Pension changes coming – act now !

Wednesday’s publication of the National Pensions Framework was mostly about outlining the government’s long term plans for pension provision in the years ahead.

Aside from the extension to the state pension retirement age to 68 and the new mandatory pension scheme from 2014, which have grabbed most of the headlines, there are some areas that may affect employees, employers and the self-employed a lot sooner.

Tax-free lump sums

There has been speculation for some months that the lump sum element of a person’s retirement benefits, which is tax-free regardless of its size, would be taxed on any amount above €200,000.

The framework document had this to say: ‘‘The Commission on Taxation recommended that pension lump sums of less than €200,000 should not be taxed. The government has accepted this recommendation and decided that arrangements for the tax treatment of lump sums greater than €200,000 would be considered and developed during the implementation of this framework.”

So it’s still likely that such a tax will be applied in due course, but we don’t know when. Anyone who has already accrued an entitlement to a lump sum substantially greater than €200,000, and who is of an age that they can retire, should consider doing so now before this tax is implemented.

In Budget 2010, Minister for Finance Brian Lenihan announced salary cuts across the public service.

But he also included a provision that any retirements this year would be on existing, pre-cut pay terms. This, combined with the looming tax on lump sums over €200,000, serves as a further incentive for high-ranking career public servants to retire before December 2010.

New form of tax relief

The framework indicates that a new form and rate of tax relief on pension contributions, equivalent to relief of 33 per cent , will be implemented for the new auto-enrolment pension scheme.

This form and rate of relief will also be extended to existing occupational and personal pension schemes, and will replace the current system of tax relief at the standard and higher rates of 20 and 41 per cent. Presumably, this change to tax relief will occur in 2014 if prevailing economic conditions are favourable at that time.

This effective rate of relief of 33 per cent will represent a small reduction for higher-rate taxpayers, who currently enjoy tax relief at 41 per cent. However, higher rate taxpayers have been given a window of at least four years to maximise their contributions and avail of the 41 per cent relief, before any reductions take effect.

There has been some confusion over the effect that the new 33 per cent rate of tax relief will have on pension provision for higher-rate taxpayers. I’ve seen it suggested that such a reduction would make it inefficient for higher-rate taxpayers to make contributions at all, as a pensioner would be taxed at 41 per cent on their pension while receiving only 33 per cent relief on contributions.

Such suggestions ignore two very important considerations: (1) at retirement, a substantial portion – typically 25 per cent or more – of a person’s accumulated pension fund will be completely tax-free; and (2) tax exemptions, credits and standard rate tax bands apply in retirement, so only part of any pension will be taxed at the 41 per cent rate.

Let’s take an example of a married couple, both aged 65, who are retiring today. If we assume that they qualify for the state pension in full, this is €22,703 per year.

This couple could have an accumulated private pension fund of about €600,000 and still be entirely exempt from income tax under the current exemptions. The first 25 per cent, or €150,000, would be a tax free lump sum.

The balance could be used to buy a guaranteed pension for life of about €17,000 per year, which would give them a total annual pension income including the state pension of €39,700 – totally exempt from tax under current exemptions.

There are no plans in the framework document to change the taxation of pensions in retirement, aside from the ceiling on tax-free lump sums. So, even at a rate of relief rate of 33 per cent, this represents excellent tax planning – relief of 33 per cent on contributions, no tax whatsoever on the proceeds.

Even if they accumulate a fund of more than €600,000, only some of the resulting pension would be taxed at 20 per cent. If they invest part of their fund into an approved retirement fund (ARF) and withdraw the minimum permitted 3 per cent per year, they can have an accumulated fund of significantly more than €600,000 and still be exempt from income tax.

Streamlining of retirement

The framework document announced that, from 2011, all defined contribution (DC) pension arrangements will have access to the same options at retirement.

At present, employees who are members of DC occupational pension schemes and are not 5 per cent directors of their employer’s company have limited choices at retirement – they can take their tax-free lump sum and the balance of the fund must be used to purchase a guaranteed fixed pension for life, known as an annuity.

Such an annuity dies with the pensioner. It can’t be inherited, unless it includes provision for a spouse’s pension.

Company directors owning at least 5 per cent of the shares, self employed sole traders, those contributing to personal retirement savings accounts (PRSAs) and those with additional voluntary contribution (AVC) funds have more choice at retirement. This includes the option to transfer some or all of their fund to an ARF, a more flexible vehicle which permits variable pension income to be withdrawn and the balance of the fund, if any, can be inherited on the pensioner’s death.

From 2011, it is proposed that members of DC schemes will have access to these ARF options, provided they have a minimum income from other sources of at least €18,000 per year. These ARF options and the increased flexibility they bring will be attractive to many.

Employees in DC schemes who would otherwise have been planning to retire this year may decide to wait until next year to avail of the additional options if they will apply to them.

On the other hand, employees with tax-free lump sum entitlements of greater than €200,000 will need to take into consideration the possibility that their lump sum may be taxable if they postpone their retirement until next year.

It’s interesting to note that the framework document proposed no change to the temporary measure that was introduced in December 2008, allowing retiring members of DC pension schemes to defer the purchase of their annuity until December 31, 2010.

This was introduced to assist retiring scheme members who had suffered substantial losses on their pension funds during the investment downturn that followed the global credit crunch.

Such a situation only affected those scheme members who, for some reason, didn’t receive or take advice to switch their pension fund into less risky assets in the years leading up to their retirement.

Although it was not something that could have been accurately foreseen by the government, with hindsight this measure was a good move for affected scheme members, as most pension funds have increased strongly in value over the past year.

For example, if someone deferred the purchase of their annuity from February 2009 to February 2010, the average Irish managed pension fund increased in value by 31.8p er cent in that period, which would have a corresponding effect on the pension they will now be able to purchase.

However, such people will not have the option to defer the purchase of their annuity beyond December 31, so won’t have access to the more flexible ARF options that will be open to those who retire from next year onwards.

Trustee training

Although the framework document does refer to the importance of financial education, no specific reference was made to training of pension scheme trustees. Yet this is an area that anyone who operates an occupational pension scheme, even for only one member, must address.

The Pensions Act was amended to include a requirement for trustees to undertake training at regular intervals.

New trustees are required to undertake training within six months of being appointed, while existing trustees must be trained within two years. All trustees will then be required to undertake training every two years thereafter.

If the employer acts as trustee for the scheme, as is the case for many smaller schemes, then all directors of the company, without exception, must undergo the training. The training is divided into nine modules, and the Pensions Board suggests that each module should take approximately one hour to complete.

This requirement for regular trustee training will, over time, eliminate the common practice of company directors agreeing for their company to act as scheme trustee with only very limited, if any, knowledge of the responsibilities that being a pension scheme trustee entails.

It may also result in some employers deciding to implement PRSA schemes for staff as they don’t require trustees.