How to value final salary pension benefitsby
Richard Service exposes the secrets of assessing the tax value of a member’s pension benefits due to be paid from a defined benefit scheme.
Bias in the system
There is one aspect of the pension tax rules which has remained untouched despite all the recent legislative upheavals: measuring the value of a member’s entitlement under a defined benefit (DB) pension scheme. The absence of any review underlies what’s widely believed to be a bias in the tax rules in favour of DB, or final salary, pension schemes.
Why do the annual allowance and lifetime allowances apply more severely to contributions paid in, and benefits extracted from, defined contribution (DC) and personal pension schemes, than to DB schemes?
For a DC scheme the taxpayer’s annual allowance is measured against the premiums paid into the scheme, and their lifetime allowance is measured against the payments out of the scheme. Straightforward.
The members of DB schemes don’t have a “pot” of money allocated to them within the pension scheme. Indeed, the largest DB schemes still offering benefit accrual – the civil service scheme – is unfunded.
For a member of a DB scheme their annual allowance and lifetime allowance are both tested against values calculated using their pension entitlements from the scheme, not the amounts actually paid in or out.
For a DB scheme the annual allowance is measured against the “input amount”. This is the increase in the member’s accrued pension over the scheme year, multiplied by 16 (FA 2004 s234).
Based on Shelia’s service at the end of the current scheme year, she has accrued an entitlement to a pension of £25,000 per annum. At the beginning of that same year her pension entitlement, increased by CPI, was £23,000 pa. Her input amount for that year is £32,000 (16 x £2,000). This is compared to her annual allowance for the year, which would nominally be £40,000 for 2016/17.
It is not straightforward to compare the annual allowance valuation factor for DB entitlement with a DC scheme, as the multiplier of 16 is applied regardless of the age of the member. For a member aged 30 the factor of 16 may still be unfairly severe; at 59 the factor of 16 is incredibly favourable.
The lifetime allowance for a member in a DB scheme is tested against 20 times the member’s annual pension (FA 2014, s276). This test is only applied when a member takes benefits from the scheme.
It is relatively simple to check the reasonableness of the factor used for the lifetime allowance. At current annuity rates, a DC fund of £1m will allow the member to purchase an index-linked annual pension with widow's benefit worth approximately £30,000 pa.
For a member of a DB scheme, the value for lifetime allowance attributed to a pension at retirement of £30,000 pa is £600,000.
Putting it another way: a DB member can have an annual pension of up to £50,000, as the lifetime allowance is currently £1m (20 x £50,000). Any higher pension will create a lifetime allowance charge for the member.
Using the current real pension values the estimated capital value of a £50,000 inflation-proof pension with widow’s benefit could be £1.67m. In effect, the lifetime allowance for those in DB schemes is not £1m – it is in the region of £1.67m.
Whilst the government has not permitted members of their DB schemes to use the pensions freedom to transfer to personal pension schemes, there have been reports of trustees of private sector DB schemes offering members transfers to DC schemes valuing their benefits at 30 times pension entitlement.
Why no review?
The most recent review of the factors used for DB pension entitlements of 16 and 20 was undertaken by the Government Actuary in 2010. In paragraph 1.2 of this report it says: “the valuation factor is intended to be suitable for use over the medium term, for say the next five to ten years”.
In 2015 I asked HM Treasury if they had approached the Government Actuary to refresh the report for current market conditions. On 29 January 2016 HM Treasury responded:
“As you are aware, the report by the Government Actuary in 2010 set out an intention to review the Annual Allowance and Lifetime Allowance five to ten years from its original publication – between 2015 and 2020. The Government has yet to commission the Government Actuary to re-examine these factors. As you may also be aware, the Government launched a consultation on the future of pensions tax relief at the Summer Budget 2015. The Government has been consulting on whether there is a case for reforming pensions tax relief to strengthen incentives to save, and offer savers greater simplicity and transparency, or whether it would be best to keep with the current system.”
I reckon HMT’s response did not address the point that assumptions underlying the 2010 report are now well out of date. Were the playing field tilted in the opposite direction, favouring personal pensions, would HMT/HMRC be as reluctant to refresh the report?
Whilst most of those who benefit from, what seems to me, to be a bias in favour of DB schemes are public sector employees, there are opportunities for private companies to take advantage of the bias. I’ll cover this in a future article.
Richard Service is a volunteer adviser with Tax Help for Older People. Please consider supporting the Bridge the Gap appeal which raises funds for the tax advice charities: Tax Aid and Tax Help for Older People.