Individuals that do not have access to an employers pension must establish their own private
pensions where the contributions will be made from their income only. Employer pensions such as final salary offer valuable benefits, having evolved significantly since 1975 when there were no statutory rights afforded to the a member on leaving early.
The Social Security Act 1973 (SSA 73) brought in major improvements and this Act continues to make additions on a regular basis. The Pension Schemes Act 1993 (PSA 93) and the Pensions Act 1995 added further protection, the latter introducing the Occupational Pensions Regulatory Authority (OPRA) to regulate employer
The employer can offer an occupational
pension scheme, such as final
salary pensions where the benefits are related
to the member's earnings at retirement and length
of service and this is known as a defined benefit
scheme. Alternatively, an employers occupational
money purchase scheme gives a pension income linked
to the fund value, this being dependent upon the
contributions made, retirement age and investment
return and is known as a defined contribution
These are usually contributory schemes but occasionally
the employer offers the scheme
member a non contributory scheme where the
member is not required to make personal contributions,
but will still accumulate retirement
benefits over time. If the employer has a
group personal pension or stakeholder pensions
often the employer will match the employees contributions
up to a certain percentage.
Since the introduction of stakeholder
pensions from 6 April 2001, all companies
with five or more permanent employees that do
not have an existing pension arrangement must
have establish either a group
personal pension (GPP) or group stakeholder
All these schemes are subject to the Pension Simplification regulations, introduced on 6 April 2006 and referred to as A-Day, that have established limits on the annual allowance of contributions to a pension fund and lifetime allowance of the size of the fund at retirement.
Any pension scheme, whether an employers pension scheme or
private pension scheme, where the member is required to contribute
is known as a contributory
scheme. For an employers pension scheme, the employer
will make a contribution to the scheme if required to meet the scheme funding objective.
The employer may be required not to make contributions to the scheme if it is in surplus but this will not affect
pension rights at retirement age. In extreme circumstances
even the members may not be required to make payments until
the scheme is in balance, creating a non contributory scheme
for a period of time. A private pension scheme will always
be contributory as the onus is on the member to make payments
if he or she wishes to accrue a sufficient fund value to deliver
their desired retirement benefits.
Any employer pension scheme where the members are not required
to make contributions and where the employer is responsible
for funding the members pension rights is referred to as a non contributory
scheme. The majority of employers operate contributory
schemes as non contributory schemes have high operating costs.
If an employer pension scheme is non contributory, they will
typically be associated with a defined benefit final salary
service scheme may also be non contributory, such as the
civil service, and although this scheme will also be unfunded,
the members pension rights at retirement age are guaranteed
by statute. For an early leaver, there is a risk to the scheme
member leaving within two years, as the employer can apply
of contributions made by the member. This means that in
a non contributory scheme no contributions are made so the
member will have no accrued pension benefits on leaving
Since 6 April 2006, Pension Simplification has set a limit of the annual allowance at £215,000 for 2006/07 tax year rising to £255,000 in 2010/11 tax year and reducing to £40,000 for the 2014/15 tax year onwards. These limits are for payments to a defined
contribution scheme or as accrued benefits within a defined
This has allowed individuals of an occupational
money purchase scheme
to make contributions subject to the annual allowance and this
gives them the opportunity to contribute considerably
more to their retirement planning.
For members of a defined benefit final salary pension scheme
the value is calculated as the increase in value of the
employees' pension benefits accrued during the year using a
valuation factor of 10:1, as opposed to the factor 20:1 used
at retirement to determine the lifetime allowance.
Prior to A-Day the contribution maxima for an occupational pension scheme was limited to 15.0% of relevant
earnings, irrespective of age by the Inland Revenue, now HM Revenue & Customs (HMRC). This could be different
to the schemes pensionable
earnings where usually only the basic salary is used to
determine an employers contribution to the members pension
and the benefits at retirement age. A member could enhance benefits where
there was a shortfall by purchasing added years or making
contributions to an additional voluntary contribution scheme
Similarly, Prior to A-Day a free standing additional voluntary contribution (FSAVC)
scheme linked to an occupational pension regime limited the member's contributions to 15.0% of pensionable
earnings. For a group personal pension the Inland Revenue maxima varied with the members age from 17.5% below 36 years of age
to 40.0% above 61 years of age, being scaled between these
A pension scheme where the rules specify the benefits to be
paid to the scheme members at retirement is known as a defined
benefit scheme. Both the employer and member can finance
the scheme to meet the benefit obligations in the future from
the contributions. Where the contributions are made to a pension fund without specifying the benefits, such as an AVC scheme,
stakeholder pension or money purchase scheme, are known as defined contribution
With the development of low cost employer sponsored stakeholder
schemes that every employer must offer if they have 5 or more
full time employees, effective from 8 October 2001, many employers
salary pensions are closing these schemes to new entrants
due to the high operating cost. These defined benefit schemes offer valuable
defined benefits at retirement
age based on a scheme members salary at that time where
the risk of providing the benefits is with the employer. The
maximum benefits that can be taken from a defined benefits
scheme are 2/3rds of final salary subject to the lifetime allowance.
The total benefits a member will accrue will depend in part
on the eligibility rules as set out by the scheme. This could include a waiting
period before joining, indicate the type of employees that
can join the scheme, the accrual
rate applied, the level of benefits, retirement age and
whether it is non contributory or contributory and if so the
level of personal contributions.
Although a group scheme may be established by the employer,
they really represent a collection of individual policies
owned by the member and operated by a provider. When the member
leaves the company all the contributions accrued by the member
and the employer, belong to the member. The contributions
can be left in the group scheme or a pension
transfer made to another provider.
All schemes can pay a tax
free lump sum of up to 25.0% of the fund value and to
a maximum of 25% of the lifetime allowance irrespective of
the type of pension. This includes protected rights portion of a pension, AVC,
FSAVC's and transfers received from occupational pension schemes.
Both defined benefit and defined contribution schemes are subject to the Pension Simplification regulations introduced from 6 April 2006.
standard lifetime allowance is the maximum amount of pension
savings that can benefit from tax relief and has been initially
set at £1.5 million in 2006 rising to £1.8 million in 2010. The allowance is based on the approximate
amount of money that would be needed to purchase a pension equal
to the maximum the HMRC would permit
under the tax regime.
In terms of occupational scheme benefits the HMRC have determined
that the lifetime allowance of £1.5 million is broadly
the amount required to provide maximum benefits for a 60 year
old with earnings at the earnings cap of £105,600 in 2005/06. The HMRC are using a valuation factor of 20:1 for converting
a defined benefit scheme to a cash equivalent. Therefore the
£1.5 million lifetime allowance represents a gross income
of £75,000 per annum.
All schemes are able to pay a tax free lump sum limited to 25.0% of the fund value up to the lifetime allowance. For defined benefit schemes such as final salary pensions
the scheme must calculate the value of the pension to determine
the maximum tax free cash. The calculation used by the HMRC
is a 20:1 value for converting a defined benefit scheme to
cash. Therefore assuming a pension accrued of £15,000
per annum, this would represent a cash value of £300,000
which would produce a tax free cash sum of £75,000.
If the tax free lump sum in total exceeds 25.0% or more than
£375,000 (25% of the £1.5 million lifetime allowance
for 2006/07) a tax charge would be made.
Prior to A-Day the defined benefit tax free lump sum was calculated
by multiplying 3/80ths of final pensionable earnings for each
service. For example, for someone retiring with earnings
of £20,000 a year, after 40 years of service the tax
free lump sum will be 40 x 3/80ths or 120/80ths or one-and-a-half
times pensionable earnings, providing a sum of £30,000.
Alternatively, if it produces a larger lump sum the member
could take up to two-and-a-quarter times the full initial pension
In contrast, before A-Day a money
purchase scheme had no limit on the amount of benefit that could be taken at
retirement age, but the member was limited by the contributions
made and the earnings cap. The scheme member was able
to take a fixed 25.0% tax
free lump sum from
the fund value irrespective of the number of years service
or members retirement age.
Earnings and taxation
Since 6 April 2006, Pension Simplification has replaced the differing contribution levels of defined benefit and defined contribution schemes with a lifetime and annual allowance. In terms of the annual allowance this is £215,000 in 2006 rising to £255,000 in 2010 with tax relief on the contributions limited to
100% of relevant earnings.
As defined in the Income
and Corporation Taxes Act 1988 (ICTA 88) any income that
is chargeable to UK tax is considered relevant
earnings include the following:
||Schedule E earnings including benefits
||Income from a property related to the
taxable emoluments of employment;
||Income chargeable to income tax under
schedule D after deducting business expenses arising from
a trade, profession or vocation as an individual or partnership;
||Income from patent rights and treated
as earned income;
||Income from certain commercial lettings
of holiday accommodation assessed for tax after 1995/96
under schedule A.
Where funding exceeds
the annual allowance an annual allowance charge of 40% is levied
on the excess in contributions. Any investment growth or loss
in the value of the fund for all money purchase schemes, whether
private pensions or occupational pensions, are not included
in the annual allowance.
The lifetime allowance was initially set at £1.5 million in 2006 rising to £1.8 million in 2010. Funds that exceed the lifetime allowance can be taken as a lump
sum and in this case the lifetime allowance charge would be
at 55%. There is a charge of 25% on pension
funds that exceed the lifetime allowance and are used to provide
a pension income. The income would also be subject to income
tax at the individuals marginal rate and probably this would
be a 40% higher rate tax, therefore the likely overall effect
would be a tax rate of 55%.
Prior to A-Day the Finance Act 1989 imposed limits for any post-89 pension
scheme members pension arrangement by the earnings
cap. The earnings cap limited the taxable earnings of a
member that could have been used for pension planning, latterly £105,600
for the 2005/2006 tax year before pension simplification was introduced. A pre-89 pension
scheme member was not limited to the earnings cap and for an
occupational pension scheme could retire on two thirds of their
with no upper limit.
Although the scheme member can commute part of their retirement
benefits to a tax
free lump sum, the pension income is taxable as earned
income at a basic rate of 20% for the 2009/10 tax year. This means
that the normal tax rules apply to this income after deductions
for personal allowances. For a couple on divorce where the
scheme member is a higher rate taxpayer while in retirement,
sharing order could actually mean both parties will become
basic rate taxpayers after the pension income is divided.
Where a member needs the
maximum pension income it is possible to buy a purchase
life annuity with the tax free lump sum. By doing
this the member will reduce the tax liability because
the income is paid as capital
and interest. This means that, say for a 65 year old, about 4/5ths of the
income is deemed by HM Revenue & Customs to be a return
of capital and therefore tax free and the other 1/5th
is interest and taxed at the savings rate of 20%. This
taxation results in less tax paid and more income for the
rest of the annuitants life.