Does the Government actually want people to save for their retirement?

I do not often get emotive about a particular issue – I leave that up to those whom I follow on Twitter. However I am planning on handing a letter to Steve Webb at the NAPF conference in Liverpool this week which I crafted jointly today with the Unite union on the topic of retrospective tax legislation (namely the Finance Act 2004 as amended by the Finance Act 2011).

One would assume that it was not the intention of Government to penalise individuals who have made prudent and proper provision for their future retirement and now find themselves subject to retrospective and punitive tax.

I know of examples from pension schemes in the private sector who have taken on generous redundancy liabilities from the public sector and whose employees are now finding themselves adversely impacted by two areas of tax legislation. These employees are earning in the region of £30,000 to £45,000 – not exactly high-earners trying to avoid income tax.

To increase awareness I summarise the main facts in the rest of this article.

It is not uncommon for there to be collective agreements in place ensuring that employees who are outsourced retain their contractual entitlements to enhanced pension benefits in redundancy situations, often including additional service enhancements. In many instances these public sector outsourcing contracts have been in place for a number of years before the introduction of the relevant tax legislation.

From 6^th April 2011, the annual allowance was reduced by the Government from £225,00 to £50,000 per annum, although any unused tax allowance from the previous three years can be used to offset any liability in the current tax year.  This is a change to the employee's personal tax position and is administered via self-assessment.

The increase in the value of defined benefit pensions on redundancy means that some employees will be subject to an annual allowance tax charge of 40% on any amount above the £50,000. This additional tax is calculated by HMRC based on a notional value of the increase in benefits over the last 12 months even if the employer has not made any additional contributions and requires the tax to be paid up front.

I have seen circumstances where this tax bill is greater than the tax free cash sum the member is receiving on retirement and about the same level as a year’s Salary. The tax man wants more than the employee has actually received!

Sometimes due to differences between a pension scheme’s pension input period and the tax year, this tax liability is not calculated nor due for some time – in one example an employee leaving at the end of July 2012 is not due to pay the tax until January 2015. The tax charge and the timing of its payment could therefore act as a disincentive for an individual to look for further employment due to being subject to a higher personal rate of tax in the following year.

Plus has anyone thought about the impact of auto-enrolment for an individual who has already exceeded the annual allowance, not in the year of being auto-enrolled, but in a subsequent tax year, due to the impact of being made redundant?

As a result of the likely increase in annual allowance charges the government has introduced legislation to allow individuals to ask their scheme to pay the tax on their behalf with their benefits being reduced correspondingly (“the Scheme pays” facility). However it is not completely clear how the Trustees can implement such a facility when the amount of tax falling due will not be known by the scheme member at the time they need to make such an election (ie before the benefits become payable). This in itself could be problematic if the Trustees reduce the pension at some future date once the tax charge is known as this becomes an unauthorised payment.

The Finance Act 2004 categorises pension payments that are permitted as “authorised payments” and any payments that fall outside the requirements are “unauthorised payments” which carry penal tax charges for both the member and the pension scheme. One of HMRC’s requirements for a pension payment to be authorised is that the amount of pension paid should not reduce year on year unless the reduction is expressly permitted under the Act (in very limited circumstances).

I know of several final salary pension schemes in the private sector where a temporary pension is paid on redundancy until such time as the individual can claim their pension from the previous scheme, again based on collective agreements originating from public sector outsourcing.

 If the employer chooses to pay this temporary pension from cash flow and via payroll then fine, but if it is a pension scheme that makes these payments then a tax charge arises at the time the temporary pension ceases and the pension in payment is reduced. This tax charge is made up of the following: a retrospective tax charge of either 40% or 55% (see the HMRC manual to work out which – if you can) on any tax free lump sum which has already been taken at retirement, plus the future pension payments have an ongoing tax liability (for-ever) of 40% (which again could be increased up to 55% on the first 12 months pension payments) as opposed to perhaps a marginal income tax rate of 20%. 

In my example mentioned earlier of the guy who had to pay more income tax as an annual allowance charge than he had received from the scheme as a cash lump sum – he then had to pay tax at 55% on the same cash lump sum when his temporary pension ceased to be paid 5 years later!

This was originally recognised by HMRC as being an issue and transitional arrangements were passed in legislation in 2009 but the exemptions given only applied to employees who left service before July 2007, so it is still an issue for anyone in that situation today.

You may say that we can no longer afford these generous public sector redundancy terms – and I agree - but where does it leave those employees who have been moved to the private sector and are now seeing their valued redundancy rights more than eaten away by retrospective taxation.