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Pensions - The Basics

The following sections provide a brief summary of the main types of pension benefits in the UK. The Pensions Act 2004 has recently been enacted which provides for fundamental changes to Pensions legislation, including the introduction of the long-awaited Pension Protection Fund and a new set of Scheme Funding Requirements. Combined with recent far-reaching changes to the taxation of pensions, this makes for a fast-moving, highly complex area of the law in which care and professional advice should always be taken.

Pension Schemes

Essentially, there are two types of pension scheme: occupational (or company) pension schemes and personal pension schemes. They enjoy broadly similar tax concessions, although from April 2006 the same tax regime will apply. Provided a pension scheme is approved by the Inland Revenue, contributions paid by the employer and the employee are tax deductible.

The pension fund is exempt from income tax on investments (although subject to tax on dividends) and deposits and from capital gains tax on the disposal of investments. Benefits may be taken in the form of a tax-free lump sum and an annuity (pension), which will be treated as earned income and therefore subject to income tax. With some exceptions, an earnings cap (£102,000 for the tax year 2004-2005) restricts the earnings which may be taken into account for both types of scheme when making contributions and calculating benefits which can be paid out.

At the moment there are also restrictions on the amounts which individuals can contribute to their pensions and which depend on age (e.g. if you are 35 or under the maximum percentage of net relevant earnings you may contribute to pensions is 17.5%, and so on). However, under the Government's proposals on the reform of pension scheme taxation, these restrictions will be removed and individuals will be entitled to contribute whatever they like up to a lifetime limit currently set at £1.5 million (there is ongoing debate about the level of this limit and it is possible that it will have increased by the time the Government's proposals are implemented on 6 April 2006).

Both types of pension scheme can provide one or more types of pension benefits. The two types of pension benefits are defined benefit (also known as final salary) and defined contribution (also known as money purchase).

Pension Benefits

  • Defined benefit (also known as final salary)

    A defined benefit scheme is almost always an occupational (or company) scheme. In this type of pension benefit the employer promises to make sure the employee receives a guaranteed level of pension, based on the employee's earnings before he retires and how long he has been a member of the scheme. Thus the amount of pension to which the employee is entitled is not dependent on external factors such as the stock market. The employee may or may not be required to contribute, with the balance of cost and investment risk resting with the employer, which has to make up any shortfall in funding. If the employer becomes insolvent, the pension is not guaranteed, although there may be a claim on the Pension Protection Fund from April 2005 and the "Lifeboat Fund" before then.

  • Defined contribution (also known as money purchase)

    There is no guaranteed level of pension in this type of benefit. Employers and employees contribute at a set rate and, on retirement, the employee's individual account (pot) of accrued investments is used to buy an annuity to provide him with a pension. The fund available to purchase the employee's pension will comprise the contributions made and the investment return on those contributions. The investment risk that arises from stock market volatility rests with the employee - it is not the employer's responsibility to top up benefits in the event of poor investment returns.

Types of pension scheme

(Note that personal pensions are dealt with separately.)

  • Occupational pension scheme (OPS)

    These are usually run by trustees and are highly regulated. Employers must contribute a reasonable percentage to their OPS in order for it to be approved by the Inland Revenue; employees (or members) may be required to pay contributions of their own and will be able to make additional contributions (subject to limits imposed by legislation). Employer and member contributions paid into the scheme are pooled to form a pension fund. Employees are not entitled to any specific assets of the fund. Employers generally meet the entire administration costs of the fund.

  • Small self-administered scheme (SSAS)

    A SSAS is a special type of OPS. A SSAS has twelve or fewer members. At least one of the members will be connected with another member, trustee or employer in relation to the scheme. As such, SSASs are suitable for smaller employers (for example, family businesses) and are also often used to provide benefits for company directors.

    The trustees of SSASs have much wider powers of investment compared with those allowed under other approved pension schemes, including the ability to lend part of the pension fund back to the employer to assist in the expansion of the business, to purchase shares in the employer's business and to purchase commercial property and lease it back to the employer (from 6 April 2006 it will also be possible to purchase residential property and lease it back to the employer). Such "self-investment" is subject to limits laid down by the Inland Revenue.

    The facility to re-invest the SSAS assets in loans to the company is of great benefit, since the contributions obtain relief from corporation tax and the interest on the loan attracts relief when the company pays it. Since there is the possibility of abuse of these investment freedoms, the Inland Revenue has required SSASs to have a special type of trustee, known as a Pensioneer Trustee, whose role is to ensure that the SSAS complies with the relevant rules and regulations applicable to SSASs. However, the Government has recently proposed removing the requirement for a Pensioneer Trustee and it is likely that by 6 April 2006 the appointment of these will no longer be necessary.

    SSASs can also exempt themselves from a variety of administrative requirements if all the members of the SSAS are trustees and make decisions unanimously. This can lead to problems if the trustees fall out.

    Although SSASs are by nature small pension schemes, the range of permitted investments and additional regulations mean that the trustees will still need advisers. Employers must therefore weigh up the potential costs involved against the benefits.

Personal pensions

Personal pension providers include insurance companies, banks, building societies and friendly societies. Most members are people who do not want to or cannot join an OPS, for example those who change jobs a lot or who are self-employed.

In certain circumstances it is permissible to become a member of a personal pension scheme whilst still an active member of an OPS. It is also possible to join more than one personal pension scheme in respect of the same source of income. However, the additional costs that may be incurred might not make this an attractive option. At the moment, a maximum percentage limit of contributions dependent upon the member's age must be adhered to, irrespective of the number of personal pension schemes (although this restriction is set to be removed under recent Government proposals). Personal pensions almost always provide only defined contribution types of benefits. Some specialist types of personal pension are:-

  • Group personal pension (GPP)

    This is where a group of employees at one company, or a group of self-employed people, all take out personal pension schemes from the same provider. Each person still has their own scheme. If an employer arranges a GPP (which will be administered by an insurance company) they may, but are not obliged to, pay contributions into their employees' schemes. GPPs are an attractive option for employers, given the minimal administration costs and obligations.

  • Self-invested personal pension (SIPP)

    SIPPs are geared at directors of private companies and the self-employed who are used to running their own business and who require investment flexibility. SIPPs allow the member to control the investments personally, which is generally not possible with insured personal pensions. For the company director, self-employed partner, or sole proprietor, a SIPP can, for example, be used to invest in commercial property (such as offices) with tax relief, which can be let on arm's length terms to the member's business. The purchase could be funded not just from the fund itself, but from borrowings or a transfer payment from previous pension arrangements. Provisos do apply, one of which is that the SIPP investor must pay commercial rates if he uses any of the facilities.

    Contributions are subject to the same limits as other personal pensions. Although there is no maximum limit on the pension payable, the tax-free lump sum cannot exceed 25% of the fund.

    The main disadvantage of a SIPP compared with any type of occupational scheme is that a SIPP is mainly funded by personal contributions by the member. Also, even if the member makes all the investment decisions, an administrator must still be appointed.

Pension Protection Fund

Previously, when companies have gone bust and their schemes have been underfunded, workers have sometimes found their pensions fall significantly below that which they were expecting. In an attempt to deal with this, the Government is to introduce the Pension Protection Fund (PPF). The aim of the PPF is to provide increased protection for members of defined benefit schemes by paying compensation should their employer become insolvent and the pension scheme be underfunded.

  • How the PPF will work

    Once implemented (from April 2005), the three main functions of the PPF will be: (i) to pay out pensions and fraud compensation; (ii) to manage the calculation and application of the three annual levies; and (iii) to set and oversee the investment strategy.

    Scheme members will only become eligible for PPF compensation when the sponsoring employer is insolvent and the pension scheme has insufficient assets to buy out the PPF level of benefits. Under the Pensions Act 2004 the protection offered by the PPF is 100% of the original pension actually in payment to existing pensioners and 90% of the pension for deferred pensioners (subject to a cap). It should be stressed that the PPF does not guarantee that these rates will be paid and there are some serious issues over how the fund will remain solvent, especially in the event of substantial claims being made in the early days.

    The PPF will charge a compulsory annual levy on all defined benefit schemes, which will take in the remaining assets of the pension scheme upon insolvency.

    Not all types of pension schemes are eligible for cover by the PPF. Ineligible schemes include, for example, money purchase schemes and schemes exempt from the application of the Minimum Funding Requirement.

Stakeholder Pensions

Stakeholder pensions are low-cost, flexible pensions. They are designed for people who do not have a private pension already, particularly those with earnings of around £10,000 to £20,000 a year. This note outlines the stakeholder pension scheme.

When you must have a stakeholder pension scheme in place?

Since 8 October 2001, those who employ 5 or more employees may have to make a stakeholder pension available to their staff. If there are relevant employees, employers (unless exempt) must:-

  • give employees access to a stakeholder scheme within 3 months of their starting work;
  • consult with their employees and then designate a stakeholder scheme which is registered with the Occupational Pensions Regulatory Authority (OPRA) (designation does not mean an employer has to set up a separate scheme for its employees);
  • give employees information about contacting the designated scheme;
  • make deductions from an employee's salary for his pension contributions to the designated scheme.

What are they?

The key features of stakeholder pension schemes are:

  • they are set up under either a trust or a contract between a person authorised by the Financial Services Authority and the employee;
  • employers do not have to contribute;
  • employees do not have to join;
  • employees may choose the amount they contribute (although the scheme rules may bar payments of less than £20 at a time) provided changes are not made more than once every six months;
  • charges should be no more than 1% per year of the value of the member's funds in the scheme;
  • employees who are already in an occupational pension scheme, who are not controlling directors and who earned £30,000 or less in any one of the previous 5 tax years may (from 6 April 2001) pay into both a stakeholder scheme and an occupational pension scheme at the same time, up to certain limits;

Exemptions

An employer need not provide access to a stakeholder scheme for any employee who is not a "relevant employee" because he falls within one of the following exceptions:

  • he is entitled (unless he is within 5 years of scheme retirement age or aged under 18) to join an occupational pension scheme within 12 months of starting work for that employer, i.e. there is a waiting period of no more than 12 months;
  • he has worked for that employer for a continuous period of less than three months;
  • his earnings have fallen below the national insurance lower earnings limit for one or more weeks within the last three months;
  • he cannot contribute to the stakeholder scheme because of Inland Revenue restrictions (for example, employees working abroad who may not satisfy the residency conditions);
  • he is a consultant, agency worker, seconded employee or other worker not employed under an employment contract.

Employers who currently operate pension schemes should check whether they satisfy the exemption criteria. In particular, employers should check the terms and conditions of any group personal pension scheme (GPP) relating to entry requirements and to charges on transfers out or on stopping contributions.

An employer need not comply with the employee access requirement if he has no "relevant employees" or if he has fewer than five employees. An employer will not be exempt if he has "relevant employees" working in Great Britain, even if the company is resident or registered outside the UK, or if the company is resident or registered in Great Britain and there are "relevant employees" employed outside the UK .

An employer also need not provide access to a stakeholder scheme if he offers all "relevant employees" (except those under 18 years old or earning below the Lower Earnings Limit) the opportunity to join a GPP which is sponsored by the employer and is subject to the following conditions:

  • the employment contract requires the employer to contribute to the GPP on behalf of any employees who join the GPP;
  • the employer contributes to the GPP at least 3% of its employees' basic pay at the same frequency as employee deductions;
  • the GPP does not impose charges or penalties on a member who decides to leave the GPP or stops paying into it;