New attack on Final Salary Pension Schemes

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15 February 2010

If you are a member of a final salary pension scheme and not yet retired, proposed changes from April 2011 could impose penal new tax charges on you. In one case we have seen, the effective tax rate was 230%!

In the 2009 pre-Budget report it was announced that from 6 April 2011, tax relief on pension contributions will be limited to 20% for those earning more than £180,000 p.a. and there will be a phased restriction for those earning between £150,000 and £180,000.

The proposals are still at consultation stage but lurking within the consultation is a new proposal to bring final salary "defined benefit" schemes under the same restrictions. At face value this seems fair enough. However, when the practical effects are considered it soon becomes apparent that "defined benefit" schemes will be hit particularly hard if these changes go through.

The difficulty in treating final salary schemes in the same way as defined contribution schemes is that there is no obvious "contribution" on which to impose the tax charge. Instead HMRC propose to value the "promise" (of increased pension) and to charge tax on the value of that promise. Of course, how one values a promise is not an easy exercise. The consultation seeks to discuss this question in some detail. However, the technical nature of much of the discussion, manages to obscure (perhaps deliberately?) the true impact of the proposals. We suspect this is why there has not yet been significant outcry.

An example will, however, illustrate the point:

Jim is in a final salary scheme and 7 years off retirement. His salary has just increased by £20,000 and he is delighted that as a result, his pension will also increase by £8,000 p.a. The value of the "promise" of additional pension is, of course, much more than £8,000 - perhaps around £120,000. And, if Jim is a high-earner, HMRC will want 30% of that figure - i.e. £36,000. On a salary-increase of £20,000, that represents a tax rate of 180%. And, remember that Jim will already have paid £10,000 of mainstream income tax too: a total tax rate of 230%.

Worse still - at least as presently proposed - there is no rebate if you die; if your actual pension is less than this; or your pension fund becomes insolvent. The only proposed concessions are that you may elect for the pension fund to pay the tax charge for you (but only if it can afford to do so) or to spread the tax charge over 3 years (but there will be another tax charge potentially waiting for you next year and each year until retirement).

There are a number of possible solutions if you find yourself in this position. These might include retiring early: but note that if you are between 50 and 55 at the moment, the minimum retirement age is about to increase to 55 with effect from 6 April 2010.

Of course, pension decisions are complex and full advice needs to be taken about your exact circumstances. Working together with your financial advisor, Burges Salmon's tax lawyers can help you to understand the rules, the likely impact of the proposals and the available options.

If you would like further information please contact John Barnett on +44 (0)117 902 2753 or by email on (for advice to individuals) or Tim Ilston on +44 (0)117 939 2284 or by email on (for advice to sponsors and trustees).

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