Partial DB transfers – the best of both worlds?

Partial DB transfers could be the perfect solution for those caught between needing income security and income flexibility.

Not only could partial DB transfers offer the best of both worlds to clients, it could also be advantageous to employers and trustees too. Most people with a DB pension will be best advised to stick with it. A DB pension offers the peace of mind of a fixed income for life. It will be too much for most people to contemplate giving up, no matter what level of transfer value is on offer.

But what if the guaranteed income level needed to allow clients to sleep easily knowing that they’re financially secure can be met with only part of their accrued DB promise? Transferring the excess to provide income flexibility when required, or to be passed on efficiently to future generations, could generate a situation where everyone is a winner.

  • Member – win: For members who want some guaranteed income, but not as much as their full DB entitlement,  partial DB transfers may be the best fit for their needs. It can provide the guaranteed income they need, plus flexibility with the balance of their accumulated DB wealth.
  • Employer – win: Growing numbers of employers have realised that allowing partial transfers helps get DB liabilities off their balance sheet efficiently. If they stick with an ‘all or nothing’ stance, more liabilities will stay on their books.
  • Trustees – win: Every transfer paid normally improves their scheme’s actuarial funding position – leaving remaining members more secure. It’s rare for a transfer value to be higher than the actuarial ‘technical provisions’ they have to reserve for to back the DB promise.

Who might it be right for?
It may be clear cut whether or not partial DB transfers are appropriate for most clients. But there will be some who sit in the ‘grey area’, needing some guarantee but equally attracted to DC and the benefits that freedom and choice can offer. And it’s these clients who will benefit most from seeking a partial transfer. 

A guaranteed retirement income may provide peace of mind that the bills will be paid in old age. Giving up this guaranteed, inflation-proofed income for life could be a risk too far. Most simply can’t take on the downside risk of moving to DC and should stick with DB.

But for wealthier clients, worries about paying their bills or running out of money won’t be an issue. A DB income for life may simply mean surplus income and unnecessary tax. A transfer to a modern, flexible DC pension may be a better fit for their needs. The ability to take income and tax free cash from a SIPP at the levels they need, when they need it, may give a more tax efficient income and a larger legacy for loved ones.

The advice framework – and how partial transfers fit in
The FCA rules are clear. An adviser’s starting assumption should be that a DB transfer isn’t suitable. A transfer to DC should only be recommended if it’s clearly in the client’s best interests.

This doesn’t mean it’s safe to leave clients in DB where DC would suit them better. But it gives advisers a useful ‘no transfer’ default for cases in the grey area – and some leeway over where they draw the line.

However, where a partial DB transfer is an option, this changes the advice equation – and can remove any grey area. Although a full transfer may not be appropriate, a partial transfer might meet the client’s needs and aims better than sticking with the full DB pension.

Example – A client with a £40k yearly DB pension may only need a guaranteed income of £24k. A transfer value of £1M is on offer in lieu of the pension. But the client couldn’t sleep at night without their guaranteed £2k a month.

  • No transfer: Sticking with the full DB pension provides the guaranteed income the client needs. But it also gives an extra £16k a year unneeded income, an unnecessary income tax bill and, potentially, an IHT problem further down the line.
  • Full transfer: Transferring it all into flexible DC won’t guarantee the required £24k a year – risking a bad client outcome, regulatory sanction and lost sleep all round. And in current conditions, partial annuitisation under DC post-transfer to secure the £24k a year may not make economic sense.

What if a partial transfer was available?

  • Partial transfer: Leaving £24k a year guaranteed income in DB, and transferring the other 40% of the value (£400k) into a flexible DC plan, could give the best of both worlds. It covers the client’s guaranteed income needs efficiently and gives flexibility to draw extra funds when needed, manage tax or create a legacy with the balance. The ideal advice solution?


Will schemes offer partial transfers?
Many schemes don’t currently offer the option of a partial DB transfer. It simply wasn’t historically a feature of the DB landscape. But the numbers now offering partial transfers is on the rise.

The barriers holding some DB schemes back from introducing a partial transfer option are the perceived complexity and cost. Legal fees to amend the scheme documents, actuarial fees to develop a transfer basis and the costs of implementing the necessary administrative processes can all be off-putting.

But these are all achievable. If scheme trustees thought about it, they already provide partial transfers every time they receive a pension sharing order. It’s just about industrialising the process. And the payback for all concerned could be worth it.

Clients with DB and DC rights under the same scheme now have a statutory right to transfer their DC rights and leave the DB pension behind (or vice versa). An ‘all or nothing’ transfer ultimatum doesn’t always support the best member outcomes. It’s why the law was changed to allow DB and DC rights to be transferred independently. But there’s currently no statutory right to make a partial transfer of DB rights.

There are some potential legislative obstacles which may prevent a partial DB transfer. For example, the law doesn’t allow for a partial transfer of GMP rights. And scheme specific protection to both tax free cash entitlement and early retirement ages may be affected following a partial transfer. But there are normally ways to plan around these.

In summary
If this ‘best of both’ option is the best fit for your client’s needs, ask the question of the DB trustees – does their scheme offer partial transfers? And if not, ‘why not?’ By articulating the win/win result this option can produce, it might just trigger a light bulb moment for the employer/ trustees that opens up the most appropriate option for your client and creates the best advice solution for you.

retirement-options-guide-couple

Partial DB transfers – the best of both worlds?

 

Source: Standard Life technical consulting 10th May 2017

Pension contributions – How they can help business owners.

How pension contributions can help business owners

The dividend tax changes have strengthened the case for business owners taking more of their profits in the form of pension contributions. Many directors of small and medium sized companies face an increased tax bill this year as a result of how dividends are now taxed. And pension contributions could provide the best outcome by cutting their future tax bills.

Dividends have long been preferable to salary or bonus as a way for shareholding directors to extract profits. But that advantage has narrowed for many high earning directors. It reinforces the case for directors taking at least part of their benefits as a pension contribution where possible.

Dividend changes

Paying themselves dividends remains a better option than salary. But the gap has narrowed for high earning directors. A director receiving a dividend of £100,000 could be £6,300 worse off under the new rules.

Everyone now gets a £5,000 tax free dividend allowance. Dividends in excess of the allowance will be taxable at 7.5%, 32.5% or 38.1%. Previously, business owners only paid tax on dividends when they took income above the basic rate tax band. That’s because the notional 10% tax credit satisfied the liability for basic rate tax payers. But the changes mean that business owners could now be paying a higher rate of tax on a larger slice of their income.

Tax efficient extraction

Pension contributions remain the most tax efficient way of extracting profits from a business. An employer pension contribution means there’s no employer or employee NI liability – just like dividends. But it’s usually an allowable deduction for corporation tax – like salary.

And of course, under the new pension freedoms, those directors who are over 55 will be able to access it as easily as salary or dividend. With 25% of the pension fund available tax free, it can be very tax efficient – especially if the income from the balance can be taken within the basic rate (but remember, by doing so, the MPAA will be triggered, restricting future funding opportunities).

In reality, many business owners will pay themselves a small salary, typically around £8,000 a year – at this level, no employer or employee NI is due and credits will be earned towards the State pension. They will then take the rest of their annual income needs in the form of dividend, as this route is more tax efficient than taking more salary. But what about the profits they have earned in excess of their day to day living needs?

The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher rate taxpaying shareholding director this year.

  Bonus Dividend Pension income
taxed at 20% *
Pension income
taxed at 40% *
Gross profit  £40,000 £40,000 £40,000 £40,000
Pension contribution  £0 £0 £40,000 £40,000
Corporation tax at 20%  £0 £8,000 £0 £0
Dividend  £0 £32,000 £0 £0
Employer NI £4,850 £0 £0 £0
Gross bonus £35,150 £0 £0 £0
Director’s NI (£703) £0 £0 £0
Income tax (£14,060) (£10,400) ** (£6,000) (£12,000)
Net benefit to director £20,387 £21,600 ** £34,000 £28,000

* Assumes pension income is taxed after taking 25% tax free cash, and there is no Lifetime Allowance charge.
** Assumes full £5,000 annual dividend allowance has already been used against dividends received in the basic rate band.

Tapered Annual Allowance

Many high earning business owners could see their annual allowance (AA) tapered down to just £10,000. However, by reducing what they take in salary or dividends and paying themselves a larger pension contribution instead could mean they retain their full £40,000 AA.

For example – Amy, 55, runs her own business and pays herself dividends of £150,000 for the 2016/17 tax year. She has no other income. She makes employer contributions of £20,000 into her SIPP.

There are two tests which determine whether the AA is tapered:

  1. If adjusted income is more than £150,000 the AA is reduced by £1 for every £2 subject to a minimum allowance of £10,000
  2. But only if the threshold income is greater than £110,000.

Her ‘adjusted income‘ is £170,000 (income + employer pension contribution). As this is £20,000 above the £150,000 cap, it would normally cut her AA by £10,000 (to £30,000). This means any opportunity to increase her funding for this year, or in the future using carry forward from 2016/17, would be limited to a further £10,000.

However, if she cuts her dividends by just over £40,000 her ‘threshold income’ (total income without employer contributions) would be below £110,000, preserving her full £40,000 allowance.

She could pay the corresponding amount into her pension as an employer contribution using carry forward of unused AA from previous tax years.  This would not affect her AA for 2016/17 because only employer contributions as part of new salary sacrifice arrangement are used to determine threshold income. A shareholder director making an employer pension contribution rather paying salary or dividend is not salary sacrifice.

As Amy is over 55, she has unrestricted access to the funds in her SIPP. If she made use of the new income flexibilities she would trigger the money purchase annual allowance (MPAA) cutting her future funding to £4,000 a year from April 2017, with no opportunity to use carry forward. However, if she only touches her tax free cash and takes no income she would retain her full AA.

Why now?

There are some very strong reasons for maximising pension contributions now. Corporation tax rates are set to fall from 20% to 19% from the financial year starting April 2017, with a further planned cut to 17% from April 2020.

Companies may want to consider bringing forward pension funding plans to benefit from tax relief at the higher rate. Payments should be made before the end of the current business year, while rates are at their highest.

Business owners who take flexible drawdown  income to replace salary or dividends will see their future funding restricted by the MPAA. So they may need to pay now and mop up any unused allowance using carry forward. But remember that dipping into pension savings by only taking tax free cash maintains the full allowance for ongoing funding.

Source: Standard Life technical consulting – February 22 2017