Scheme Pension: When is it right?

Martin Tilley looks at the issues advisers need to bear in mind when recommending scheme pension.

Many end of year round ups have focused on the problems experienced by IFAs and clients facing formal drawdown reviews and the change in method of pension receipt to capped drawdown.

Several factors such as the underperforming investment markets and reducing gilts yields could have been featured in possible future scenarios when income drawdown was first proposed. However, the Government review of the Actuary's drawdown tables as well as the draconian removal of the 20% uplift over standard tables may not have been and the latter has the most significant influence on maximum income reduction.

Many advisers will have made reference to such variables and recommended a level of income well below the maximums. This means that at review, reductions in income will be less severe than where clients looked to strip out the maximum income. For those who did strip out maximum income reductions of up to 50% might now be the unwelcome result.

With gilt yields below 3%, existing income drawdown clients and indeed clients now vesting are being steered toward scheme pension. Indeed many firms have been promoting this as an alternative to annuity and capped drawdown. But while this option may appear attractive initially there are a number of considerations that need to be understood as there is the potential for serious tax penalties if scheme pension is wrongly adopted.

What to consider
Firstly, scheme pension was introduced as a method of providing a form of secured pension. Intended for use initially by larger corporate schemes, it has however been adopted by Small Self Administered Schemes (SSASs) and Self Invested Personal Pension (SIPP) providers. A recent legislative change concluding that scheme pension is a defined benefit has called into question the continued use of this arrangement within these money purchase vehicles and clarification on the intent of legislation is still awaited.

Assuming these vehicles are exempted, an adviser still has a great deal to consider. For instance, being a secured pension it should provide a sustainable income for life, be paid at least annually and critically, not reduce year on year except in certain prescribed circumstances. Generally, provided any decrease applies in equal proportion across the scheme membership it should be acceptable. For this reason, scheme pension often requires the establishment of a new single member scheme with its associated costs. Also HMRC reserves the right to apply tax sanctions, including making these retrospective if it believes that the initial level of income has been set at an artificially high or unsustainable level.

There are two crucial factors that will influence the scheme actuary in setting the initial level of income, both of which are judgement calls rather than factual data such as member and potential dependant age, guarantee period and level of escalation. These are health and investment yield.

Taking health first, where a client may be in poor or seriously impaired health, there would appear to be a clear advantage over standard annuities or indeed capped drawdown which takes no account of a reduced life expectancy. Thus an accelerated rate of withdrawal would provide a higher income, but how should that income be assessed?

Before entering into scheme pension, the member must have been offered the opportunity to secure an insurance backed lifetime annuity and one would assume that this would have been costed and underwritten by the life company actuary. If impaired, this will often be a good starting point, but if a different level of mortality is assumed then additional justification for it must be obtained, evidenced and documented. Indeed, where a scheme pension is paid on ill health grounds, the scheme administrator is required to hold evidence from a registered medical practitioner. The downside being if the individual outlives his estimated mortality, there will be a cut back of income or worse still, the depletion of the fund such that income ceases. In such circumstances HMRC may question the initially set level of income and evidence obtained.

Investment
With investment, as with health it is critical that each individual is assessed separately. One size does not fit all and the use of an "average return" is entirely inappropriate since a single member scheme is not subject to any "average". It is specific and it is here that the advisers input should be sought.

The client will have an agreed attitude towards risk and from this an investment strategy will be agreed and implemented. It is from the assets comprising this strategy, that the actuary should deduce an appropriate anticipated yield. With the past performance of stockmarkets, fixed interest and property indices as a guide and with another eye on the future investment markets, an actuary needs to be cautious and realistic in their assumptions.

The importance of the actuarial role should not be underestimated, HMRC has powers to tax as unauthorised member payments any payment to the member that they deem has not been made as a scheme pension. If the initial assumptions cannot be justified and thus the initial or reviewed level of income cannot be paid for life and thus as a scheme pension, there is the risk that these tax penalties might be substantial.

Martin Tilley is director of technical services at Dentons