The 6th of April 2006 has seen a revolution in pensions.

6 April 2006 was A Day. It heralded the introduction of dramatic changes to the way in which pensions operate in the UK. It is the most radical overhaul in decades, and is going to have a profound effect on the way everyone plans for the future.

For instance, it aims to offer far more interesting and attractive methods of saving and investment for retirement. There’ll be a new annual allowance, lifetime allowance and, when you decide to take your benefits, a tax free cash allowance too. There will also be more retirement options to choose from, such as new types of annuity. There are also a number of ways to protect your existing pension benefits to ensure you’re not disadvantaged by post A-Day.

Importantly, A-Day has also seen changes to the current retirement and pension age limits.

The proposed new pension regulations have:

1. Simplified pensions so that people feel more comfortable with them and everyone is encouraged to save for retirement.
2. Offer far more freedom of choice and flexibility when it comes to planning for the future.
3. Improve competition between providers so that there are broader and a better range of retirement options.

Has A-Day affected you?

You may be wondering whether A-Day has had an impact on you. If you answer yes to any of the following questions, you’re more than likely to be affected and you need to know more, read on…

• Are you thinking of drawing your pension before you’re 55?
• Are you likely to have a pension fund in excess of £1.6 million

One simplified set of tax rules

Before A-Day pension schemes operated under any one of no less than eight pension regimes. Frankly, it was complex and confusing. But now the picture is a lot simpler, with the eight regimes being replaced with just one set of tax rules covering all pension plans.

Also you may now join any type and number of pension schemes you want. Better still, having to transfer between different schemes in order to gain tax advantages will be a thing of the past too.

So if you are currently a member of an occupational pension scheme, you will be permitted to arrange your own pension to complement this occupational pension arrangement (subject to contribution limits).

An end to contribution limits

One of the most dramatic developments to emerge out of A-Day will be the fact that the current limits on pension contributions will be swept away and replaced with a more flexible system of annual allowances.

The new annual allowance for the tax year 2007/08 will be set at £225,000. This will increase each year, reaching £255,000 by tax year 2010/2011 and will be reviewed each year thereafter.

If your total contributions, including any employer contributions, exceed that annual allowance any excess will be taxed at 40%.

Tax relief will be given on personal contributions up to £3,600 or 100% of your earnings (whichever is the higher figure) at the basic rate of tax. Higher rate taxpayers will be able to claim further tax relief.

So, for the vast majority of people, they will be able to pay as much as they want into their pension and still benefit from tax relief.

New Lifetime allowances

The Government will also be setting a new lifetime allowance. When benefits are taken, if the combined value of the pension benefits exceed an allowance, they may be subject to tax. This lifetime allowance will be set at 1.6million for 2007/2008, rising to £1.8 million by 2010/2011.

When pension benefits are taken, any fund exceeding this allowance will be taxed at 25% if benefits are taken as an income, or 55% if taken as cash. As at present, any pension taken as income from your pension fund will also be liable to income tax.

Of course, many people are unlikely to have a fund worth over £1.6 million. However, if your pension fund already exceeds this lifetime allowance, or is likely to when you retire, you should discuss this. This is because there are steps you may take to protect the fund from higher rate tax.

Carry Back Contributions

Given the new higher contribution allowances the Carry Back option has being abolished.

Tax-free cash

The A-Day change means that when you start taking your pension benefits, the maximum you will be able to take tax-free as a cash lump sum is 25% of your fund or 25% of your lifetime allowance, whichever is smaller.

Existing restrictions on the amount of tax-free cash you can draw after transferring a company pension into a personal pension or stakeholder plan have also been removed.

Retirement Options

When you want to draw your pension benefits, the new A-Day legislation will give you the freedom to consider a far wider and more interesting variety of options.

Currently, you can use your pension fund to buy an annuity – in other words an insurance contract that delivers a regular income for the rest of your life. Alternatively, you could leave your fund invested and draw an income from it. Otherwise known as income withdrawal, this allows you to draw an income which you can raise or lower each year according to your needs and tax position. But you should bear in mind that the income drawn is subject to Government limits.

Whichever option you choose at retirement, under current rules you must convert your pension into an income and buy an annuity when you reach 75.

A wider choice of retirement options at A-Day.

Most significantly, A-Day will remove that strait-jacket and you’ll be under no obligation to buy an annuity at age 75.

Instead, you’ll have the freedom to take an Alternatively Secured Pension. This will allow you to leave your fund invested and withdraw an income for an indefinite period. There will be no minimum income that must be taken and the maximum allowed will be equivalent to 70% of the income you would get from an annuity. Funds remaining on death must in the first instance provide pensions for dependants. If there are no dependants, then the funds may be transferred to a nominated charity or pass to another nominated member of the pension scheme.

The Capital Taxes Office have recently clarified that Inheritance Tax would apply to benefits under this plan that are transferred to another member of the policyholder’s pension scheme on the individual’s death.   Inheritance Tax would not apply on transfer to a charity, a spouse / civil partner or dependent.

Additionally, if a spouse / partner or dependent inherited these benefits on the death of the member, on their subsequent death any remaining funds would be added to the original planholders’ estate to calculate if any additional Inheritance Tax liability arises. 

New Forms of Annuity

After A-Day you’ll be able to choose from two new additional forms of annuity.

Limited Period Annuity – this option allows you to use part of your pension fund to buy a fixed-term annuity lasting up to five years. You can then keep the remainder of your pension fund invested, and use part of that to buy another Limited Period Annuity or a lifetime annuity or an income withdrawal at any time.

Value Protected Annuity – with this option, if you die before the age of 75 your dependants will receive a lump sum equal to the cost of your annuity, minus the income that you’ve already been paid. However, any benefits paid out to your estate will be taxed at 35%. This option is likely to pay out a lower income than a lifetime annuity.

Removal of the ‘normal’ retirement age

If you have a company pension, you will no longer have to retire to start drawing your pension. Instead, you’ll have the option to phase your retirement, perhaps choosing to work part-time, while also taking some of your pension income. You will need to check with your pension scheme to understand what options are available to you.

An increase in the pension age

On 6th April 2010, the minimum age at which you will be able to draw your pension will increase from 50 to 55. And all pension savings will have to be converted into an income by the age of 75 – either by buying an annuity or opting for an Alternatively Secured Pension.

So if you are currently planning to retire before age 55 after 6 April 2010, you should review your plans now by seeking immediate guidance.

It’s worth bearing in mind that people in certain occupations currently have earlier permissible retirement dates. In most cases, this option will still be available. However, if you are employed in one of these occupations it is worth seeking clarification.

Protecting your pension benefits

If you think you might exceed the pension fund lifetime allowance limit before A-Day, or when you retire, you can protect this and reduce or eliminate any excess tax liability.

There are two options available to you:

Primary Protection – If your pension fund value exceeds £1.6 million on A-Day, a new personal lifetime allowance will come into play. This is linked to the new lifetime allowance. As long as any further growth in your fund doesn’t exceed the annual increase in this allowance, you won’t be penalised. If it does, the excess will be taxed at 25% if benefits are taken as income, or 55% if taken as cash.

Enhanced Protection – This option allows you to protect the full value of your fund and any existing tax-free cash allowance greater than 25% of your fund value. However, once you have arranged this protection, you will not be able to make any further contributions.

If you have a company pension scheme and you don’t opt for either of the protection measures above, then any existing tax-free cash entitlement above 25% of the fund is automatically protected while you remain in the scheme.

Death benefits

A number of changes to death benefits will be introduced as a result of A-Day.

If you die before you take your retirement income, the value of the pension fund may be paid to your beneficiaries in cash. However, if this value exceeds the lifetime allowance of £1.6 million in 2007/08, then the excess will be taxed at 55%.

Now you will be able to have any number of pension plans, you will be able to take advantage of pension term assurance. This is a low cost form of life insurance over a set period of time – and you can receive tax relief on the premiums you have to pay. This benefit will count towards the lifetime allowance.

If you die after you have started taking your retirement income, the type of death benefit paid and any tax to pay will depend on the type of pension plan. Individual advice will be require in relation to this matter.

Pension plan with ‘protected rights’

Some people have protected rights benefits because they are, or were at some point, contracted out of the state second pension (formerly known as SERPS). If your pension falls into this category, A-Day will signify three changes that you need to be aware of:

1. When you start drawing your pension benefits, you will have the option of taking tax-free cash up to 25% of your total fund, or 25% of the standard lifetime allowance – whichever is the smaller amount.
2. From 6th April 2006 you will be able to draw benefits from the age of 50 before 2010, 55 after 2010.
3. When your protected rights pension starts to be paid, there will no longer be any requirement for the pension to increase each year. You will be able to choose if you still want this.

As now, if you are married at the time of your death, any protected rights must be used to provider an income for your surviving spouse.

Action Points

If you are due to retire some of the areas that you need to consider are:

• Is investment within pension plans the right retirement planning strategy for you now?

The annual allowance makes it possible to delay the start of pension contributions until much nearer retirement than is currently possible. This will be especially the case as there will be no annual allowance ceiling for a scheme in the final year before drawing pension benefits in full from that scheme.

Some experts have suggested that the right strategy now will be to use other savings vehicles initially – such as individual savings accounts (ISAs) – and then apply their value as fund contributions when retirement nears. This will provide greater flexibility because the funds would not be locked in a pension plan until a later date. However, outside an ISA, the strategy might be less tax-efficient and runs the risk that future changes in legislation or personal circumstances could limit the scope for last minute contributions.

• How should you top up the retirement benefits from your employer's pension scheme?

After A-Day, it will make no difference how you decide to top up your retirement benefits, because the same tax rules would apply to all pension arrangements. However, in practice not all top up arrangements are likely to offer all the flexibility that the new rules should make possible. For example, in-house AVCs would be unlikely to offer an unsecured pension option or investment in residential property.

• If your fund is close to the lifetime allowance, should you opt for enhanced protection?

Enhanced protection would mean that if your fund grew to over the lifetime allowance, you would not suffer any lifetime allowance charge. However, it would also mean that you would have to cease active membership of all schemes, although you can revoke the enhanced protection option at any time before age 75.

• Do you need to fill an income gap before age 55?

If you want to retire before age 55, but this would be after 5 April 2010. You could not look to your pension arrangements to provide you with an immediate replacement income without transitional protection. You might therefore need another retirement investment to bridge the gap before you could draw on your pension plans.

• How should you draw retirement benefits?

Just because you will be able to draw 25% of your fund as a tax-free lump sum will not mean that you should automatically do so. At present, the factors used by many final salary schemes to convert pension to cash fail to reflect the pension's true value. Strange though it may seem, a taxed pension can sometimes be better value than a tax-free lump sum.

Please note that tax and legislation are liable to change. The information provided here is based on our understanding of law and HM Revenue and Customs practice as at April 2006. Tax relief can be altered and its value depends upon financial circumstances.