Pension alternative has certain tax appeal

Published on Friday 13 March 2009 19:11

UNDER pension reforms that became effective three years ago, retirees no longer had to use their defined contribution and personal pension funds to buy an annuity at age 75.

The reforms introduced a new option in the form of alternatively secured pensions (ASP), a more restrictive form of pension fund income withdrawal (also referred to as unsecured pension, or USP).

ASP enables pension income withdrawal to continue beyond age 75 but there are several crucial differences between USP and ASP.

Firstly, whereas USP allows income within pre-set HMRC limits (broadly between 0 and 120 per cent of that which could be secured by a conventional annuity at that point in time), ASP narrows this range to between 55 and 90 per cent.

And while USP withdrawal limits must be reviewed every five years, under ASP the review must occur annually. This means that it is likely that pensioners in ASP are very likely to see their maximum income fall year on year.

But ASP's most venomous bite is arguably the tax treatment of such remaining funds on death of the member. Under USP, on the member's death the remaining fund can be paid out as a lump sum, subject to a special rate of tax, currently 35 per cent. Alternatively, if there is a financial dependent, they can continue USP or else purchase an annuity with the remaining fund.

While the two latter options remain available under ASP, any fund paid out as a lump sum under ASP will be subject to various tax charges (including IHT) amounting to an effective rate of 82 per cent, although these taxes can be avoided if the residual funds are left to a registered charity or political party.

The common alternative to entering ASP from USP at age 75 is to buy an annuity, which includes a ten-year minimum payment term guarantee. On death occurring within ten years, the pension instalments would continue to be paid until the end of the guarantee period.

However, a further option at age 75, now offered by a small number of pension providers, is a scheme pension. Previously available only under certain occupational pension schemes, a scheme pension offers the potential for taking higher levels of income than would usually be available under ASP, as it is not bound by HM Revenue & Customs limits.

A scheme pension is calculated based on the member's age and health as well as anticipated investment performance of the associated pension scheme assets. Like annuities, scheme pensions can be guaranteed for a maximum of ten years, which ensures that a large proportion of the member's fund will be extracted. Moreover, income payments under the guarantee can be paid to nominated beneficiaries and are taxed as income in their hands. Alternatively, the income payments could be directed in to a discretionary trust. There would be no IHT chargeable to these payments in either case.

It is also possible to have other members join the same pension scheme. Any funds remaining on death of the scheme pensioner may be redistributed to these other members in the form of pension benefits, although certain restrictions normally apply to "connected persons" such as family members.

Most UK pension providers have shied away from offering scheme pensions, refusing to change their scheme rules to allow it. A certain Edinburgh-based insurance company has even rubbished the concept. However, one very respectable insurer now actively offers a scheme pension, which I am certain will grow exponentially in popularity.

&#149 Paul Lothian is a chartered financial planner at Verus Financial Planning in Dundee.