DB & DC – the AA anomaly
I am often asked for a comment about defined benefit to defined contribution scheme transfers, however, there is little in the way of pension tax legislation that directly impacts on this type of transaction. On the contrary, the vast majority of principles impacting on such transfers are those set out by the Financial Conduct Authority plus an advisory firm’s own internal compliance procedures.
Bearing this in mind, I thought it would be useful to cover some of the pension tax legislation differences between defined benefit arrangements and other money purchase arrangements. In this b I am only going to look at the differences in the way the pension input amount (PIA) is calculated for annual allowances purposes.
The annual allowance in effect limits the amount of tax privileges available on pension savings paid by or in respect of an individual in a tax year to a registered pension scheme. The measurement works on the principle of how much was saved from the start of the pension input period (PIP) to the end of the PIP, which is referred to as the PIA. PIPs are now aligned with tax year ends making it easier to calculate the PIA. Where the PIA exceeds the individual’s annual allowance, including any carry forward from previous tax years, an annual allowance charge will be payable at the individual’s marginal rate of income tax.
For other money purchase arrangements, such as a Sipp, the PIA is the sum of the following paid during the PIP:
• All relievable pension contributions paid by or on behalf of the individual under the arrangement, and
• Contributions paid in respect of the individual under the arrangement by an employer of the individual.
Calculating the PIA for Sipp is therefore relatively straightforward; in the case of a defined benefit (DB) arrangement it is slightly more complicated. It is not, as may be envisaged, a case of taking the percentages for employer and employee contributions and applying these to pensionable earnings, but rather the PIA is a notional contribution based on the increase in benefits accrued over the PIP. Take the following example:
Assume pension accrued at the start of the PIP is £39,360 p.a. (lump sum through pension commutation), and the annual increase in the consumer price index (CPI) to the previous September was 3%. The accrued pension at the end of the PIP is assumed to be £42,000.
◦ Opening value = (39,360 x 16) x 1.03 = £648,653
◦ Closing value = 42,000 x 16 = £672,000
The PIA is therefore £23,347 arrived at by taking the closing value from the opening value (£672,000 – £648,653).
“And…” you may ask, so let’s look at this in a slightly more oblique way.
In the DB example, the individual’s PIA was £23,347 for an increase in pension income of £2,640. Compare that with an other money purchase arrangement PIA of £23,347 that was used to immediately purchase an RPI linked annuity with 50% spouse’s pension to give a comparison with the equivalent DB benefits. In today’s low annuity environment a 65 year old male (spouse 5 years younger) would get around £60 a month paid in arrears, or £720 per annum (source; The Money Advice Service); hardly an equitable outcome for the person with a Sipp with a yield of 2.73% when compared to the DB yield of 11%.
To add salt to the wound, while the PIA for the DB scheme is only £23,347, the actual capital value of the contributions for the accrued pension could be close to twice as much. For example, the NHS scheme has an accrual rate of 1/54 with an employee gross contribution rate of 14.5% (8.7% net of higher rate tax relief) for those earning over £111,377 and an employer contribution of 14.38%, 28.88% in total. Using the figures in the earlier example, the individual in question would have a pensionable salary of £142,560 and a total monetary contribution amount of £41,171. On this basis the individual would have exceeded the current standard AA of £40,000 and yet under the actual methodology used to calculate the PIA, they would be able to carry forward up to £16,653.
The calculation of the PIA for AA purposes is not the only area in which, I would suggest, other money purchase arrangements are treated unfavourably under pension tax legislation when compared to the DB arrangements. Other areas where this is apparent are when testing benefits against the lifetime allowance and benefit crystallisation events at age 75. The one area where perhaps money purchase arrangements are more favourably treated is when it comes to death benefits, which I’ll cover in a later blog.
This blog first appeared in Money Marketing on 15 March 2018