRS provides for benefits roughly equal to S2P. To demonstrate that this is so, the scheme actuary must provide a certificate at least once every three years that the conditions have been met.

Contracted Out Money Purchase Schemes (COMPS)

From 1988, employers could contract out of SERPS (and later S2P) through a Money Purchase Scheme. The money saved from reduced National Insurance Contributions (from both employer and employee) must be paid into the scheme. In addition, the Inland Revenue makes a contribution once a year. The amount of this additional contribution depends on the age of the employee, and increases as the employee gets older. This is known as the Age Related Rebate.

These contributions are kept separate from any other contributions, and they are known as protected rights. Benefits under protected rights may be taken from age 60, and are governed by the normal rules relating to State Pensions. In particular, these protected rights may not be used to provide any lump sum on retirement. They must be used entirely to provide a pension.

Contracted Out Individual Pension Schemes (COIPS)

Since 1988 employees who were not contracted out through an employer’s scheme were entitled to contract out through an Appropriate Personal Pension (APP). This is now available as:

• Personal Pension Plan.
• Stakeholder Pension.
• Free Standing Additional Voluntary Contribution.

The principles governing these contributions are similar to those outlined above for COMPS. In particular, the contributions are treated as protected rights. However, the main difference is in the method of contributing. The employer and the employee continue to pay the full National Insurance contributions, and at the end of the year, the Inland Revenue make a rebate to the provider of the APP.

Retirement Annuity Plans

These plans were the precursors of Personal Pension Plans. Since 30 June 1988, new plans are no longer available, but plans taken out are still valid, and governed by the rules governing them when they were taken out.

Contributions and tax relief

Contributions were only allowed to people having income from:

• employment,
• self-employment, or
• furnished holiday lettings.

The maximum limits are slightly different from those under Personal Pension Plans, as follows:

Contributions are not subject to the earnings cap, as are Personal Pension Plan contributions.

If there is a difference between the limits under Personal Pension Plans and Retirement Annuity Plans, and the individual pays contributions under both types of plan, then the limit which may be paid into Personal Pension Plans is governed by the following table:

Tax free lump sum

The Retirement Annuity Plan fund may be used to provide a tax-free lump sum, in the same way as Personal Pension Plans. However, there is a different limit. The limit is calculated at three times the value of the residual pension left after the lump sum is taken. For plans taken out after 17 March 1987, the lump sum was limited to £150,000 for each policy.

Saving schemes and ISAs

The majority of the pension planning vehicles considered in this book are specialised ones, with tax or other advantages. In return for these advantages, the benefits are restricted in certain ways. However, it is always possible to make use of regular savings methods to build up a fund which can be used for retirement benefits.

Using regular savings in this way does not attract any special tax advantages, unless the savings are in the form of an ISA, or any other tax sheltered form. There is equally no restriction on the way these funds may be used. That may represent a great flexibility, but it may also be a disadvantage. For instance, if you wanted to retire before age 50, any savings scheme could be used to fund that purpose. The disadvantage is that the funds are not tied up until your retirement age, and you may draw on them at any time for other purposes. They are not then available when needed for retirement. Self-discipline is therefore needed.

The main principles of saving and investing are considered in more detail in Chapter 9, and Appendices 3, 4 and 5.

ISA or pension?

With tax relief available to a certain extent on both ISAs and pension contributions, it is worth comparing the relative advantages and disadvantages of each. These are compared in the following table:

The comparison shows several interesting features:

• A younger person may be able to take more advantage of ISAs, since the limit may be more than their earnings limit.
• A higher rate taxpayer may benefit from a large tax benefit when paying in, but then is often only a basic rate taxpayer when receiving the annuity.
• An ISA demands more self-discipline to retain the investment and not draw on it.
• Both types of investment allow a fairly wide investment choice.
• Of course, both ISAs and pension contributions may be made concurrently, benefitting from the advantages of each.

An interesting comparison can be made of the projections for saving in an ISA and in a Pension Plan, then taking the benefits. Assuming a growth rate in the fund of 5%, the funds accumulated from an investment of £100 per month from age 30 to age 60 would be as follows:

• An ISA fund of just over £81,500.
• If this fund were used to produce an income, the ISA fund invested in fixed interest investments could, at rates current when writing this, achieve a return of 6%, which gives a tax free income of just over £4,890 a year.

Investing £100 per month net in a pension plan means that the grossed up contribution for a basic rate taxpayer is £128.21, which would produce a fund of just over £104,500.

• If this fund were used to provide a level annuity for a male non-smoker, non-guaranteed, the annuity rate current at the time of writing this would be 6.42% gross – and it would be liable to tax. Therefore, if the person was a basic rate taxpayer in retirement, the net amount of the annuity would be nearly £5,240 a year, but a higher rate (in retirement) taxpayer’s net annuity would only be just under £4,025 a year.

Investing £100 per month net in a pension plan means that the grossed up contribution for a higher rate taxpayer is £151.28, which would produce a fund of just over £123,350.

• If this fund were used to provide a level annuity for a male non-smoker, non-guaranteed, the annuity rate current at the time of writing this would be 6.42% gross -i.e. it would be liable to tax. Therefore, if the person was a basic rate taxpayer in retirement, the net amount of the annuity would be nearly £6,180 a year, but a higher rate taxpayer’s net annuity would only be just under £4,750 a year – still less than the tax free income of the ISA investment.

However, if the investments continued to be made until age 65, the picture looks quite different as follows (all other assumptions the same as above):

• The ISA fund would be just under £110,850. This would produce a tax free income at 6% of just over £6,650.
• The pension plan contributions for a basic rate taxpayer would produce a fund of just over £142,115. The annuity produced by this for a 65 year old would be 7.4% gross, and for a basic rate taxpayer in retirement, this would mean a net annuity of just over £8,200 a year, or for a higher rate taxpayer in retirement, just under £6,310 a year.
• A higher rate taxpayer’s fund would amount to just under £167,690 at age 65. The net annuity produced by this would be just over £9,675 for a basic rate taxpayer in retirement, and just over £7,445 for a higher rate taxpayer in retirement.

Thus, it can be seen that the relative advantage of pension contributions gets more as the age of retirement advances, and less as the retirement age is lower.

FURBS (Funded Unapproved Retirement Benefit Scheme)

Why should anybody want to use an unapproved scheme?

We have seen that certain Inland Revenue restrictions apply to approved schemes, in return for the tax relief and concessions. Amongst other things, these restrictions include:

• Maximum pension limit of two thirds of final salary.
• Earnings cap applied to the proportion of earnings which may be contributed.

An unapproved scheme can be used when the Inland Revenue restrictions penalise higher earners, particularly directors. Because the scheme is unapproved, it can increase the retirement benefits above the Inland Revenue limits. However, because the scheme is unapproved, there is no tax relief on employees’ contributions, and the scheme’s fund is not tax sheltered. However, a company employer making contributions to a FURBS is allowed this amount as a deductible item for tax purposes. (But the employee for whose benefit the contribution is made is taxed on this amount as a benefit in kind, and is therefore liable to Income Tax and National Insurance contributions on it).

A FURBS is a single member scheme, set up under a trust document. Contributions may be made by the employee and the employer company.

The advantages of a FURBS are:

• There is no requirement to use the fund to purchase an annuity.
• The entire fund could be used to pay a tax free lump sum.
• There are no limits on benefits payable.
• There are no restrictions on the investment powers of the trustees.
• The requirements of the Pensions Act 1995 do not apply (i.e. there is:
• There is no age limit on taking any benefits.

UURBS (Unfunded Unapproved Retirement Benefit Scheme)

There are no contributions to the scheme, and therefore no tax liabilities. The employer company merely makes a promise to the employee of the benefits payable at retirement – either in the form of pension paid, or lump sum.

When the benefits are paid, they are fully taxable on the employee and fully allowable as an expense of the employer company.

Early retirement

Rules for schemes vary considerably for early retirement.

Occupational Schemes

Each scheme has its own rules relating to early retirement, but they must be within the framework of the Inland Revenue permitted rules. The Inland Revenue rules allow retirement at any time from age 50. The scheme rules may allow early retirement at any age provided it is not lower than 50.

An Occupational Scheme should provide that in order to retire early, the member must actually leave the employment. Other rules commonly included in Occupational Schemes include:

• Early retirement must be subject to the consent of the employer. You should not assume that this will be granted automatically.
• Preferential terms for those who retire directly from the employer’s service (as opposed to those who retire after having left the employer’s service).
• There may be enhanced pension rights for early retirement if offered as part of a redundancy deal.

The pension rate will of course be much lower because of two factors:

• 1.The benefits will have been paid for a shorter period.
• 2.The life expectancy will be much higher.

The new lower rate may be defined by the scheme rules, or by recommendation from the scheme’s actuary.

If the scheme includes contracted-out contributions, there may be additional problems. As we have seen earlier in this chapter, contracted-out contributions are known as ‘protected rights’ contributions. This means that the pension will not normally be payable until age 60, and that the pension must be at least the ‘Guaranteed Minimum Pension’ (GMP). This means the same amount as would have been provided by SERPS or S2P for the same contributions. Thus, early retirement would not be permitted in relation to the contracted-out contributions until age 60. In addition, the reduction in pension may well reduce it to an amount less than the GMP. Thus, schemes which include contracted-out contributions may not permit early retirement until the reduced pension is at least equal to the GMP.

Additional Voluntary Contributions (AVCs) and Free Standing AVCs (FSAVCs)

Although AVCs are considered as part of the main Occupational Scheme, the Inland Revenue rules allow different retirement rules to apply for that part of the funds represented by AVCs and FSAVCs. These rules allow retirement any time between the ages of 50 and 75. However:

• The AVC pension may be taken without having to retire from the employer’s service.
• The AVC pension does not have to be taken at the same time as other benefits.
• These provisions only apply if the trustees of the scheme permit. They are not automatic rights.

Personal Pension Plans

Normal rules allow retirement at any age from 50 onwards. However, there are earlier limits for those engaged in certain professions, such as:

• sportsmen or sportswomen,
• dancers,
• models.

Early retirement due to ill health or incapacity

Occupational Schemes can adopt rules allowing members to take early retirement for incapacity. The pension payable may be reduced, or equal to the pension at normal retirement age. It may even be greater than the pension at normal retirement age – it all depends on the scheme rules.

The definition of incapacity will vary according to the scheme rules, but generally it means that the member is unable to carry on their occupation due to mental or physical illness. Some schemes may include a definition which means that the member is not just incapable of doing his or her occupation, but any occupation at all.

Case law has decided that to be eligible, any medical condition must be permanent – that is, it must be likely to last until death, or at least the normal retirement age.

The area of early retirement through ill health has recently caused more disputes between members and trustees, and many schemes are tightening up their procedures since this area is incurring greater costs for the scheme, and thereby restricting funds available to other scheme members.

Hitting problems

Divorce and pension rights

When a marriage breaks down, and one partner was a member of a pension scheme, the former spouse loses retirement benefits. This includes the death in service benefits and the benefits at retirement age – the pension and the tax free lump sum. The Pensions Act 1995 and the Welfare Reform and Pensions Act 1999 determine how pensions are dealt with on divorce. Pension rights are often the second largest asset after the family home, so they always loom large in settlements. It is not always the case that all assets (including the pension rights) should be split equally on a divorce.

Therefore, it is important to arrive at a valuation of the pension rights of the scheme for an equitable settlement on divorce. The child carer (usually but not always the wife) will probably have little prospect of being able to build up a pension fund of his or her own. The main earner (usually but not always the husband) will have the prospect of continued earnings from which to build up a pension fund.

Courts tend to take one of three main ways of sharing pension value on divorce:

• 1.Offsetting. Taking into account the needs of the children, if any, the court may well award the home to one partner – the child carer. This usually involves a large amount of equity, and instead of splitting the pension, the value of the pension may be offset against the value of the home. For example, the wife may be awarded the house, while the husband may retain his pension rights – and other assets may be used to provide a balancing amount.
• 2.Earmarking. The courts have the power under the Pensions Act 1995 to ‘earmark’ a portion of the pension rights, including lump sums as well as pension, to the other partner. This method is not usually favoured if the parties to the divorce wish a ‘clean break’. It also means that the non-member has to wait until the member’s actual retirement before getting their share of the benefits. This also means that the scheme member could cease contributions to the scheme which is the subject of the earmarking order and start contributions to another scheme after the divorce. This would effectively deprive the non-member of part of a larger pension.
• 3.Sharing. The Welfare Reform and Pensions Act 1999 introduced the option of sharing pension benefits. This is different from earmarking in that the pension provider is ordered to split the pension between husband and wife. Each can then make their own arrangements within the rules of the pension scheme. Thus, the non-member need not wait until the member spouse takes their pension benefits. The non-member actually receives their share by what is known as a pension credit, and this can be transferred externally to another pension provider if desired. The sharing is done at a fixed date, and thus the non-member spouse will not benefit from any further contributions to the plan made by the member spouse. The exact proportion of sharing between the parties to the divorce will be determined by the court, or by agreement between the parties involved.

All types of pension arrangements can be split on divorce, even including the basic State Pension and the State Earnings Related Pension Scheme (SERPS). A Defined Contribution Scheme (also known as a Money Purchase Scheme) is usually the easiest type to divide between the parties to a divorce, and a Defined Benefit Scheme (also known as Final Salary Scheme) is usually the most complex.

Defined Benefit Schemes

These are the most complex because the benefits at the normal pension age depend on the number of years’ service and the final salary of the member at retirement age. There is no fund value to use as a basis. The scheme must be valued as a whole by an actuary, and the benefits due to each member of the scheme evaluated, to determine if the scheme as a whole has sufficient funds to pay its obligations now and in the future. Therefore, assumptions have to be made about several factors, such as:

• inflation,
• investment return,
• growth of earnings generally,

• discretionary benefits to members,
• future salary increases to members,
• career progression of members,
• mortality rates,
• cash flow considerations – i.e. when the money will be needed for benefits.

There is also a minimum funding requirement, to ensure that Defined Benefit Schemes are neither underfunded nor have excessive surpluses. It can easily be seen, therefore, that the valuation of any one member’s pension rights in a Defined Benefit Scheme is no simple matter.

However, the court starts from a Cash Equivalent Transfer Value (CETV), which the scheme provider must produce. This figure is based on the assumption that the member leaves the scheme on the date of the valuation. This assumption is nearly always incorrect, and the member’s pension rights are greatly undervalued by the CETV method. In these cases, the court will usually appoint a pensions expert to determine an adjusted CETV which reflects the individual circumstances of the case – i.e. the career progression of the scheme member, and the probable date of retirement. The specific needs of both parties to the divorce are taken into account as far as practicable in this process, which is referred to as a pension audit, which takes into account all the pension arrangements entered into by the parties to the divorce.

Defined Contribution Schemes

A great number of schemes come under this heading, including:

• For individuals:
• For employees:

In these cases, the fund will be the basis for the CETV. The only case where there may be some difference between the fund value and the CETV is in an Occupational Money Purchase Scheme, where there could be additional death in service benefits provided by the employer to scheme members. In this case, the court would decide whether the cost of a pension audit would justify the possible added value to the non-member spouse involved in the divorce.

State Pensions

The basic State Pension cannot be subject to a pension sharing order by the court. The other spouse involved would have to apply directly to the Benefits Agency to adjust the member’s basic State Pension and any other benefits at pension age. Any reduction would then mean that the amount by which the pension was reduced would be paid to the spouse who applied.

SERPS may be made the subject of a sharing order by the court. The SERPS benefits may have been built up in the SERPS fund, or by contracting out. Any rights which are shared in this way become safeguarded rights for the other spouse, and subject to the normal conditions as any other State Pensions on retirement age.