Members leaving early
Before 1975 a scheme member of an occupational pension scheme
had no statutory rights to benefits and could loose most or
even all benefits that accrued as a result of leaving the scheme
early. The introduction of the Social Security Act 1973 (SSA
73) saw a significant improvement in the members retirement
benefits within an employers pension scheme by allowing the
member a deferred
pension on leaving service.
When the Act was introduced on 6 April 1975 it allowed for the
preservation of a members
pension rights, known as preserved benefits, after 5 years
of service and would include both employee and employer contributions.
For less than 5 years service the scheme member was entitled
to a refund
of contributions that they had personally made to the scheme.
This duration was reduced in the Social Security Act 1986 to
2 years and a refund of contributions being made with less than
2 years service. However, Tax and a contribution to purchase
membership of the state
pension scheme will be deducted from the refund before payment.
The Finance Act 1981 introduced the first pension transfer product
in the form of section 32 policies, allowing the early leaver
an opportunity to transfer out of an occupational pension scheme.
Where a final salary pension has contracted out of the state
scheme the guaranteed
minimum pension (GMP) relates to the earnings component
of the State Pension that the member would have earned while
in the employer's scheme, had the member not contracted-out.
GMPs ceased to accrue after 5 April 1997.
For early leavers from January 1985 the Health and Social Security
Act 1984 allowed the revaluation
of GMP to be separate from that of preserved benefits. Prior
to January 1985 the practice was to absorb GMP into the preserved
pension and this was known as franking. As a result, the accrued
entitlement to the member increased significantly as this includes
the members pension
transfer value.
From January 1986 the Social Security Act 1985 allowed the member
the right to transfer from an occupational pension scheme rather
than leave the preserved
benefits. This Act also introduced revaluation of preserved
benefits other than the already revalued GMP for leavers from
1986 in line with the retail price index (RPI)
to a maximum of 5.0% a year up until retirement age. The Social
Security Act 1986 introduced legislation to prevent employers
from making membership of their occupational pension scheme
compulsory and also approved personal pensions (APP) to receive
pension transfers.
The Social Security Act 1990 extended the revaluation of preserved
benefits by allowing members leaving
service early of final salary schemes from January 1991
to have preserved benefits in addition to GMP to rise by RPI
with a ceiling of 5.0% per annum up until retirement
age.
Enhancing benefits
The accrual rate is the rate at which future benefits in a defined
benefit final
salary pension will accumulate, based on a formula linked
to the scheme members pensionable earnings. This formula is
usually expressed as a fraction of final salary, such as 1/60th
or 1/80th and the pension benefits at retirement age will increase
as the length of service increases. The Inland Revenue maximum
retirement benefits are two thirds of final salary.
This means that for
an accrual
rate of 1/60th the member will have to work for
40 years to reach the maximum and from this there is the possibility
for commutation to a tax free lump sum. For a public service
scheme the accrual rate is 1/80th but the member can only
work for 40 years giving a maximum pension income of half
final salary.
However, the member will receive a tax
free lump sum in addition to the income. Where a member
needs the maximum pension income it is possible to buy a purchase
life annuity with the tax free lump sum. By taking this
approach the member will reduce the tax liability because
the income is paid as capital
and interest. This means that about 2/3rds of the income
is deemed by the Inland Revenue to be a return of capital
and therefore tax free and the other 1/3rd is interest and
taxed at the savings rate of 20%. This advantageous annuity
taxation means less tax paid and more income for the rest
of the annuitants life.
Although very rarely exercised, an employer may enhance the
benefits to employees by offering a scheme with accrual rates
of say 1/45th or 1/30th. This means an employee need only
work for 30 years or 20 years respectively to retire on the
maximum benefits of 2/3rds final salary.
Members of a final salary scheme that will
not complete 40 years service by their normal retirement age
may be eligible to purchase added
years by paying extra contributions to make up some or
all of the shortfall. This will apply to pensionable earnings
and depending on the scheme rules, may exclude other taxable
income and benefits
in kind. To make up any shortfall on other taxable income
and benefits in kind, the member would have to make contributions
to an additional
voluntary contributions (AVC) pension.
Due to the impact of inflation during the
1980s and 1990s, the benefits from occupational pension schemes
could be easily eroded. The Pension
Act 1995 introduced regulations requiring exempt approved
schemes to apply indexation
to pension benefits in payment by at least the appropriate
percentage known as the limited price indexation (LPI), that
is the Retail Price Index (RPI) up to a maximum cap of 5.0%
per annum. These indexation regulations do not apply to voluntary
contributions made by the scheme member such as an AVC, which
are excluded.
LPI
applies from 6 April 1997 and includes protected rights benefits
from contracted out final salary pensions as well as personal
pensions in respect of Department of Social Security (DSS)
rebates for the 1997/1998 tax year onwards.
Continuous service
A scheme member can qualify for continuous service of an occupational
pension scheme such as a final salary pension in respect of
pensionable
service even though there has been a break of employment
or if contributions are made to another scheme of the same
employer. Pensionable service can be treated as being continuous
if the member is transferred from the employment of one company
to another that also participates in the same employers pension
scheme, such as is the case with a public
service scheme.
Also, continuous service applies if the scheme member was
absent from work due to ill health, on maternity leave or
taking a sabbatical or if the member has transferred between
associated employers. The practice notes issued by the Pension
Schemes Office (PSO) define associated employers as a
company that is directly or indirectly controlled by the other
or both companies are subsidiaries controlled by another company.
For the employee the transfer between associated
employers is seen as continuous service in relation to
their members pension rights, whether this involves a switch
of companies while remaining in an employers pension scheme
or leaving pensionable service of one scheme for another within
the same employer. The Inland Revenue will establish the employees
maximum benefits by combining total benefits from both employers.
Whereas post-89 members are subject to the earnings
cap on their relevant
earnings, pre-87 and pre-89 members with continued rights
will be able to maintain their retirement benefits under those
advantageous tax regimes.
An occupational
pension scheme such as a final salary pension will usually
allow an employee to continue as an active scheme member even
though he or she is not actively at work due to an illness
or taking a sabbatical. The maximum period for such temporary
absence is 30 months. During this period retirement benefits
continue to accrue and the employee remains covered for death
in service benefits.
Salary sacrifice
A scheme member can agree a salary sacrifice with the employer
whereby a reduced salary is exchanged for extra pension contributions
paid to an occupational pension scheme, such as a final salary
pension or money purchase scheme, by the employer. This will
save the employer National
Insurance (NI) contributions on the salary sacrificed.
The advantage to the scheme member is that the extra contributions
would benefit from a commutation
to a tax free lump sum at retirement age whereas an additional
voluntary contribution (AVC) scheme would only pay a pension
income. The member would also benefit from inflation proofing
by of the pension
income at the retail price index up to 5.0% per annum
after retirement whereas this will not be the case with an
AVC.
However, a salary sacrifice
will reduce the members definition of pensionable earnings
for maximum retirement benefits, death
in service benefits, widows pension and state benefits.
|
|
