Regular as clockwork, the annual speculation started prior to this week’s Budget in respect of higher rate tax relief on pension contributions supposedly being abolished. I couldn’t see it myself not only for the fact that this seems to come up every year but never gets a mention in the Budget.
We still haven’t forgotten that one of Gordon Brown’s first acts as Chancellor of the Exchequer in 1997 was his disastrous decision to withdraw the ability for a pension scheme to reclaim the ten per cent tax credit on dividends within pension funds. This blatant tax grab may have brought an extra £5 billion a year to Treasury coffers but it generated a huge amount of criticism for undermining what was regarded as one of the best pension system in Europe.
The controversial changes were blamed for the collapse of numerous pension schemes and neither has the passage of time allowed this financial albatross to be forgotten. Recent newspaper allegations have maintained Mr Brown was seeking £8 billion with this tax change and it took a row with Tony Blair to get the burden reduced. So with this decision still there to haunt him damning his debatable credentials as a master financier, Mr Brown would have been very brave indeed to have got rid of the higher rate tax relief.
But, true to form, Mr Brown has surprised us all. In this week’s Budget his Chancellor, Alastair Darling, proposed to reduce tax relief on pension contributions for those with incomes of more than £150,000.
The change has yet to happen and the waters are further muddied by the fact the Conservatives may well be in power next year.
But as things stand from April 2011 those in this salary bracket will no longer get the higher rate relief on pension contributions. His proposal is a sliding scale of reduced tax benefits that will drop down to 20 per cent when earnings are more than £180,000 a year.
Forgetting the income tax aspect, this Budget is a severe blow for the highly-paid in private pension terms. Not only is a tremendous tax relief measure disappearing but they will not be allowed to take advantage of existing pension tax relief rate by investing large sums ahead of the 2011 change. More importantly, this relief is probably the biggest incentive for individuals to fund pensions. In addition to the fund growing tax-free, it enables one to take 25 per cent of the fund as a tax-free cash lump sum.
Let’s face it, the Government has to provide us with as many incentives as possible when they want us to take personal responsibility to fund for our own retirements to somehow ease the burden on the state pension system.
The benefits of tax relief are incredible and remain for those who earn less than £150,000 per annum. For example, take an individual, 30 years old, a higher-rate taxpayer paying £1,000 per month gross into a pension and wanting to retire at age 55. The total gross contribution over the years amounts to £300,000, However the actual cost to the individual will have been £180,000 as the remainder, £120,000, is made up from tax relief.
This was one of the reasons for the Chancellor introducing a tax charge on passing pension funds to other individuals post age 75 – he didn’t like the fact that a third party would be benefiting from this tax relief.
The benefits of funding monthly rather than making a single premium on one given day have been touched on before. For example, investing a single premium of £60,000 in the Standard Life Managed fund on May 1, 2008 would have purchased 44,117 units and on October 1, 2009 would be worth £50,867.
Compare this to dripping £10,000 per month into the fund over a six-month period. In this scenario you would have purchased 46,840 units, an increase of 2723 units. The value as at October 1 this year would be £54,006, an increase of £3,139 on the single premium investment method.
For the majority of us, the earliest we will be able to retire is at the age of 55. Current legislation allows an individual to retire at 50 but, as from April 6, 2010 this will increase to age 55.
In my view, this change in legislation could pass by unnoticed. My guess is that the change is going to cause the financial services industry many problems with individuals who will have to wait at least another five years before they can take benefits.
Basically, individuals who are contemplating retiring after 2010 may want to accelerate their plans. Those who are between 50 and 55 need to check they are fully vested. The question to ask is, have you taken your full entitlement to tax-free cash? For those who are in phased retirement, this means those with income derived from a mixture of tax-free cash and income will need to fully vest the whole of their funds to ensure they have access to 100 per cent of the income immediately.
For those who are 50 now delaying the “opening” of new segments beyond April 5, 2010 will mean that they will have to wait until age 55 before they can access the remainder of their pension fund.
Retiring five years early all sounds well and good. But retiring at 50 may mean a lower fund and this is compounded further by lower annuity rates. Take for example our 30-year-old. Retiring at 50 would provide a pension fund of £452,000 assuming seven per cent growth. The resulting pension based on a single life, level with a five-year guarantee would provide an annuity of £24,717 per annum.
Delaying retirement for five years and continuing to pay premiums would realise a fund of £673,000, an increase of £223,000 (33 per cent).
This demonstrates how the fund increases significantly within the last five years prior to retirement and that one third of the final fund value has accumulated in the last five years. This additional growth has a significant impact on the final pension. Based on a fund of £673,000 this would provide an income of £39,054 per annum compared to the £24,717 per annum for retiring aged 50. Whether now, with the economic climate and position of stock markets, is the right time to be considering crystallising pension funds may be debatable. But the increase in the early retirement age should be treated as a priority if it affects your pension plans even if you are in the one per cent earning more than £150,000 a year.
Trevor Law is a director with Montpelier Group (Europe) Ltd, the privately-owned independent financial advisers located at Barston near Solihull. E mail: TILaw@montpeliergroup.com