6 April 2006 is a date imprinted on the minds of all private client advisers as “A” Day: the day on which the Government’s much-vaunted pens...

6 April 2006 is a date imprinted on the minds of all private client advisers as “A” Day: the day on which the Government’s much-vaunted pension reforms will come into effect. It is more than a year away, so there must be plenty of time before the issue really needs to be thought through, the impact considered and any pro-active advice need be given and action need be taken? No.

On “A” Day, a lifetime limit for the value of an individual’s total pension rights will be imposed on every individual who will qualify for a future pension under UK regulations. An individual whose total pension rights exceed the limit will face a penalty tax charge at an effective rate of 55% on the excess.

The lifetime limit will initially be set at £1.5 million. It will increase over time, but the increases are expected only to keep pace with inflation. Private clients in particular will clearly be affected by this limit, but it will by no means only be the super-rich that are hit: at current annuity rates, pension rights currently valued at £1.5 million might give an indexed annuity now (assuming 25% tax free cash) of around £40,000. Any client that is relying on pensions for their retirement is likely to be anticipating an annual income greater than this, especially if a pension will be their only or main source of income, so the limit is likely to cause a problem for a substantial number of people.

There are four ways in which individuals might protect themselves from the penalty tax. First, by making sure that the total value of their pension rights never gets anywhere near the lifetime limit, simply by either ceasing to pay into a fund, or by never starting one in the first place: this will obviously only be appropriate where the individual has some other form of retirement planning in place. Many people nowadays consider that the tax benefits of pensions are far outweighed by the investment and accessibility restrictions placed on the fund. “A” Day will also herald a relaxation of many of those restrictions, and so pensions may become more attractive for some people. However, those changes are outside the scope of this article.

For those who already hold pension rights with a total value in excess of or possibly even slightly below the £1.5 million limit, Primary Protection is available. This form of protection gives the pension holder their own personal lifetime limit, based on the value at “A” Day and indexed up over future years. The index is unlikely to be in line with the level of growth that one might hope to achieve in the fund itself, so it is possible that excess growth in future years will still face the penalty tax charge, but for someone with very substantial pension rights at present, Primary Protection could be very valuable. Although future pensions contributions by someone who has Primary Protection will be allowed, the imposition of the personal limit will mean that one would hope that future contributions should not be required, unless a fund underperforms.

Enhanced Protection is likely to be of much more interest, especially amongst clients who still have some years to go before retirement. With Enhanced Protection, no future contributions will be allowed, but the pension holder is effectively exempted from the lifetime limit regime, because all future growth in the pension rights that exist on “A” Day will be protected.

The fourth way in which a private client might be advised to protect themselves against the penalty tax charge is to apply for both Primary and Enhanced Protection. This would allow the most flexibility, and it would delay the point at which the decision has to be made as to which protection to use and which to drop.

None of this brings “A” Day any closer. However, it should be clear from the way in which the protection systems will work that, assuming you want to maximise your potential benefits from pensions (rather than from, for example, directly owned property), you will have to maximise your fund before “A” Day. This means contributing the maximum amount possible between now and “A” Day. Since pension contributions are currently limited by reference to net relevant earnings in a particular tax year (something else that is going to change to some extent), there are only two tax years left in which to beef up a fund. One of those tax years ends on 5 April, so there may not be long to benefit from the current tax year.

Of course, it will presumably continue to be possible to make a contribution next year and relate it back to this tax year, within the restrictions of doing that. However, this is not possible for everyone. Furthermore, if 2004/05 is to be the basis year for net relevant earnings for 2005/06 (and 2004/05), then it will be necessary to maximise those earnings now, regardless of when the contributions are actually made.

In any event, both Primary Protection and Enhanced Protection will have to be applied for before “A” Day in order to take advantage of what is effectively transitional relief. This then raises the question of how to determine what will be the value of a client’s total pension rights by the time “A” Day arrives, so that the appropriate advice can be given? Obviously the starting point will be obtaining a current valuation, but with more and more pension holders asking for this information between now and “A” Day, some providers have apparently already admitted that they will not be able to cope. Action should clearly be taken sooner rather than later.