If there is one thing that shows how quickly pensions policy can move to the detriment of investors, it is the lifetime allowance. This is the artificial barrier imposed by the government on people who manage to save up a relatively comfortable pension.
The pensions lifetime allowance will drop to £1.25m for the 2014-15 tax year (from £1.5m for 2013-14). This level of pension will buy a man aged 65 an inflation-protected pension of around £43,000 a year that will leave his wife half this income if he dies. The problem with an artificial limit is that it is not based on contributions. It is simply a limit on the size of the pension pot, making no allowances for investment volatility.
Benefits above the lifetime allowance can suffer a 55 per cent tax charge when the fund is taken as a lump sum or a 25 per cent tax charge on top of the pension investor's marginal rate of income tax when income is taken.
Say an investor is on track to achieve a £1.25m pension but manages to achieve strong investment performance and breach the limit. Should he be penalised? It seems unfair that people near the limit should be forced to let the tax tail wag the investment dog, investing conservatively in order not to suffer punitive tax.
But now we have a new development in the lifetime allowance story. The government is making plans to offer transitional protection for about 30,000 people affected by the drop in the lifetime allowance to £1.25m.
There are two types of protection available. People have up until 6 April 2014 to apply for "fixed protection" on their pension savings up to the value of £1.5m. This will protect the growth of existing savings up to £1.5m.
Alternatively, under "individual protection" those with more than £1.25m of pension savings on 5 April 2014 can apply for a personal lifetime allowance equal to their existing savings at that time, subject to a maximum of £1.5m. This will not protect the future growth of these savings. However, unlike fixed protection, with individual protection people are able to continue to make further pension contributions on which they can benefit from immediate tax relief at their highest rate. These future contributions are likely to provide benefits that exceed the lifetime allowance and will suffer a 55 per cent tax charge when that excess is taken as a lump sum.
Anyone in this situation should take specialist advice on which form of protection to take (for how to find an adviser, see below). However, in general, higher and additional rate taxpayers who are members of company pension schemes may be better off under individual protection, which allows them to receive pension contributions rather than receiving the benefit as additional salary. Not being able to make pension contributions under fixed protection means an employee may lose any lump sum death benefit, as well as any future employer contributions.
Even if the employer agrees to pay the pension contribution to the employee as part of their salary instead, the tax and National Insurance the employee will pay on the extra salary will leave them with significantly less to be able to personally invest outside of pension savings.
Adrian Walker, pension expert at Skandia, says: "People really need to think about what they are sacrificing, and whether they outweigh the additional 55 per cent tax liability that may be payable in the future."
Meanwhile, stockbroker Charles Stanley points out that there is a time bomb awaiting unsuspecting Sipp investors. Many people who started in drawdown several years ago may not have applied for protection of their funds from the lifetime allowance charge because their total fund at retirement was well below the allowance at the time. However, in relation to this lifetime allowance, drawdown investors have to carry out one final check at the age of 75 years. Particularly if they have had good investment performance, by this time their fund may have breached the new lower 2014-15 lifetime allowance.
Someone who felt in 2006 that they would never breach the limit could now be caught unless they hold "enhanced protection" that was offered up to 5 April 2009 on the proviso that no contributions were paid after 5 April 2009.
Case study:
John retired on his 70th birthday in July 2010. The lifetime allowance that year was £1.8m and the total value of his pension benefits was £1.5m, so he was not affected by the cap. He did not expect to be affected so had not previously applied for enhanced protection.
On retirement, he released his tax-free cash to pay for various projects, but as he is still earning, he only takes a little income from the fund in the form of drawdown.
As a result of low drain on capital and successful investment growth (averaging 15 per cent a year), by July 2015 his Sipp fund has grown to a splendid £2.7m. On his 75th birthday he is hit with a tax bill of £341,656.
Source of figures: Charles Stanley
