Double, double, toil and trouble; Marcus Underhill, Principal at Mercer Human Resource Consulting looks at the position of pensions and tax efficiency on employee savings post-April 2006.

“Fire burn, and cauldron bubble…”
Despite many attractions, pension simplification has the potential to lead many employees to conclude that early contributions to a pension arrangement are inappropriate.

“Round about the cauldron go;
…In the poison’d entrails throw…”
With the continuing growth of flexible benefit arrangements, the popularity of alternative employer-facilitated or even employer-sponsored investment opportunities is likely to increase.

Currently, the media seems preoccupied with how the new pensions regime will allow more advantaged people to ‘buy their holiday home in Madeira’ or ‘purchase fine wines tax effectively’ from April 2006. However, by early next year we can expect more attention to be paid to how the changes will impact average employees in a company pension arrangement.

“By the pricking of my thumbs,
Something wicked this way comes”
The question is, will these changes mean pensions will no longer be tax-efficient? Largely they will be, the exception being if an individual develops a pension pool of funds in excess of £1.5m after 2006.

For most scheme members, maximum pension contribution limits will cease to have any impact from April next year. However, tax relief on employee pension contributions will continue to be available at an employee’s highest marginal rate – typically 22% or 40% depending on their earnings in a given tax year.

We therefore start to see an example of the law of unintended consequences at play. For employees who earn just below the high-rate threshold (around £32,500) but anticipate becoming a higher rate tax payer at some point in the future, it may be better to defer their voluntary pension contributions until that time. After all, why settle for 22% tax relief now when you can get 40% in a few years’ time?

Historically, employees have generally been encouraged to contribute to pension arrangements from as early an age as possible, to maximise the compounding of investment returns. Now we have legislation that, at best, complicates this principle.

Mixing in alternative savings vehicles
“fillet of a fenny snake
in the cauldron boil and bake”
The attraction of early investment within an approved pension arrangement is the near tax-free investment growth. But pension arrangements are not the only tax-relieved investment option; a range of investment vehicles provide tax relief in various ways.

Examples include, employer share schemes, Venture Capital Trusts, National Savings and Individual Savings Accounts (ISAs,) perhaps the most comparable with an employee’s voluntary contributions to a defined contribution pension arrangement).

ISAs offer similar investment options to those within a defined contribution pension scheme or Additional Voluntary Contribution (AVC) contract. ISA contributions are paid out of taxed income but, once invested, enjoy the same tax-free growth as pension funds. They can also be disinvested tax-free. A pension contribution would get tax relief on the way in, but the emerging benefit will largely be taxable.

“Cool it with a baboon’s blood
Then the charm is firm and good…”
So, what does all this add up to?

• Deferring the payment of employee voluntary contributions until the member is a 40% tax payer provides an extra 18% contribution from the Government;




• Investing the money in an ISA until it is ‘transferred’ into the pension arrangement maintains the almost tax-free investment growth;




• The individual retains access to the ISA fund at any time prior to transfer (whereas pension contributions will be pretty much locked in until at least age 55 from 2010); and




• There is a small disadvantage caused by the loss of investment growth on the tax relief that would have been available to an earlier pension contribution.

Not surprisingly, some providers of pension contracts are already designing ISA products that can be linked to, and communicated in tandem with, pension arrangements for this purpose. Employer ‘buying power’ should also facilitate lower charges for ISAs, which are currently quite expensive investments compared with pension arrangements.

While this all sounds fairly rosy, there are two inherent problems:

• ISAs only permit an investment of up to £7,000 a year and then only until 2009 under current legislation. Some employees may already be using some, or all, of this allowance; and




• The accessibility to the ISA fund at any time will be its downfall in terms of being a suitable vehicle for retirement saving, i.e. employees will cash it in early.

So simplification? … let me read that again in the dictionary.

“O Well done! I commend your pains.
And every one shall share I’ the gains.”