For the majority of pension scheme members, Alistair Darling's 2009 Budget has no material pension implications. 

However, for individuals earning more than £150,000 a year ("high earners") its impact could be both immediate and, in the longer term, serious.
As well as freezing the lifetime allowance and annual allowance from next year until 2015/16, the Budget announced changes to the tax treatment of pension savings under registered pension schemes from the tax year 2011-12.  But it also announced transitional anti-avoidance provisions, taking immediate effect, to prevent "front-loading" of benefit accrual to obtain full tax relief at 40% in advance of the 2011-12 changes. These will apply in both tax years 2009-10 and 2010-11.

The lifetime allowance - total tax efficient pension savings

The lifetime allowance (the value of retirement benefits that can be taken without attracting the "lifetime allowance charge") – currently £1.75m – will rise to £1.8m from 6 April 2010 and remain at that level until (and including) tax year 2015-16. 

Over time, more senior employees are likely to be affected by the lifetime allowance charge.

The annual allowance - ongoing tax efficient pension savings generally

The annual allowance is the maximum amount of contributions payable to a money purchase arrangement in, normally, a tax year – or the maximum increase in the "value" of a member's benefits in a DB arrangement which can occur over that period – on a tax-relieved basis.  (The increase in accrued DB pension over the year is generally multiplied by 10 to work out its "value" for this purpose.) 

The annual allowance is currently £245,000, and will rise to £255,000 on 6 April next year.  The Budget confirmed that this too will be held until 2015/16. 

This change on its own could mean that, over time, more senior employees are affected.  However, there is a more immediate issue for "high earners".

"High earners"

The more serious implications are for individuals with a "relevant income" in a particular tax year, or either of the two preceding tax years, of £150,000 or more.
"Relevant income" is, broadly, the total income that would be chargeable to income tax less certain specified deductions.  This is significantly wider than simply employment income and includes, for example, savings, dividend and rental income.  It also adds back in any pension contributions made by the individual. 

The most serious changes will apply from tax year 2011-12 but there are also immediate changes too.

What happens in 2011-12?

Part of the bad news for high earners is that, from 6 April 2011, they will receive more limited tax relief on all contributions paid to a money purchase arrangement and on any increase in the value (as above) of their DB pension arrangements.  It seems that there may be some tapering of tax relief, with the expectation that only 20% tax relief will be available for those with relevant income of £180,000 or more. 

As tax relief will be limited and income tax for high earners will rise to 50%, it seems that those above £180,000 may end up paying 30% income tax even on pension contributions/DB accrual; and the intention seems to be that this will apply not just to contributions/accrual over a certain minimum level but to the whole amount. 

Given that at least 75% of the emerging pension (i.e. after payment of any tax free cash lump sum) will then be taxed again when the scheme pays it out, it seems that high earners will need to think carefully about whether they want to build up any additional pension at all after April 2011.  In many cases, depending on how far the final legislation reflects these proposals, they might find they would be better off opting out completely.

What happens from now until 2011-12?

The Budget also included measures to stop high earners trying to bring forward pension contributions or accrual to the current tax year (or next tax year) in order to get full tax relief.  It does this by imposing a new "special annual allowance charge" above a certain level (£20,000) of annual pension savings.  However, this new charge will not apply to regular pension savings already in place before the Budget. 
Looking first at money purchase:

  • if a high earner's pension contributions to a money purchase arrangement go up this year to a higher rate than on 22 April 2009 (and to more than £20,000 per annum), even now they will in practice get tax relief at only 20% on the excess unless the increased rate was agreed before 22 April 2009. 
  • And where the employer contributes too, any increase in the rate of contribution will count towards the new charge (and so the individual will pay tax on the increase in employer contributions at 20%) unless the increase was agreed before 22 April 2009. 
  • Increases that were "agreed before 22 April 2009" would appear to cover increases under scheme rules due to an age related contribution scale or an increase because the same percentage of salary was paid but the salary has increased. 
  • Where individuals make special contributions to a personal pension scheme or as money purchase AVCs to an occupational pension scheme this tax year or next tax year which will only attract 20% tax relief because of these changes, the contributions can be repaid as a refund during the next tax year (if the scheme rules allow).  The scheme administrators (not the individual) will be liable for tax at 40%, which they will want to deduct before paying the refund.

Turning now to the DB context - there are a few exemptions to the new 20% tax charge.  These are:

  • Where the individual, already a scheme member, continues to accrue benefits in the same way.  Added years contributions will also be covered, where they were being paid at least quarterly before 22 April.  This means there is no issue for a high earner whose DB pension increases in value merely because of a pay increase or as a result of revaluation – the increased value will simply result from the normal operation of the current scheme rules;
  • Where there is a "material change" to the rules under which benefits are calculated, but this affects at least 50 active members.  This means changes to rules generally may not  cause a problem, but small (e.g. executive) sections of schemes may prove more problematic;
  • Where someone joins a scheme and there are at least 20 people who are accruing on the same basis as the new member. Again – this may cause difficulties if there is only a small executive section of a scheme; and
  • Where the member draws benefits from the scheme (or dies), the charge will not apply to any increase in defined benefits during that tax year unless it breaches the anti-avoidance provisions (described below).

The draft legislation includes anti-avoidance provisions which apply where the individual drawing benefits is part of a scheme one the main purposes of which is to avoid or reduce liability to the annual allowance, lifetime allowance or new special annual allowance tax charges.  Although the draft legislation seems very broadly drafted, the Government's guidance explains that the avoidance arrangements provisions are intended to apply where arrangements are made so that the increase in pension savings (on the annual allowance basis) is artificially low.  This could be the case, for example, where arrangements are made for a member to have a very low starting pension with artificially high guaranteed pension increases, or where an augmentation was made to waive the normal early retirement discount.

The draft legislation also includes provisions designed to stop high earners entering into salary sacrifice deals to bring their incomes below £150,000 so that they can then revert to enjoying full tax relief on contributions and benefit accrual.

Immediate practical issues

Any high earner will need to think carefully before, for example, increasing the rate at which he or she contributes to any form of money purchase pension arrangement – including payment of AVCs if the individual isn't already making AVCs.  Employers may wish to contact individuals who they think will be high earners to alert them to the issue sooner rather than later.

Schemes will need to be amended if refunds of AVCs that will attract the new charge are to be allowed.  Although any refunds will not be paid until 6 April 2010 at the earliest, individuals may want certainty about their options well before then. 

Augmentations – for example, using redundancy payments to augment defined benefits – are likely to fall within the scope of the new 20% tax charge unless the member retires at the same time.  But this should be reviewed on a case by case basis as it may still prove more tax efficient to make provision through the scheme rather than a cash payment, at least until 2011-12.  This may have serious immediate implications where redundancy exercises involving high earners are underway. 
Where a member retires at the same time as an augmentation is awarded, it seems that the new charge will not apply – but this is not clear from the draft legislation (and the Government's explanatory materials seem self-contradictory in this area).  Until the legislation is finalised, it would seem prudent to advise members that there is a risk that the augmentation may be caught by the new charge and provide them with information so that they can make an informed decision on a "worse case" basis or allow them to defer their decision where this is feasible.

Longer term implications

Over the longer term, the proposed changes from 2011-12 would make pension benefits far less tax efficient and so less attractive to "high earners".  This could make alternatives, such as unfunded promises with or without security, a more attractive part of the remuneration package for senior employees who still want some pension provision from their employer.

The Government has promised to consult on the detail of this legislation, so it is not yet clear on a number of points. 

We will be discussing the implications of the 2009 Budget at our forthcoming Quarterly Pensions Managers' Briefing and Quarterly Governance Round Table for Chairman of Trustees and Independent Trustees later in May.  However, if you would like to discuss the implications of 2009 Budget for pension schemes, please do not hesitate to get in touch with your usual Mayer Brown contact or:

Ian Wright
Tel: +44 20 3130 3417