Finding your way through Britain’s pension maze

published 5 December 2005

Pensions are not popular in the UK. Poor performance, tough exit penalties and a string of scandals have eroded many people's confidence in the sector. Yet at the same time, increasing longevity and an ageing population mean that it has never been more vital to save. The sweeping changes to pension rules due to come into force in April 2006 demonstrate the Government's desperation to get us all to do so. As of A-Day - as 6 April 2006 has been dubbed by the Inland Revenue - there will be just one set of rules governing all types of pension plans. The rules will offer a lot more flexibility and provide new opportunities for those who have hitherto shunned the sector; residential property, works of art and fine wine could, for example, all suddenly become part of your pension.

Although the final rules will remain unknown until the publication of the Finance Bill 2005 later this year, the main principles of the reform and much of the detail is already known. And while these rules have not yet become law, if you don't get to grips with them in advance, you could lose out.

Here's how the whole thing will work. From 6 April 2006, the existing eight sets of tax rules for different kinds of pension will be scrapped and replaced with a single set for occupational and private pensions. Of the many proposed changes, those likely to be of greatest interest, says Pamela Atherton in The Daily Telegraph, include the ability to hold residential, in addition to commercial, property in a Sipp (a self-invested personal pension); the potential to avoid compulsory annuity purchase at the age of 75; and the opportunities for inheritance tax (IHT) planning. The main changes to be implemented are outlined below.

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Lifetime allowance

A new lifetime allowance is being introduced, which will cap the total value of individual pensions at £1.5m from April 2006, rising to £1.8m by 2011. Anything in your fund that exceeds the limit at the time of your retirement will be taxed at a punishing 55%. If you have already exceeded this limit - or are likely to do so by A-Day - you should take steps to protect your money. You have two options and can register for them until 2009. If you have pensions savings already worth more than £1.5m, you can register for primary protection'. This will protect you from the 55% recovery tax and also allow you to top up your fund by the equivalent percentage increase in the Lifetime Allowance in the years leading up to your retirement. Alternatively, anyone can register for "enhanced protection". This may be useful if your fund is currently below the £1.5m limit, but you expect it to have grown substantially above the ceiling by the time that you retire. No recovery tax will apply, as long as you stop contributing to your pension on A-Day.

Maximum annual contribution

These are being increased. As of 6 April, you will be able to invest an amount equivalent to either your entire annual earnings, or £215,000, whichever is lower, ever year. As a result of this generosity, Carry Back rules, which allow you to mop up unused allowances from previous tax years, are to be scrapped. Savers will continue to enjoy the same tax reliefs. For every £78 you invest in a pension, the Inland Revenue will top up your contribution by £28 (effectively a refund of the 22% tax you've already paid). If you're a higher-rate taxpayer, the taxman will let you claim the extra 18% too (40% minus the 22% he's already given you). This money is not paid into your pension plan, but instead refunded to you. Any funds or assets within your pension plan are allowed to grow completely tax-free; since returns from most investments from shares to bank interest can be taxed at up to 40%, this concession is very valuable.

Greater flexibility about how you take your pension

The minimum retirement age is being raised from 50 to 55. If you belong to an occupational scheme that has given you the right to retire at 50, you still can. Under the new rules, you will also be able to take 25% of your pension savings as a tax-free lump sum. But the greatest advantage for anyone retiring after April 2006 is that they will have more choice about how they receive the rest of their money.

At present, once you reach the age of 75, you have to buy a compulsory annuity with all your savings, which is fully taxed. An annuity provides a monthly income made up of interest, plus some of your original capital. The income is guaranteed for life, but should you die early, your heirs generally get nothing. From A-Day, you will no longer be forced to buy an annuity at 75. Instead, should you wish, you can pay yourself a new type of income drawdown called Alternatively Secured Income (ASI). This allows you to vary your income from £1 to 70% of the maximum annuity you could have bought at the age of 75. Should you decide, at any point, to buy a traditional annuity, you can do so. The great advantage is that you can keep control of your money and, for the first time, pass any pension savings remaining on your death to your heirs. Unfortunately, there are likely to be strict controls on what can be passed on tax free, so you will have to wait until the final rules are published to decide how best to act. Between the ages of 55 and 75, you can either buy an annuity or use income drawdown. If you use income drawdown (simply drawing money from your pension), it will still be fully taxed as you take it out, but will at least have greater flexibility: you will able to take out as little as £1 and as much as 120% of the income you would have received had you bought an annuity (currently you can only take between 35% and 100%). This is very useful if you want to keep your savings invested with a view to earning more later on.

Holiday homes and other assets

Under the new rules, it will be possible to buy assets that you can personally enjoy, such as works of art and a holiday home. Such use will, however, create a tax charge, says Nick Braun in his book, Retire Rich with a Property Pension. For the first time, you will also be able to hold residential property in addition to commercial property in your pension.

General flexibility

From April next year, you will be able to belong to both your employer's pension fund and a personal pension plan. You will also be able to carry on working part-time and draw benefits from your company's pension scheme, enabling you to make a much more gradual transition from work to retirement.

Taking action before A-Day could save you money. If any of the following apply to you, do something now.

Have you been building up a business and cutting down on salary and benefits to reinvest in your company? If so, now is the time to act, says Stephen Womack in the Mail on Sunday. Current rules allow up to the whole value of an Executive Pension Plan (a type of occupational pension scheme) to be paid tax-free, providing the value of that fund is less than 3/80ths of final pay, multiplied by the number of years worked. So someone with 20 years of service paying themselves £50,000 in the year before retirement is allowed to take £37,500 tax-free. These rules are being scrapped next April, but as long as you set up a pension under this framework before then, you can preserve your rights to the maximum tax-free sum.

Other existing pensions, including Section 32 contracts and Retirement Annuity Contracts (RACs), may currently have more generous allowances for tax-free cash than the post A-Day 25%. While these entitlements may be preserved beyond A-Day, if the pension is then modified or moved to another firm, the extra allowances are lost. As a result, Paul Clark of IFA, the Cavanagh Group, advises any such pension holder wishing to transfer to another provider for, say, a wider choice of investments, to do so before A-Day.

Are you on, or near, the new lifetime limit of £1.5m? If so, the next 12 months provide a window of opportunity for you or your employer to contribute as much as possible into your pension pot before registering yourself for protection against the 55% penalty.

Are you close to retirement? If so, you should probably consult a pensions adviser to find out whether it is worth delaying taking their pension until after A-Day, if necessary tiding yourself over with savings. If, say, you are one of the millions who have contracted out of the Serps state pension, it may be worth delaying your retirement so that you can receive 25% of your fund in tax-free cash. Alternatively, you may belong to an overfunded' company pension scheme, which, under current rules, means that you are not allowed to draw the maximum income the money held in the fund could buy. After April 2006, overfunding will no longer be an issue, so again, it may be worth waiting. Most personal schemes are flexible about the date to start drawing a pension, but you might have to negotiate with your employer to delay drawing a company pension.

Do you want to invest in residential property via a self invested personal pension? The borrowing limits on residential property Sipps will be quite stingy - you will be able to borrow a sum worth just 50% of your pension fund's net assets - so the more money you can contribute to your pension fund now, the more you will be able to borrow after A-Day. Since you won't be able to invest in residential property straight away, one option for those who don't want to invest in shares or bonds in the meantime might be to start contributing to a stakeholder pension. The charges are extremely low, and you will be able to transferring all the cash out of the scheme to a Sipp at a later date without paying any charges.