In his 2014 budget, the British Chancellor of the Exchequer announced the most significant pension liberalisation of the past century. The action by George Osborne affects all people with UK private pensions. It’s worth noting, however, that the UK state pension, funded by national insurance contributions and run by Her Majesty’s Revenue and Customs (HMRC), is unaffected, although these old-age pensions are also subject to a different reorganisation and revision of rules.
HMRC has always taken the attitude that a pension is an investment set up for an individual to provide an income during his or her retirement years. It has thus always been impossible to liquidate or cash in your private retirement fund, or pension. There has always been a regulation that allows individuals to draw 25% of their investment pot at the point of retirement, free of any UK tax. The remainder is to be used to provide an ongoing pension income that is taxable for UK residents and non-residents.
There are two major types of private pensions. The first a defined contribution scheme (DCS), where money is paid into an investment pot that becomes yours when you retire. The defined contribution is usually a percentage of your salary. The 25% tax-free initial lump sum may be taken from the total investment pot at retirement. The balance is to be used to create a pension income through the use of an annuity or regular drawdowns.
The second type is a defined benefit scheme (DBS). Here the retirement benefits are set regardless of the level of contributions — the “defined benefit”. Pension amounts are calculated according to your length of service with your employer’s scheme and the final salary you were paid at the point at which you retire.
A specific formula is used to calculate the benefit you will receive. So if you were employed by a company for 40 years and your salary in the last three years averaged £60,000 (2.9 million baht) annually, using a formula of 1/80, your pension would be calculated as £60,000x40/80 = £30,000 per year. This annual sum would usually be increased each year in line with a measure such as the retail price index or inflation rate, both before and after you retire.
If you have a DBS, you can also receive a 25% initial tax-free lump sum. This requires a calculation by an actuary of the investment value of the scheme, at the point of retirement, for each individual.
An actuary will calculate the investment value of a DBS by ascertaining how much it will cost to provide the projected income for the life expectancy of the individual in question. The age and life expectancy of the individual are used, along with current interest rates.
So, using our DCS example, how much of a lump sum is required to pay a pension income of £30,000 a year for the expected life of the individual in question, taking into account future inflation at current rates of interest? The interest rates used are UK government gilt rates. The initial lump sum is then calculated as 25% of this figure. We will come back to the actuarial lump-sum figure later.
Although this seems a little complex, it is generally thought that DBS pensions are more valuable than the DCS type. This is usually true because the benefit payable is set and the scheme takes the risk if the underlying fund declines in value. The individual members simply enjoy their pension income.
However, we must also think about what might happen in a time of difficult market conditions and the scheme’s overall value declined to the point where the pension benefits could not be paid. This could be catastrophic for the members.
If you have a DCS you can effectively have control of the investment management of your own pension and not worry about the management of a DBS being out of your hands. This is a debate that can get complex.
The next significant thing to consider is what happens to your pension when you die? This again gets complicated. If you die prior to retirement there is usually a benefit payable to someone. If you have a DBS, usually a lump sum will be given to a spouse. If you die after retirement, a continued pension usually is given to your spouse. If you are unmarried or your spouse dies, the pension is lost. With a DCS, a residual pot may be offered to your heirs. Depending on the circumstances you have a broader scope of beneficiary options than just a spouse.
If a lump sum is given to any beneficiary upon your death, it is usual for either inheritance tax or death tax to be imposed on the benefit. If the benefits are ongoing pension payments, these are taxable in the hands of the beneficiary. There is an age milestone of 75 where taxes change, and sometimes tax is not imposed if you are younger or if you have not drawn any benefit from your pension.
My apologies for the lengthy explanations here. I discussed this subject previously in “The UK budget and the expat” (Net Worth, April 6, 2014) when the liberalisation of pensions was first announced. Effective from April 2015, once people reach age 55, they will have the option to liquidate their pension and do with it as they wish.
The 25% initial lump sum remains a tax-free payment. However, any drawdown above this will be subject to income tax in the UK at the member’s marginal rate of tax, or their highest rate of personal tax for all other income for the year in which the payment is made. This option is viewed by many as a double-edged sword. Although one has access to the pension, there is tax to be paid on any withdrawal made above the tax-free lump sum.
In addition there is a total revamp of taxes on any benefits left to heirs if a member dies and leaves a pension investment as a lump sum. The eventual outcome here is that any benefit of an inheritance if you die before you reach 75 will be free of tax. If you die after age 75 a death tax will be imposed. The rate has yet to be decided. Many are grumbling about this new rule because the current life expectancy of the average person in the UK is more than 75.
Some of the major advantages of transferring a UK pension to a qualified recognised overseas pension scheme (QROPS) were: negation of UK income tax on pension income; diversification of investments; management of investments; currency flexibility; access to pension income at age 55; initial lump-sum payment of 30% of the investment value; the ability to specify any heirs desired; negation of both inheritance and death taxes.
At first glance some of these advantages have been removed. This is not actually the case although the advantages have been eroded to some degree. We will discuss this further in the next column. n
Andrew Wood has been an expat in Asia for 35 years and is executive director with PFS International. He has been writing Net Worth articles for seven years and has made a significant contribution to the PFS library of financial service articles dating back over 10 years. These articles, which cover the complete A-Z of financial planning, are available to readers on request. Questions to the author can be directed to PFS International on 02-653-1971 or emailed to enquiriesthailand@fsplatinum.com.