Is time nearly up for large pension contributions?

Companies have been making contributions of up to £800,000 per member to small company pension schemes and receiving full tax relief in their company accounts using innovative pension scheme design. Even highly paid employees, caught by anti-forestalling legislation, can have contributions of over £70,000 paid on their behalf with no special annual allowance charge, where they could only pay up to their special annual allowance of £20,000 to a money purchase scheme.

These pension schemes have all the investment freedom and flexibility usually associated with small self-administered schemes. Loans of up to 50% of the fund can be made back to the principal employer to fund future company growth.

At a future date the member can transfer their pension fund out to a money purchase arrangement with the full flexibility of unsecured pension drawdown.

How does this work?

Since April 2006, contribution limits each year have been expressed as a capital amount or annual allowance, currently £255,000. This is the maximum contribution that can be paid in a year to a money purchase pension scheme for a member under normal circumstances. For defined benefit schemes, the limit is dependent upon the increase in pension payable from normal retirement age. A flat ratio of 10:1 is used to convert the ‘pension increase’ into the annual allowance. Thus a member can accrue a pension increase of up to £25,500 per annum in a defined benefit scheme and not breach the £255,000 annual allowance.

In practice, however, the actual cost of providing such benefits will vary by age, gender, expected retirement age and level of ‘ancillary benefits’, such as indexation of pension in payment, guaranteed period, attaching spouse’s and dependants’ entitlements. Accordingly, it would be for an actuary to calculate the true cost of fulfilling this defined pension benefit promise; in most cases, this will be far in excess of the 10 x ratio used for the annual allowance test. It is this actuarially calculated ‘true cost’ figure that may be used to justify higher contributions than a straight money purchase contribution structure can allow.

Typically, for a 50 year old, accruing £25,500 per annum, payable from age 55, the contribution payable by the company will be over £750,000. With a new company scheme, this would be fully relievable in the company accounts.

However, some highly paid employees are caught by the anti-forestalling legislation. Instead of being able to contribute £255,000 their limit is restricted to a special annual allowance, which means a contribution of only £20,000 to a money purchase pension scheme. But the principle above still applies and in a defined benefit pension scheme the contribution would be over three times higher.

The same schemes can be of great benefit in other scenarios. Small businesses may have directors whose spouses have worked in the company, sometimes on a low salary and they have never made any pension provision. In a defined benefit arrangement a significant contribution can be made to fully fund a pension commensurate with their low salary.

Ironically, it is the increasing cost of funding defined benefit pension entitlements, causing financial worries for so many companies, that is the key to making significant pension contributions for directors and other top company employees.

What will happen after April 2011?

On 14 October HM Treasury published ‘Restricting pensions tax relief through existing allowances: a summary of the discussion document responses’ following the consultation on ‘Restriction of pensions tax relief’, setting out proposed pension reforms from April 2011. HMRC has reconfirmed that the discrepancy in the treatment of benefits accrued in a defined benefit arrangement and a money purchase arrangement is set to continue, albeit with the flat ratio to convert the ‘pension increase’ into annual allowance, increasing from 10:1 to 16:1.

In addition, HMRC is proposing to reduce the annual allowance for all pension scheme members from £255,000 to £50,000, but with the inclusion of the opportunity to carry forward unused annual allowance up to £50,000pa from the three previous years.

These proposals would seem to indicate that small defined benefit schemes will become more popular as the premier way for making larger contributions for key employees.

Opportunities for significant pension contributions will continue from April 2011, but companies wishing to take advantage of old annual allowance limits need to act soon.

David Downie is director of actuarial services at Rowanmoor Pensions