Final salary scheme members and people who started their pension early in their working lives could be caught out by rules that previously affected only the most affluent savers.
Under a change taking effect in April, the maximum amount that can be saved tax-free into a pension – known as the lifetime allowance (LTA) – is being slashed from £1.5 million to £1.25m.
It was lowered from £1.8m to £1.5m in 2012, and many expect further reductions that will take more savers above the LTA.
While the figure remains high, experts warn that members of final salary schemes could unwittingly be dragged above the LTA. Anyone retiring with a total pension fund above £1.25m – including private and company pensions – faces a tax charge of 55 per cent on the amount in excess of the allowance.
The change was announced in the Autumn Statement in December 2012 and there are ways for people likely to be affected to retain the current £1.5m limit. But just a third of people earning more than £50,000 are aware of the LTA, according to research by Standard Life.
Carl Melvin, chartered financial planner at Affluent Financial Planning in Paisley, said: “The government has singularly failed to make the public aware of the LTA issue and I am sure that not everyone affected will realise in time – a nasty tax bomb will explode later, leaving the member feeling screwed because they have worked long and hard in their job and are rewarded with a good pension scheme.”
The danger is that while few people expect to accumulate pension savings anywhere near the new LTA, many underestimate the value of their final salary pension. And while final salary schemes are increasingly rare in the private sector, millions of public sector workers continue to benefit from the generous pensions.
That means public sector workers in Scotland such as civil servants, doctors and even teachers could be at risk from the lower LTA, as well as middle and higher-level managers in the private sector.
“Final salary scheme members don’t think their benefits will exceed the LTA because they don’t understand the formula used to test against LTA, so they are blissfully unaware that there may be a problem,” said Melvin.
In some cases, people can be pushed above the limit by ay rises late in working life. A further issue is that people who started saving young may breach the LTA in the future – particularly if they reach senior levels in their job – but won’t know until it’s too late.
Take the example of someone who started saving into a pension at 25, with a target retirement age of 65 after 40 years of making pension contributions.
They could hit the new £1.25m limit at retirement simply by paying just under £430 a month into their pension, assuming 3 per cent a year contributions growth and annualised investment growth of 7 per cent.
It would take total monthly contributions of more than £500 to breach the current £1.5m limit.
There is protection available to mitigate against the LTA but, with a 6 April application deadline, time is running out to take advantage. Savers who think they will be caught by the new LTA can apply for fixed protection, whereby they can retain the £1.5m limit.
The option is open provided the saver is in a final salary scheme and ceases to build up benefits, or they’re in a defined contribution scheme (now the norm in the private sector) and make no further pension contributions.
There is also an individual protection option, allowing people with pension savings already above £1.25m the chance to secure a personal LTA equivalent to their current pot size, up to £1.5m. Under this arrangement, for which applications are open from 6 April 2014 until 5 April 2017, contributions can still be made to a pension.
“Get advice quickly to determine your exposure and then consider what protection measure you can implement to alleviate the LTA tax exposure. Professional advice will be necessary as the rules and calculations are fiendishly complex,” said Melvin.
• For more information, go to www.hmrc.gov.uk/pensionschemes