Pensions and Retirement Planning

Transcription

1 Pensions and Retirement Planning Learning Outcome 5 By the end of this learning outcome you will be able to demonstrate an understanding of the structure, characteristics and application of Defined Benefit schemes to an individual s pension planning. Aviva v 2016

2 5.0 Defined Benefit Schemes Defined benefit schemes, also known as final salary schemes, provide a guaranteed level of retirement income, which is usually a percentage of the member s salary at or close to retirement. 5.1 Hybrid Defined Benefit Schemes There are a number of variations (hybrids) of defined benefit schemes: Hybrid scheme Details Defined benefit with defined contribution underpin Provides benefits on retirement / earlier death that are the higher of the benefits calculated on a defined benefit basis versus the benefits calculated on a notional defined contribution plan. For early leavers, any transfer value will be the higher of the transfer value of the defined benefits provided by the scheme versus the fund built up in a notional defined contribution scheme. Defined contribution with defined benefit underpin These schemes are the mirror image of the above scheme. A separate, unallocated account, is used to meet the cost of the defined benefit underpin if there are insufficient funds in the member s account. Defined cash schemes Career average schemes These are schemes established before A Day which provided a lump sum of 3/80ths of final salary for each year of scheme membership. They still exist today, but only provide 100% cash benefits in respect of protected pre A Day accrual. The benefits from a career average scheme are based on the average earnings over the member s career. Due to the timeframe involved, the earnings may be revalued in line with inflation. This approach to defined benefits tends to provide a lower benefit than a conventional defined benefit scheme, with a lower cost to the employer. Integrated schemes The retirement benefits from these schemes are reduced to take account of the member s basic state pension. Often, a deductible is applied to the definition of final pensionable pay, which effectively amounts to a reduction in the pension at retirement by the same amount as the basic state pension. Aviva v 2016

3 5.2 Defined Benefit Scheme Rules Defined benefits schemes are occupational pension schemes. They are established under trust and have their own scheme rules. The trustees appointed are required to administer the trust in accordance with the scheme rules and the law in general Normal Retirement Age The scheme rules will specify the scheme s normal retirement age, which must be the same for men and women. Members are eligible to take benefits at any age from 55 - although the scheme may refuse to give them until the scheme's normal retirement age. Scheme member does not have to retire to take benefits from the scheme. Scheme membership and employer contributions must continue for those who choose to work beyond the scheme's normal retirement age Factors which determine benefits Pensionable Service Usually the same as the employee s service with the employer. Some schemes have a waiting period of, say, a year before new employees can join. Pensionable Remuneration Often the member s basic salary at the date of retirement or earlier death. Some scheme rules may include other earnings such as bonuses or overtime. The basic salary and / or the other earnings may be an average over, say, the last three years, rather than at the date of retirement or earlier death. Accrual rate For example, the accrual rate may be 1/60 th of pensionable remuneration for each year of service. Aviva v 2016

4 Karen started employment with her employer on 1 June She joined the final salary scheme after a one year waiting period. Karen reached the scheme s normal retirement age on 1 June The scheme s accrual rate is 1/60 th for each year of pensionable service. Her basic salary was 39,000 and her annual bonus is 6,000. The scheme s definition of pensionable remuneration is basic pay. What pension did Karen receive? Based on Karen s final pensionable remuneration, the scheme provides a pension of 10/60 x 39,000 = 6,500 10/60ths is used rather than 11/60ths as Karen had to complete a one year waiting period. 39,000 was used rather than 45,000, as the scheme s definition of pensionable remuneration is basic pay Scheme contributions The employer must pay contributions into the scheme as they are responsible for covering the costs of providing the defined benefits. The cost depends on a number of factors, including:- The level of the member s final pensionable remuneration in the future. The cost of providing guaranteed benefits to members who leave the scheme before the scheme s normal retirement age. The number of members who die before the scheme s normal retirement age. The profile of the scheme membership e.g. age and marital status of members as this determines the period over which contributions will be made and the level of spouse s benefits that may need to be provided. The investment returns achieved by the underlying pension fund. The annuity rates available when a member comes to retirement. The scheme s actuary is required to calculate the level of contribution required at least every three years. Scheme members may be required to contribute, sometimes as a condition of membership, to help cover the costs of providing the defined benefits. The employee s contribution is usually expressed as a percentage of the employee s pensionable pay. Tax relief on members contributions is usually via the net pay method, though the scheme can use the relief at source method. The employer s contribution is paid gross and is normally deductible as a business expense. Aviva v 2016

5 5.3 Contracted-out Salary Related Schemes (COSRS) Under a defined benefit scheme, the employer used to be able to make the decision as to whether the scheme should be contracted out of the state second pension or not. If the scheme was contracted out, it was referred to as a Contracted-out Salary Related Scheme (COSRS). With the introduction of the Single-Tier State pension in April 2016, it is no longer possible (in the UK) to contract out under a salary related scheme from this date. Under COSRS both the employer and employees paid lower levels of national insurance contributions (NICs). The reduced employer s NICs helped reduce the cost to the employer of funding the scheme. Now that it is no longer possible for an employer to operate a COSRS, it s likely that employers will look to reduce the future benefits payable and/or increase member contributions, in order to make operating the scheme more manageable. For contracted out service between 6 April 1978 and 5 April 1997, COSRS had to provide a Guaranteed Minimum Pension (GMP). This is calculated to be broadly the same amount as the pension that would otherwise have been payable under the State Earnings Related Pension Scheme (SERPS). Although it is no longer possible to actively contract out under a defined benefit scheme, the requirement to provide any accrued GMP benefits still remains. There are statutory requirements for the treatment of the GMP, both in deferment and in payment, as follows:- A widow s pension must be included in respect of service up to 5 April A widow s, widow(er) s or surviving civil partner s pension must be included for service since 6 April If a member leaves service before age 65 for males, and age 60 for females, the GMP must be revalued in deferment, at a prescribed rate dependent upon when they left service. 5.4 Funding methods and issues A yearly actuarial valuation is required for defined benefit schemes. Alternatively, this can be every three years if the trustees obtain interim actuarial reports detailing any developments that impact on the size of scheme liabilities, in the intervening years. Trustees must take advice from their actuaries, but are not obliged to follow it. Each private sector scheme has a statutory funding objective. This requires the scheme trustees to ensure that the scheme funding meets the scheme s technical provisions (i.e. that scheme assets are sufficient to cover the scheme s future liabilities.) The trustees must establish a statement of funding principles, detailing how the statutory funding objective will be met: The scheme s assets are valued at market value. The scheme s liabilities are the cost of providing the benefits when due. Aviva v 2016

6 The funding (contribution) rate for the period to the next review is based on the difference between the assets and the liabilities. A schedule of contributions must then be produced, specifying the contribution rates to be paid by the employer and if appropriate, by the members. This must be produced within fifteen months of the valuation s effective date. The trustees must keep members informed about their scheme s funding position by issuing regular summary funding statements. If an on-going valuation reveals that the scheme is in deficit a recovery plan must be submitted to The Pensions Regulator detailing how the deficit will be overcome. The plan must include target dates by which it is expected that half the shortfall will be eliminated and the amount of additional contributions to be made is half the total due under the plan. Factors trustees need to take into account in developing recovery plans The sponsoring employer s financial position and prospects and their willingness to maintain funding of the scheme s benefits. The scheme s membership profile: the greater the proportion of pensioners in the scheme, the shorter the recovery period should be. The likely benefits available to members were the employer to become insolvent in the short term. The potential disruptive effect on funding of any impending changes e.g. bulk transfers. The effect of assumptions in the recovery plan not being met in practice. The anticipated level of the risk-based element of the PPF levy over the recovery period and how this is met by the employer. The options open to trustees and employers dealing with pension scheme deficits include:- Transferring existing employer assets into the scheme. Reducing or stopping completely the accrual of future benefits. Increasing employer and member contributions. Options Revising the investment strategy away from equities to bonds to limit any increase in the deficit if market conditions are poor. Aviva v 2016

7 5.4.1 International Accounting Standard 19 (IAS 19) IAS 19 was introduced to make transparent the costs to a company of running its pension scheme. It uses a fixed discount rate based on AA-rated bonds to value liabilities and uses market values for assets, so ensuring consistency between companies. IAS 19 requires the pension scheme surplus or deficit to be shown on the company s balance sheet, as well as the cost of the pension scheme to be shown in the company s profit and loss account. One of the issues with IAS 19 is that by valuing liabilities in relation to high quality corporate bond yields, there is the potential for an investment mismatch, creating cost volatility. This is because the scheme is likely to have a significant equity rather than bond holding Insolvency valuations for Pension Protection Fund (PPF) Schemes The rules governing the calculation of these insolvency valuations are in Section 143 of the Pensions Act 2004 and the Pension Protection Fund (Valuation) Regulations This is why insolvency valuations are commonly called Section 143 valuations. The latest PPF guidance requires that:- Valuations are based on the PPF compensation entitlement of each member, not their full entitlement. Where the pension increases in deferment, the discount rate used for the deferment period for a non-pensioner is based on an index yield for long-dated index-linked gilts. Where there is no increase in deferment, the basis is a 20-year gilt index yield. For pensions in payment, different index-linked and conventional gilt index yields are used. The mortality basis uses prescribed pensioner mortality statistics with specified adjustments, including an age adjustment based on the level of compensation. Expenses for wind-up and payment are as specified. The use of gilts for discounting on a Section 143 valuation produces very similar results to buy-out costs quoted by insurance companies. Section 143 valuations place a much higher value on benefits than on-going or IAS 19 valuations, though the impact of this may be countered by the compensation cap applied to benefits under the PPF. 5.5 Trustees and Defined Benefit Schemes Trustee Responsibilities include They must hold and invest the trust assets, according to their powers of investment which are in the trust deed. They must use the trust assets for the benefit of the beneficiaries who are the scheme members and anyone benefiting in the event of the death of a scheme member. They must produce a statement of the investment principles (SIP) used by the scheme. Aviva v 2016

8 They must maintain the scheme in the best interests of the members and act impartially at all times. They must act within the provisions of the trust deed. They must know and understand the scheme, its provisions and its financial background, including associated documentation such as:- - The scheme explanatory booklet. This explains the main features of the scheme and must be made available to any member on request - Minutes of trustee s meetings. The proceedings within these meetings must be minuted and any unresolved issues clearly marked for future action. - Scheme accounts. The trustees must keep accounts and submit them for annual audit by a suitably qualified account; and - Actuarial reports They must meet the trustee knowledge requirements and notify TPR of certain notifiable events Trustee powers The trust deed will give the trustees general powers as follows:- Power to carry out any transaction in connection with the scheme. Power to determine all questions and matters of doubt arising in connection with the scheme Power to hold the scheme assets, subject to the specific powers conferred on them by the deed and rules of the scheme, to apply those assets, and to do such other acts and things as may seem to them expedient or necessary for the support and maintenance of the scheme and the benefit of the members. Where the trust deed is not specific on a particular matter, the provisions of standard trust law will apply Appointment of trustees A minimum of one third of the trustees have to be selected and nominated by the scheme members. This is subject to a minimum of two member nominated trustees, or one if there are fewer than 100 members. If the board of trustees comprises companies, then the scheme members can nominate the directors of these companies, unless the trustees act for more than one scheme (i.e. a professional corporate trustee firm). The government are currently looking to issue regulations to raise the minimum proportion of member nominated trustees from one third to one half. An exemption will apply for schemes with only one member or where all members are trustees. Aviva v 2016

9 5.5.3 Appointment of other parties The following parties also have to be appointed, by the trustees:- Scheme Actuary Prepares and certifies three yearly or yearly valuations Advises on all financial aspects of the scheme and certifies where needed including: statement of funding, technical provisions, schedule of contributions, recovery plan + changes to future accruals. Auditor Must hold a practising certificate and be a registered auditor. Must not be connected to scheme. Appointment must be in writing, stating the effective date of appointment, to whom they must report and take instructions from. Auditor must give written confirmation of their appointment, within 1 month of receipt of the appointment letter, and confirm that they will notify the trustees or managers of any conflict of interest. The auditor s statement must include an opinion as to whether contributions have been paid in accordance with the schedule and if not, why not. If there is no schedule the statement must confirm whether or not contributions have been paid in accordance with the scheme rules or policy contracts and, if not, why not. Scheme Administrator Must be appointed under the scheme rules and reside in the UK or the European Economic Area. Must have made a required declaration that they understand the responsibilities of discharging the functions required of the administrator and intend to discharge them at all times. Duties include:- Registering the scheme with HMRC. Operating tax relief on contributions under the relief at source system, if this is the tax relief basis selected. Reporting events relating to the scheme and the scheme administrator to HMRC. Making returns of information to HMRC. Providing information to scheme members, and others, regarding lifetime allowance, benefits and transfers. A scheme administrator can appoint a practitioner to act on their behalf to fulfil some of these duties. A fund manager will also be required, unless the scheme assets are wholly invested in insurance policies. Note that the trustees can only rely on advice from those they have appointed Options on leaving service before Normal Retirement Age (NRA) The options available to the member on leaving service before NRA depend on the scheme rules as well as the member s age and length of pensionable service. These may consist of a refund of contributions, a preserved pension and a cash equivalent transfer value (see 5.9) Refund of employee s contributions If a member leaves the scheme after less than two years, then the scheme rules may allow a refund of the member s contributions although they do not have to. The tax position of any such refund is as follows:- First 20,000 refunded is taxed at 20%. Aviva v 2016

10 Any excess over 20,000 is taxed at 50%. The liability for paying any tax rests with the scheme administrator, who is allowed to deduct it from the refund. The employer contribution is not refunded and remains in the scheme for the benefit of the remaining members. Please note, although the rules have changed for money purchase schemes with effect from 1 October 2015 (in that joiners on or after this date are only allowed a refund if they have less than 30 days service on leaving) the two year rule still applies for defined benefit schemes Preserved pension The member will be entitled to a preserved pension, called a short service benefit once they have completed at least two years pensionable service. During the first two years, they will also be entitled to a preserved pension if the scheme rules allow it. The preserved pension is calculated at the date of leaving service based on the scheme s accrual rate, the member s pensionable service and pensionable remuneration. The preserved pension will then normally be revalued yearly between the date of leaving service and the scheme s NRA, to help protect its value against inflation. The scheme rules detail the rates used to revalue the preserved pension however, these will be subject to statutory minimum revaluation rates. Contracted Out Benefits GMP Section 148 orders (Increase in NAEI) Fixed rate - the rate is fixed according to the date the member left service. For leavers since 5 April 2012, the rate is fixed at 4.75%. Limited revaluation only available to leavers before 6 April Revaluation as per Section 148 orders. Revaluation up to 5% provided by scheme, any excess (i.e. if NAE > 5%) provided by DWP, in return for scheme paying DWP a limited revaluation premium. Contracted in benefits and excess over GMP Date of exit pre 1 Jan 1986 No compulsory revaluation. Aviva v 2016

11 Date of exit 1 Jan 1986 to 31 Dec 1990 Date of exit 1 Jan 1991 to 5 April 1997 Date of exit after 5 April 1997 In line with increases in CPI/RPI to a maximum of 5% pa in respect of benefits (in excess of GMP) accrued from 1 January In line with increases in CPI/RPI to a maximum of 5% pa in respect of all benefits (in excess of GMP) In line with increases in CPI/RPI to a maximum of 5% pa in respect of all benefits (in excess of GMP) accrued to 5 April In line with CPI/RPI to a maximum of 2.5% pa in respect of accrual after 5 April Pension at Normal Retirement Age In terms of the pension available, this will be calculated at the date of leaving service, based on the scheme s accrual rate, the member s pensionable service and pensionable remuneration. Jane is about to reach her scheme s NRA of 60. She joined the scheme 15 years ago and has final pensionable remuneration of 30,000. The scheme is 1/60 th accrual and Jane has remained an active member of the scheme through to NRA. What will Jane s pension entitlement be? Jane will be entitled to a pension of 15/60 x 30,000 = 7,500 David is about to reach his scheme s NRA of 60 on 1 January He joined the Contracted In scheme on 1 January 1986 and left service on 31 December 1995 with final pensionable remuneration of 20,000. The scheme is 1/60 th accrual. For ease of example we will assume CPI/RPI exceeded 5% for the deferred period. David s pension at the date of leaving service was 10/60 x 20,000 = 3,333 The pension will then be revalued for the period when David was a deferred member of the scheme from 1 January 1996 to 31 December What is David s deferred pension? So, 3,333 x 1.05^16 = 7,276 pension payable from NRA Aviva v 2016

12 Once in payment the scheme rules will specify the basis of any increases. The rules may specify that any increases are at the discretion of the trustees although increases in pensions in payment are subject to a statutory minimum in certain situations: Statutory Escalation 6 April 1978 to 5 April April 1988 to 5 April April 1997 to 5 April April 2005 onwards GMP only: no scheme increase required GMP only: scheme has to provide CPI up to 3% Whole pension: scheme has to provide CPI/RPI up to 5% (Limited Price Indexation) Whole pension: scheme has to provide CPI/RPI up to 2.5% (Limited Price Indexation) Pension commencement lump sum at NRA The scheme rules will also normally provide for a pension commencement lump sum (PCLS) at NRA. The scheme rules define how much PCLS will be accrued each year, e.g. 3/80ths of final pensionable remuneration for each year of service. Unless transitional protection applies, the maximum PCLS cannot exceed HMRC s maximum of 25% of the total benefits. The scheme rules may specify that the pension and the PCLS accrue separately e.g. a pension of 1/80 th of final pensionable remuneration and a PCLS of 3/80 ths of final pensionable remuneration, for each year of service. More likely, the scheme rules may specify the accrual rate of the PCLS but require the PCLS to be provided by commutation of part of the pension. The scheme rules will specify the commutation factor to be applied, e.g. a commutation factor of 13:1 means that for every 13 of PCLS, the pension will be reduced by 1 per annum. John is entitled to a pension of 20,000 at age 60 after 20 years in a 1/60th defined benefit scheme. John can take a cash sum of 3/80th of pensionable salary for each year of service using a commutation factor of 15:1. John s final remuneration was 60,000 How much is John s PCLS and how much pension will he lose as a result? John is entitled to PCLS of 3/80ths x 20 x 60,000 salary = 45,000 45,000 / 15 = 3,000 pension pa given up to fund PCLS 20,000 pre-commutation pension - 3,000 = 17,000 residual pension Aviva v 2016

13 We noted earlier that the maximum PCLS cannot exceed 25% of the total benefits. Where the PCLS is provided separately this is quite easy to calculate. The pension is multiplied by a factor of 20 with the PCLS then added to this to give us the value of the total benefits. Therefore the maximum PCLS is 25% of this figure. Where the PCLS is provided by commutation, we do not know the amount of the residual pension to be multiplied by 20 until we know the amount of the maximum PCLS and visa versa. HMRC have issued a formula to calculate the maximum PCLS as follows:- Maximum PCLS = Pre-commutation pension x C (1+(0.15 x C)) In this formula, C is the commutation factor. So if the commutation factor is 15:1, then C has a value of 15. So, let s now calculate John s HMRC maximum PCLS:- 20,000 x 15 (1+(0.15 x 15)) = 300,000 (1+(2.25)) = 300, = 92, For any formerly contracted-out final salary schemes, it is worth noting that any GMP element cannot be commuted to provide PCLS Factors to consider and benefits on early retirement Unless the member is starting benefits early due to ill-health, then the earliest they can normally start is from age 55. In some cases, if the member decides to start benefits early, the benefits will be calculated up to the date of early retirement, based on the scheme s accrual rate, the member s pensionable service and pensionable remuneration. Then, the amount of the benefits is reduced, by applying an early retirement factor e.g. ½% in respect of every month between the date of early retirement and the date of attaining NRA. Aviva v 2016

14 So, in the above example of John, if John decided to commence benefits at age 55 instead of 60, assuming an early retirement factor of ½% per month, his benefits would be as follows:- Benefit reduction = ½% x 12 x 5 = 30% Pension entitlement 15/60 x 60,000 = 15,000 at 55 Deduct early retirement factor 15,000 x 70% = 10,500 at 55 PCLS entitlement 45/80 x 60,000 = 33,750 at 55 Deduct early retirement factor 33,750 x 70% = 23,625 at 55 23,625 / 15* = 1,575 pension pa given up to fund PCLS 10,500 pre-commutation pension - 1,575 = 8,925 residual pension *For the purpose of this example, it s assumed that the commutation factor of 15 applies at age 55 as well as age 60. In practice it may differ at different ages Benefits on ill health If a scheme member satisfies the ill-health condition as defined by the Finance Act 2004, then an ill-health pension can be paid, before normal minimum pension age, provided that the scheme rules allow this. The definition is as follows:- The scheme administrator has received evidence from a registered medical practitioner that the member is (and will continue to be) incapable of carrying on the member s occupation because of physical or mental impairment, and the member has in fact ceased to carry on the member s occupation. Some schemes may adopt a much stricter stance in their own rules by referring to any occupation or any occupation for which the member has received suitable training rather than just the member s occupation. This will reduce the likelihood of an ill-health pension being paid if the employer is able to find alternative duties for the member which they can fulfil in spite of their medical condition. If the scheme member s health improves then payments can cease altogether or be reduced (e.g. if the member returns to work on light duties ). The crystallisation of benefits for an ill-health pension is subject to a lifetime allowance test. However, no reduction is made in the amount of lifetime allowance available even though the member is crystallising benefits before age 55. The scheme rules will define how to calculate the pension on ill-health early retirement. It may be that the rules require the ill-health pension to be calculated based on service to the date of early retirement, but without any early retirement Aviva v 2016

15 penalty. Alternatively, the rules may require it to be calculated based on prospective service to the scheme s NRA, but the salary at the date of early retirement, again without any early retirement penalty. The rules may even provide for an ill-health pension somewhere between these two extremes. If the member has a life expectancy of no greater than one year, it is possible to commute all of the member s uncrystallised rights for a serious ill-health lump sum : Conditions for payment of serious ill-health lump sum The member must have had some lifetime allowance remaining at the time of crystallisation (or at age 75 if crystallisation takes place at age 75+). Each arrangement must be commuted in full, but not all arrangements have to be commuted. The scheme administrator must obtain confirmation from a registered medical practitioner that the member s life expectancy is no greater than twelve months before making payment, otherwise the lump sum is taxed as an unauthorised payment. If crystallisation takes place before age 75, this triggers a lifetime allowance test. No adjustment to the lifetime allowance occurs, even if crystallisation takes place before age 55. If the member is age 75+ at the time of crystallisation, a lifetime allowance test will have already taken place at 75, but the whole of the lump sum will be taxed at 45%, (55% where paid before 6 April 2015). No income tax is ever due on the lump sum. Aside from early retirement benefits in the event of ill-health, it may be that the employer chooses to take out group income protection insurance (also known as permanent health insurance) to provide the employee with a taxable, yet pensionable income if they are unable to work due to incapacity, with the benefit of continued membership of the scheme Benefits on death The scheme rules determine the nature of the death benefits and who can receive it. The member will be invited to complete a nomination form (also known as an expression of wishes) when joining the scheme so that they can state to whom they would like the death benefits to be paid to. The member can also notify the trustees of any changes they would like to make, if, for example, their circumstances change. The nomination form is not legally binding on the trustees, and the death benefits are paid out at the discretion of the trustees, to ensure the benefits stay outside the estate of the deceased member, for inheritance tax purposes. If the member dies whilst in the service of the employer, the scheme rules may provide for a lump sum and / or a pension to be paid to a beneficiary or beneficiaries. There is no limit on the amount of the lump sum except those set by the scheme. The amount will be specified in the scheme rules, and will normally be a fixed multiple of salary. However, if the member dies before age 75, any part of the lump sum in excess of the lifetime allowance will be taxed at 55%. Aviva v 2016

16 If the member dies after age 75, and payment is made on or after 6 April 2016, the whole of the lump sum will be taxable at the recipient s marginal rate(s) of income tax (where the benefit is paid to an individual or individuals). However, where the benefit is paid to someone other than an individual (e.g. a trust) the benefit is liable to the special lump sum death benefits charge of 45%. In terms of a pension on death in service, the scheme rules will specify the amount of the pension. Typically, the amount will be defined as one of the following:- A percentage of the member s pension based on prospective service to NRA A percentage of the member s pension accrued to the date of death. A fixed percentage of pensionable remuneration regardless of service The pensionable remuneration for the calculation will usually be as at the date of death. To help control the risk of paying out substantial death in service benefits, which could prove costly to the employer, the employer may prefer to provide a separate insured death in service scheme. If a deferred member dies before taking the preserved benefits, a lump sum is not normally paid. In this situation, the beneficiaries will normally be entitled to a percentage of the member s preserved pension, revalued to the date of death. Benefits on death after retirement. A guaranteed period Dependant s pension income This is to ensure that the pension income is paid for a specified minimum period of up to ten years. So, if for example a ten year guaranteed period applies, and the member dies one year after starting to receive their pension, then the pension will continue to be paid for a further nine years. The regular income cannot be commuted for a lump sum. In this situation, usually a fixed percentage of the pension (typically 50%) will continue, but normally based on the pension the member would have had if they had not commuted any of their pension to provide PCLS. 5.8 Eligibility The scheme rules will specify the eligibility criteria, in terms of who can join the scheme and the level of benefits; the scheme may have a different category of membership offering higher levels of benefits for management, compared to shop floor workers. The scheme rules will specify when employees may join the scheme, whether there is a minimum age at entry and whether there is a waiting period before the employee may join. The employer cannot make membership of the scheme compulsory. However, many schemes have an automatic entry system, which means that new employees are automatically enrolled to the scheme. If an employee does not want to be enrolled into the scheme, they have to complete a form to opt-out of joining. Some employers maintain the death in service benefits for an employee who has opted Aviva v 2016

17 out, and may even offer the employee the opportunity to join the scheme at a later date Top up options It is increasingly unlikely that an employee will work for the same employer for all of their working life. So it is also unlikely that an employee will accrue the maximum benefits under a defined benefit scheme. To help address this issue, a member of a defined benefit scheme can choose to top-up their benefits by paying additional voluntary contributions (AVCs) to an AVC scheme offered by their employer, or by contributing to an individual arrangement such as a personal pension or a stakeholder pension. If the member chooses to top-up their benefits by paying AVCs, the benefits in the AVC scheme can accrue in one of three ways:- Flat additional amount Member knows exactly how much additional pension is being purchased by their additional contributions. Defined Contribution Member will not know how much additional pension is being purchased as this will depend on fund value when they take their benefits. Added Years Contributions will purchase added years in the scheme leading to an increased entitlement to benefits when they are taken. The additional contributions are normally expressed as a percentage of pay, so the benefits provided and the contributions increase each time the member receives a pay increase. So, added years AVCs best suit employees who expect their salaries to increase quite quickly in future. The scheme rules may also allow the purchase of added years to count towards an additional dependant s pension. As added years form part of the defined benefits within the scheme, the benefits can only be taken when the main scheme benefits are taken. In addition, they can only be transferred in their entirety. If the member leaves pensionable service, contributions to the AVC scheme must cease. Contributions to a personal pension or a stakeholder pension are not subject to these restrictions. Aviva v 2016

18 5.9 Process and assumptions for calculating a CETV If a scheme member leaves service with at least three months service completed in the scheme, they must be offered a cash equivalent transfer value. What this means is that they are offered a transfer value that is the cash equivalent of the guaranteed benefits being given up. Let s look now at the four steps involved in the calculation of the cash equivalent transfer value:- 1. Calculate preserved pension at date of leaving including main scheme benefits, any DB AVCs + benefits bought from transfers in. 2. Revalue preserved pension from that date to scheme s NRA 3. Calculate cost of buying immediate annuity now for the amount of revalued pension + survivor benefits at NRA 4. Discount* capital cost back to the present day to calculate current capital value of cost of buying revalued pension at NRA * The discount rate is based on the assumed growth rate in the value of the pension fund, needed to provide the fund at NRA. DWP regulations require that trustees must have regard to the scheme s investment strategy when deciding what assumptions will be included in calculating the discount rates in respect of the member. The higher the discount rate, the lower the transfer value and visa versa. Also, the greater the time between leaving service and attaining the scheme s NRA, the greater the impact of the discount rate on the size of the transfer value. If the scheme is underfunded the trustees can pay the full transfer value or reduce it, but only by the extent that the scheme is underfunded by. Aviva v 2016

19 5.9.1 Process and assumptions for TVAS The purpose of a transfer value analysis is to determine what investment return a CETV would need to achieve to provide the member with benefits equivalent to those that they would have received had they stayed in their occupational pension scheme. The process is as follows:- Obtain member s preserved benefits revalued to the scheme s NRA Value of the pension benefits, including any survivor s benefit, payable from the scheme s NRA has to be capitalised using FSA-specified annuity rates. Finally, the investment return required to increase the transfer value from the date of leaving service to achieve the capitalised value at the scheme s NRA, after allowing for charges, is calculated by the transfer value analysis system (TVAS). This investment return is the critical yield and is likely to be in the range of 5% to 10% per annum. When looking at the process, it is important to note that if the ceding scheme allows early retirement and the member wishes to retire early, a critical yield must be calculated to the member s expected retirement date. In addition, the ceding scheme s death benefits must be compared with those available immediately after the start of the individual arrangement or on joining the new employer s scheme. The same is true of ill-health benefits, if the member is not in good health. Assumptions, set by the FSA, will need to be made about each of the following:- Indexation If scheme rules allow indexation in line CPI on a discretionary basis, TVAS will assume a CPI rate of 2.5%. If scheme provides a fixed rate of there is no need to make an assumption. Where Limited Price Indexation applies, CPI is assumed to be 2.5%. Annuity Interest Rate (AIR) Reflects yield to redemption on high coupon medium and long term gilts. The FSA specifies an AIR each tax year based on a fixed margin of 3.5% above the rate for index-linked pensions. Revaluation Rates Non-GMP benefits, CPI is used to the date of transfer (5% cap for pre 6 Apr 09 accrual, 2.5% since). From the date of transfer, a rate of 2.5% is assumed. GMP subject s.148 orders, the current FSA assumption for NAE is 4% For fixed rate revaluation, the current rate of 4.75% is used. Mortality The FSA requires PMA92 (male) and PFA92 (female) mortality tables be used. Recent lighter mortality has been reflected by adjusting the AIR down by 0.5% in 2005, rather than creating and using new mortality tables. Aviva v 2016

20 Even if the critical yield calculated is achieved, there is no guarantee that the member will be no worse off than if they had elected for a preserved pension instead of a transfer. Unless all of the assumptions used in the TVAS are realised in practice, the final benefits for the member and / or their survivors are unlikely to match those used by the TVAS in calculating the critical yield. When deciding whether or not to proceed with the transfer, the member s attitude to risk needs to be fully explored: The adviser should bear in mind the following points:- There is a risk that the benefits from the individual arrangement will be lower than a preserved pension at retirement. Between the date of leaving service and commencing retirement benefits, there is a risk that inflation could increase and remain above the 2.5% cap for post 5 April 2009 accrual and even the 5% cap for pre 6 April 2009 accrual. In this situation, if the scheme provides no more than the statutory minimum revaluation, retaining the preserved pension would result in its purchasing power being eroded. The closer the member is to retirement, the more likely the advice is to be to remain in the scheme, otherwise the member runs the risk of falls in the underlying investments before retirement without sufficient time to recover. The investment funds being considered to deliver the critical yield need to be consistent with the member s attitude to risk for the pension transfer monies, bearing in mind the term to retirement Transfers to an overseas scheme If the receiving scheme is a qualifying recognised overseas pension scheme (QROPS), the transfer is a recognised transfer. This means the transfer is an authorised payment and so does not incur any tax penalties. However, the transfer is a benefit crystallisation event, attracting a lifetime allowance charge of 25% for any excess over the lifetime allowance. In addition to the receiving scheme being a QROPS, it is important that it is able to accept the transfer under the laws of the country in which it is established. An overseas pension scheme has to satisfy three sets of requirements to be classed as a QROPS: Requirement Overseas Pension Scheme Requirements Conditions to be met... The Finance Act 2004 and regulations made under it say that an overseas pension scheme is a pension scheme which is: not a registered pension scheme, established outside the UK, regulated and recognised for tax purposes as a pension scheme in the country in which it is established. Aviva v 2016

21 Recognised Pension Scheme Requirements Qualifying Recognised Overseas Pension Scheme Requirements Schemes must be established in: a Member State of the European Community other than the UK, or Norway, Liechtenstein, Iceland, or a country or territory with which the UK has a double taxation agreement that contains provisions relating to the exchange of information and non-discrimination, or any other country or territory if, at the time of the transfer, the rules of the scheme provide that:- At least 70% of the funds transferred would be used by the receiving scheme to provide an income for life for the member; the benefits payable under the scheme are not payable earlier than would be permitted under a UK registered pension scheme; and membership of the scheme is open to persons resident in the country or territory in which it is established The manager of the ceding scheme must have:- notified HMRC that the scheme is a recognised overseas pension scheme, informed HMRC of the name of the country in which the scheme is established. If the country is not an EEA Member State or a country with which the UK has a double taxation agreement including the exchange of information and non-discrimination provisions, the scheme manager must also provide evidence that the scheme meets certain specific requirements, provided any other evidence that the scheme is a recognised overseas pension scheme required by HMRC, undertaken to notify HMRC if the scheme ceases to be a recognised overseas pension scheme, and undertaken to provide HMRC with certain information on making payments in respect of certain scheme members GMP Benefits The receiving scheme must ensure that the transfer is notified to HMRC National Insurance Services to Pensions Industry. The trustees or managers of the ceding scheme must take reasonable steps to ensure that: The member provides written consent to the transfer. If the receiving scheme is an occupational scheme, the member is in employment to which the receiving scheme applies In respect of any GMP, the transfer is at least equal to the cash equivalent of the member s accrued GMP rights The member provides written acknowledgement that the receiving arrangement may not be regulated by UK law and that there may be no obligation under the law on the receiving arrangement to provide any particular value or benefit in return for the transfer payment The member has received a statement from the receiving arrangement showing the benefits to be awarded in respect of the transfer payment and the conditions, if any, under which these could be withheld. Aviva v 2016

22 Since 6 April 2005, GMPs can also be transferred to overseas individual arrangements Transfer from overseas to UK scheme Finally in this section we need to consider transfers from overseas pension schemes to registered UK pension schemes. Such a transfer is not a recognised transfer. However, it is not an unauthorised payment, as only registered pension schemes can make unauthorised payments. The transfer value is not treated as a contribution, so it does not qualify for tax relief. However, if the ceding scheme is a recognised overseas pension scheme, the member s lifetime allowance can be enhanced by an appropriate factor, from the date of transfer, to take account of the fact that funds were not UK tax-relieved. The member must claim this enhancement no later than five years after 31 January following the tax year in which the transfer is made, and register the amount with HMRC. If the overseas pension scheme is not a recognised overseas pension scheme, no such enhancement is available. In terms of the annual allowance, because tax relief is not given on the transfer, the transfer value is deducted from the value of benefits at the end of the input period so that it does not count towards total pension input, if the receiving scheme is a defined benefit scheme or a cash balance scheme. For defined contribution schemes, the transfer is simply ignored so that it does not count towards total pension input Public sector schemes Before we look at public sector schemes in detail, we need to make the distinction between public service schemes and public sector schemes. Public service schemes are usually established by statute and controlled by regulations, whereas public sector schemes, are established by trust (just like private sector schemes) Public service schemes These include pension schemes for central and local government employees, the NHS, teachers, the police, the fire service and the armed forces. Aviva v 2016

23 Contributions paid in e.g. Bank of England Funded Unfunded No contributions are paid in e.g. Civil Service Contributions paid to Exchequer and deemed to be invested in Gilts e.g. Teachers, NHS Notionally Funded Whether public service schemes are funded or unfunded, the government pays the benefits from the schemes, as and when they fall due. They often provide a pension accruing on an 1/80 th basis, with a PCLS accrued on a 3/80ths basis. The PCLS is not provided by commutation, so it is compulsory. The pension will escalate in line with the increases in CPI to provide protection against inflation. In the event of early retirement, the benefits are usually superior to those offered by private sector schemes. From April 2015, members of unfunded public service schemes will no longer be able to transfer out to money purchase schemes (although transfers to other public service schemes may still be possible) Public sector schemes Due to the fact that public sector schemes are funded, they have more similarities to private sector schemes, than public services schemes do. However, unlike most private sector schemes, most public sector schemes provide full inflation protection in payment The Transfer Club Members of public service and public sector schemes can benefit from the fact that these schemes are members of the Transfer Club. If a member transfers to another scheme in the Transfer Club, they are treated as if they had been in the new employer s scheme since joining the previous scheme. The member s benefits are based on their salary in the new scheme and their total service in the both schemes. Effectively, the two periods of service, with each employer, are added together when calculating benefits at retirement. To enable this to take place, the receiving scheme will supplement the transfer in to provide benefits on this basis. Aviva v 2016

24 Pensions and Retirement Learning Outcome 5 (PEN5) End of Module Test Multiple Choice Questions Question Which of the following best describes the tax relief on contributions to defined benefit schemes? Answer A. Tax relief on members' contributions is usually via the net pay method, though the scheme can use the relief at source method. The employer's contribution is paid gross and is deductible as a business expense. B. All tax relief on members' contributions is via the net pay method. The employer's contribution is paid gross and deductible as a business expense. C. Tax relief on members' contributions is usually via the relief at source method, though the scheme can use the net pay method. The employer's contribution is paid net of corporation tax or income tax as appropriate. D. All tax relief on members' contributions is via the relief at source method. The employer's contribution is paid gross and deductible as a business expense Which of the following is NOT a requirement for GMP benefits paid/payable from a defined benefit scheme? A. GMP accrued after 5 April 1988 must increase in payment in line with price increases subject to a cap of 3%. B. A widower s pension for GMP accrued before 6 April C. For members who leave pensionable service before age 60(F)/65(M), the GMP must be revalued in deferment. D. A surviving civil partner s pension for GMP accrued after 5 April Which of the following parties does NOT have to be appointed by the trustees, in relation to the management of a defined benefits scheme? A. Scheme Actuary B. Legal adviser C. Auditor D. Scheme administrator Which of the following most accurately describes the tax situation in the event of a refund of the members' contributions on leaving service within the first two years? A. First 20,000 refunded is taxed at 20%, any excess over 20,000 is taxed at 50% B. First 10,000 refunded is tax free, any excess over 10,000 is taxed at 20% C. First 10,000 is refunded is taxed at 20%, any excess over 10,000 is taxed at 40% D. First 20,000 refunded is tax free, any excess over 20,000 is taxed at 20% Aviva v 2016