4 - PENSIONS (fin.) Flashcards
Why is pension planning hard
- inflation can be damaging because DB schemes can be limited to lower of inflation/2.5% increases
- DC schemes place longevity risk on client
- cost rising
- increasing life expectancy
- annuity rates have been low recently in low rate environment + increasing life expectancy
- state pension age is increasing
- state pension only represents 20% of avg net earnings (+ it’s taxable + uses up PA)
Reasons for common pension shortfall
- 79% of people have c.135k shortfall vs funds for moderately comfy retirement
- present bias
- cossie lives
- UK savers often prefer property - more trust in market
- pensions can appear complex and expensive
- several miselling scandals
- pension fraud
- DB schemes unable to meet liabilities
- gov legislation can change dramatically
Retirement planning process
- establish current financial position and retirement strat currently being used (future inheritence, employers, amount avail for regular contributions)
- establish client health and medical condition
- establish retirement aspirations? realistic? stochastic modellling?
- determine capital required to fund plans
- assess clients existing retirement plans and protection products
- develop strat to meet needs
- identify appropriate solutions
- implement stat and keep it under review
3 ways to catergorise pensions
Trust or contract based
- trust based = typically occupational scheme - large comps typically trust based. in large corps 3 trustees must be active members
- contract based = sold by insurance companies, can be occ or personal e.g. SIPPs
Occupational or individual
- occ = workplace. can be contributory or non
- indiv = personal pension or SIPP
DB or DC
- DB = comp promises specified payment/lump sump/combo depending on employee earnings history, tenure, age. risk borne by company
DC = employer and employee decide set amount of contributions which are invested - no promise of a specific level of income, pension pot depends on contributions and investment performance
Collective money purchase scheme
-DC/DB hybrid
- trust based occupational pension scheme
- alt to DC and DB schemes
- offer members more certainty over the level of benefits they will receive than DC but be less financial burden on employers than DB
- risk shared collectively by members
-provides target level of benefits (e.g. Royal mail 1/90th pensionable pay for each year in scheme)
Features of state pension
- paid gross but is taxable
- not means tested, everyone with 35y of NI contributions/credits are entitled
- need min of 10y contributions to recieve anything
- guaranteed and payable for life
- relies on current contributions of working individuals to fund
- inflation proofed with triple lock protections - increases annually by higher of UK ewage growth/last12m CPI/2.5%
- can be deferred - 9 weeks = 1% extra (5.8% pa)
- credits towards NI
- 221.20PW if not additional state pen and not contracted out
- taken between 66 and 68 depending
State pension post 2016 retirees
- previously 2 tiered - basic flat rate pension and additional earnings related pension (based on NI contributions)
- now single tier - increased in April 2024 to £221.20 pw (11502 pa)
- Need 35y of NI contributions for full amount
- if people contracted out of additional state pension before april 2016, they may need to work longer to get required numbers of years in (you cant contract out now since there is no longer additional state pension)
Credit towards basic state pension
Individuals claiming unemployment, sickness and maternity benefits.
People aged 18 or over and in full-time approved training that does not last longer than one year
(not applicable to university students)
Parents receiving child benefit for a child aged under 12
Approved foster carers
Carers who care for someone at least 20 hours per week who is receiving disability allowance or
attendance allowance
Individuals earnings between the lower earning limit and primary threshold (below primary threshold dont pay NI but get credit for it)
State pension deferral
Can defer age at which you take your state pension
- 9 weeks min deferral
- 1% per 9 weeks (5.8% pa) - extra amount for life
- no cash option
- estate at best can claim 3m arrears
DB schemes
- pension plan where employer promises specified pension payment/ lump-sum/combo on retirement
- depends on earnings history, length of service and age not investment perf
aka final salary but not all are final salary (can have last 3y avg etc)
essentially promises given level of income @ retirment
Benefits payable depends on
- definitional of pensionable employment
- accrual rate used (e.g. 1/60th, 1/40th)
- definitional of pensionable salary
- whether it deducts basic state pension
Career average
- based on avg earnings over career
- may be revalued with RPI or NAE
- may be improvement in accrual rate
Hybrid
- money purchase or DB underpin (dont know what pension you will get but min amount underwritten
DB schemes are ‘unfunded’ = no defined pot of money, no investment fund built up - benefits just paid out by employer when they fall due alongside salaries of employees
Top up options for DB scheme
Additional voluntary contributions
- usually goes into separate DC scheme
Buy extra years
- employer determines cost and max no. of additional years is set
Invest extra contributions to separate fund
- used to buy extra annuity income @ retirement
- limited fund choice
- employer may not contribute
DB scheme commuting pension
- TFC/PCLS can be provided via commutation or in addition
- max = 25% of the value of the benefits
- formula to work out max TFC
C = based on gilt yields, usually 12 (e.g. for every £1 given up of pension we give 12) - company write to you on retirement giving pension income amount and offer lump sum payment with lower income (this is commuting your pension)
- work out default pension option
= 1/60 * 35* 65000 = 37,917 - Work out max commutation option
= 37,917 * (12/(1+(0.15 x 12))) = 162,501 - Work out adjusted pension
= 37,917 - 162,501/12 = 24,365 pa
Can take any amount of TFC and reduce pension
DB scheme earlly leavers
- benefits may be taken early from 55
- accrued benefits usually reduced by early retirement factor (e.g. 50bps pm)
- ill health early retirement permitted regardless of age
- benefits paid as PCLS and taxed income
- can be commuted for lump sum in case of serious ill health (tho lose IHT benefit if you do this, also wipes out spousal benefits)
- life expectancy <1y, benefit can be paid as TFC up to lifetime allowance
Leaver options DB scheme
- refund contributions
- preserved pension
- CETV = e.g. leaving scheme and transferring to a SIPP
- vest pension (generally 55+ = taking pension early)
Short service lump sum
short service refund can be paid..
- if <2y pensionable service (DB/DC schemes joined before oct 2015 - 30 days for DC schemes joined after)
- if payment is made beofr e75th bday
- provided payment extinguishes entitlement to member’s benefits
Max payment
- total of member contributions (not employers)
- interest can be added and investment growth can be allowed for
Tax
- on scheme administrator
- first 20k @ 20% excess @50%
- administrator deducts tax before refunds made
DB ill health early retirement
- draw benefits before normal pensionable age
- need evidence from doc to sign you off as being incapable of doing own occupation
- can be suspended if health improved
- company has right to put you in front of their own doctor
Serious ill health commutation
- life expectancy <12m
- May be extirely tax free lump sum
- satis metical evidence from registered med practitioner
- otherwise classed as unauth payment
- comp can be very generous or do bare min
TVAs
Transfer Value Analysis
- Calcs annual investment return/critical yield required from indiv pension arrangement to match benefits available from DB occ scheme @ retirement
- used when deciding whether or not to transfer out of DB scheme
- regulator not keen on transferring out of DB as giving up guarantees/protection - default postiion is that it isnt suitable and advisor must prove that it is
- if pension savings are worth 30k or more CETV must take financial advice on transfer
- calc deferred pension @ date you leave scheme
- revaule to normal pension date (using assumed inflation)
- Convert to cash equivalent using assumed annuity rates (work out cost of annuity to generate that level of pension)
- Discount this cash equivalent back to today’s date to give the critical yield (2 types A/B)
Critical yield
Shows investment return required to match income from immediate annuity purchase on retirement
Takes into account mortality drag and charges
TYPE A
- growth rate needed on drawdown investment sufficient to provide + maintain income equal to that obtainable under equiv immediate annuity
TYPE B
- growth rate needed to provide and maintain a selected level of income
Type B is capable of rigging as client can select a low yield to make transferring seem favourable, so regulator is very prescriptive about this
- type B illustrations cant be supplied in isolation and must be accompanied by type A
- type A must show annuity purchases @ 65, 60 and 75 at least
Reg prefers type A illustrations to be client specific but allows standardised tables to be used
- for client specific must show at least 2 of total critical yield, underlying annuity investment return and additional yield (diff between total critical yield and UL return)
Factors affecting the transfer value calc
Changes in
- discount rate
- assumed annuity rates
- assumed pension increases rates
- scheme’s funding position
FCA default position is to assume it’s not appropriate to transfer out of DB scheme so advisor must show why it is
Advantages and disadvantages of transferring out of DB scheme
ADV
- Ability to take benefits earlier than scheme may permit (e.g. pre 65)
- choice of when to take TFC and phasing payment whereas DB must be in full/not at all
- greater choice of pension annuity options e.g. enhanced or impaired life
- Flexibility e.g. income drawdown which can be adjusted for changing needs and not poss with DB scheme
- More flexi on range of death benefits and how these are dealt with
- more options on inheritance especially if not married to spouse (if there is money left when you die
- avoids mortality risk of early death with DB scheme
DISADV
- more flexibility comes with increased complexity
- risk of investing funds and longevity risks now on individual - must manage flexi drawdown to ensure certainty of income for whole retirement
- Must exercise management of income withdrawal to judge what is practical and adjust based on investment performance
- protection of pension protection fund is lost
- spousal benefit lost
Retirement planning tax incentives
Tax relief on contributions @ marginal rate
- can help restore PA
- relief at source (personal pensions)
- net pay arrangement (occ schemes)
Tax free lump sum
- PCLS - 25% of pot up to max of £268,275 (lump sum allowance)
- unless TFC protection in place from previous regimes
Fund grows free of UK taxes
- no VAT in management fees
Full flexibility of access and inheritability
Benefits left out of estate for IHT purps
Individual contribution LIMITS
- must be UK relevant individual to receive tax relief on a contribution
- amount that can be received is limited to greater of
- the basic amount (3,600 - 2880 = net amount someone can put in w/out any relevant earnings (e.g. a child)
- the amount of the indiv’s UK relevant earnings for tax year in question
Possi to make contributions on behalf of member - only member as to satisfy eligibility criteria
- tax relief given to member not donor
What is a relevant UK individual
- <75 and who meets one of the below in the tax year
- generate relevant UK earnings in the tax year AND
- be a resident in the UK for tax purposes at least some time during that year, or
- have been resident in the UK at some point during the preceding five years, and in the year of joining a registered pension scheme,
Or
* be (or their spouse be) an overseas Crown Employee with earnings subject to
UK tax.
What are relevant UK earnings
- employment income including taxable benefit in kind
- income derived from carrying out a trade profession or vocation
- income from patent rights
- income from UK or EEA furnished holiday lettings bis
- earnings from overseas crown employment subject to UK tax
Salary sacrifice/exchange
Procs/cons
- may be used by employee
- agree to reduced salary in exchange for employer contribution
Conditions
- written agreement must be in place to reduce salary
- must be in place before salarty reduced
- irrevocable
- cannot reduce salary beyond min wage
2006 - Pension simplification - A day
- A-Day introduced a single set of tax rules for all types of pensions
- Flexi benefits - could take up to 25% TFC
- removal of earnings cap
- introduced fixed annual amount where before it was a % (originally 235k but got up to 255k)
- for contributions pre 75
- 50k 13/14
- 40k 14/15 - 22/23
-60k from 23/24 - carry forward avail for unused annual allowance for last 3y (must thave had relevant UK earnings in the year of contribution for at least the contribution amount - use this year 1st, then back to earliest year then work forwards)
- remove gross amount from previous years to work out how much you can carry back
- accrual in DB schemes uses up annual allowance
How does accrual in DB schemes use up annual allowance
Type of pension: Final Salary
Accrual rate: 1/60ths
Service at start of the year: 25 years
Salary at start of year: £45,000
Salary at end of year£ 46,000
CPI: 1%
Step 1 – opening value @ beginning of year
Benefits accrued at start of the year:
25/60 x £45,000 = 18,750
Step 2 – increase opening value by inflation
Inflate this figure by CPI
18,750 x 101% = 18,937
Step 3 – closing value
Benefits accrued at the end of the year
26/60 x £46,000 = 19,933
Step 4 - difference
Calculate the difference
19,933 – 18,937 = 996
Step 5 – multiply by a factor of 16 (because you do!)
996 x 16 = £15,936 - this is how much of the £60,000 annual allowance has been used by the DB scheme
Step 6
Add any contributions to DC schemes
Annual allowance charge
- indiv responsibility to work this out (if you accidentally go over annual allowance)
- if excess pension savings exist this is added to members taxable income and taxed @ marginal rate
Tapering of annual allowance
Threshold income <200k = no taper
Annual Allowance reduced by £1 for every £2 adjusted income
above £260,000
If threshold above 200k but adjust BELOW 260k no tapering
1st check threshold above/below 200k
then look @ adjusted
Threshold income
If threshold inc <200k = no annual allowance tapering
Annual Allowance reduced by £1 for every £2 adjusted income above £260,000
Max reduction is 50k so min allowance is 10k
Adjursted income
If threshold inc is above 200k - look at adjusted
Can probs ignore gold as overcomplicated
if above 260k and threshold above 200k then tapering
Annual Allowance reduced by £1 for every £2 adjusted income above £260,000
Max reduction is 50k so min allowance is 10k
Money purchase annual allowance
Reduces AA to 10k from 60k
Main ways you trigger
- if you take entire pension as lump sum or start to take ad hoc lump sums
- putting pension into flexi access drawdown and starting to take income
- buying investment linked or flexi annuity where income could go down
- if you have pre April 2015 capped drawdown plan and take payments that exceed the cap
- UFPLS withdrawls where you take lump sumps and 25% of each is TF and rest taxable does trigger
Not triggered when taking SECURED PENSION INCOME
- taking 25% TFC doesnt trigger
- buying lifetime annuity with guaranteed income (includes step ups)
- taking TFC and putting pension into flexi access drawdown scheme but not taking income
- cash in small pension pots <10k
- doesnt apply to DB schemes
Fixed protection
Each round of LTA reduction has been accompanied by fixed protection
FP 2012, FP 2014, FP 2016
Each form allows you return the level of LTA that was previously avail
Must have had no other protection in place
For 2012 and 2014 - claim had to be filed with HMRC before reduction took place
Can resume contributions post April 2023 if you had it before 15 MArch 2023
Similar to Enhanced protection:
- No contributions to a DC scheme after 5/4/2012 (or 2014/16).
- Accrual with DB scheme must cease by 5/4/2012 (or 2014/16).
Individual protection
Gives protected LTA = to value of pension savings on 5.4.2014/2016 subject to max of 1.5m/1.25m
Can make further savings into plan
Transitional protections LSA
Protections LSBDA
Options @ retirement table
Options @ retirement for DC
Drawing benefits from DC scheme summary
Trivial commutation by member
commutating pension = reducing pension for one off lump sum
like small pots rules for DC pensions
- DB schemes only from 5 April 2015 (DC schemes can be commuted under small pots or UFPLS)
- member must be >55 and have avail LTA
-value of all member’s benefits excluding small pots must be <30k - first commutation payment triggers start of 12m commutation period
- all commutations must take place in this period
- member can only have one commutation period
- any payment must be entire entitlement of scheme
Benefits payable by PPF
- PPF will pay widows pension @50%
Workplace pension enrollment rules
- employers must offer qualifying scheme to their workers
- eligible jobholders must be auto enrolled into scheme
- autoenrollment must occur within one month
- if eligible jobholders opt out they must be re auto enrolled every 3y
- if they opt out within 1m they are treated as never having been a member and contributions will be refunded
pension vs isa
