The increased pension flexibility likely to be available after April 2006 may well provide an unexpected lifeline for the sponsoring employers of many of the UK’s beleaguered final salary pension schemes as well as result in increased choice for their scheme members. It is likely that the new regulations will permit occupational pension schemes to provide higher levels of tax free cash, for a significant number of members, than would be available under current regulations, which could in turn mean that the cost of providing the total benefits is lower.
However, the new regulations will not automatically apply to schemes but will have to be incorporated in to the individual scheme rules which will require early investigation and expert guidance.
So what might be the potential financial impact and what issues need to be addressed?
Martin is a Director of a medium sized engineering business which this year closed its final salary pension scheme to new entrants in a bid to control the ever escalating scheme costs. Martin, however, will have completed 20 years service when he reaches age 65 in 5 years time. The scheme accrues benefits based upon 1/60 ths of basic salary for each year of service. If Martins’ salary is £60,000 per annum at that time, and assuming he remains in service until age 65, he will receive a pension of £20,000 per annum.
In this scheme, tax free cash is available by commutation of pension benefit and would be based upon 3/80 ths of basic salary for each year of pensionable service. This would equate to a lump sum of £45,000. Based upon a commutation factor of 12:1 Martin would have to give up £3,750 per annum of pension in exchange for his cash entitlement, leaving him with a residual pension of £16,250 pa plus his £45,000 of tax free cash.
If we value the benefits using the new simplification regulations a pension of £20,000 per annum would equate, at a 20:1 conversion rate, to a value £400,000. However under the post April 2006 rules the TFC would not be £100,000 (i.e. 25% of the fund), but would be calculated using the formula C ÷ (1 + 0.15 x C) x pre-commutation pension, where C is the commutation factor. This would mean that the TFC entitlement under this example would be £85,714. As members tend to seek to maximise the level of lump sum cash available from their pension scheme this improvement in tax free cash is likely to be something which could be attractive to Martin. In reality, how valuable this cash proves to be depends to a great extent on the scheme cash commutation factor used and the age and marital status of the member at the time the cash is being taken.
If we continue to apply a commutation factor of 12:1 the £85,714 of cash would cost Martin £7,143 per annum of his pension, with all its associated ‘bells and whistles’ such as escalation and spouses benefits. Clearly the cash value obtained does not reflect the cost of securing the equivalent benefit in the open market. Indeed based upon the best annuity rates currently available £85,714 would secure a joint life escalating pension of below £3,900 pa. Martin will need to consider how likely he will be to be able to generate an investment return of over 8% pa from his tax free cash to match the scheme pension benefit he is foregoing.
A lower commutation factor such as 9:1, which is still commonly used in many schemes at age 65, would widen the gap further with Martin’s maximum TFC entitlement reducing to £76,596 and therefore, if taken, the residual pension reducing from £20,000 per annum to below £11,500 pa. Removing a scheme liability for £8,500 pa of pension at a cost of £76,596 may look like good value from the sponsoring employers’ perspective but may not be quite so attractive from the members’ point of view and trustees will need to establish their approach to ensuring ‘fair value.’
Early examination of the scheme rules and the potential impact of any changes will be required and the scheme sponsor and trustees will need to establish a mutually acceptable approach and to ensure that it is consistently applied across the scheme.
It may also be more attractive for members of final salary pension schemes to fund for additional TFC separately through some sort of money purchase top up arrangement rather than via commutation. This will have an impact on future scheme benefit and contribution design. Using member contributions in this way does appear to offer the considerable attractions of tax relief and tax advantaged investment return all with the ultimate benefits available in the form of a tax free lump sum.
There are undoubtedly benefits to be derived for all concerned as a result of the new regulations providing equitable solutions can be achieved. At a time when the Finance Directors of many of these businesses are looking for ways to reduce the impact of funding shortfalls this could be achieved with a parallel member benefit. IFA’s in conjunction with their actuarial partners are ideally placed to assist with innovative solutions.
David Davison is a Director at Spence & Partners, independent actuaries and consultants in Scotland and Northern Ireland.
Published in Financial Solutions Magazine May 2005