One of the perverse outcomes of the way the Lifetime Allowance (LTA) currently works is that DB members get far more pension for their tax relief than their DC counterparts. Is the government set to change these factors?
In 2004 George Osborne railed against how unfair LTA valuation factors were on DC members.
The Chancellor first spoke about the issue in 2004 when he was shadow chief secretary to the Treasury.
In a committee hearing on the Finance Bill 2004, Osborne said: "One pension adviser said to me: 'You might as well tie a leper's bell around the DC member's neck'. At a time when more and more schemes outside the public sector are becoming DC schemes, what we are seeing is very unfair and creates more resentment of the generous public sector defined benefit arrangements.
"Of course, we are talking about people on very large pensions, but what we are seeing sends out a message about the way in which the different types of schemes will be treated and the unlevel playing field that the government have produced for the two different types of pension arrangement, one of which-the defined contributions scheme-is becoming much more popular than the other."
He added: "Although the arrangement is clear, simple and fair for defined benefit schemes, for which the 20 to 1 valuation factor is used, the same degree of fairness does not apply to defined contribution schemes."
Indeed, one of the perverse outcomes of the way the LTA currently works is that DB members get far more pension for their tax relief than their DC counterparts - and that disparity has grown as annuity rates have fallen over the past ten years.
With a LTA of £1m, a defined benefit member would be able to accrue a pension of £50,000 a year before they reached the limit.
However, a DC member with a £1m pension pot could receive as little as half as much in pension.
Fidelity retirement director Alan Higham says £1m would only purchase an inflation-linked pension with 50% spouses benefit of around £26,000 - £24,000 less than if the same member was in a DB scheme.
Institute and Faculty of Actuaries (IFoA) president Nick Salter agrees DB members currently get much more favourable tax relief. He says: "There is a discrepancy between the way that the LTA will affect those in a DB pension scheme and a DC pension scheme, which favours those in DB schemes.
"A member of a DB scheme can receive more pension before hitting the LTA than an individual with a DC arrangement. In the DB market the assumed equivalent cost of £1 per annum of pension for life is £20, however under the present system it could cost £30 or more to buy the same £1 of annual pension on the open market."
This hardly seems fair - and numerous industry figures fear the DB valuation factors could be changed from the current factor of 20:1 to 25:1 or more.
Mercer senior partner Nigel Roth explains: "We're concerned that the government may change the terms on how DB schemes are valued for LTA purposes.
"If they change the DB valuation factor to, say 25:1 then with a revised LTA of £1 million, any person with a DB pension worth more than £40,000 at retirement will be hit with a penalty tax charge."
HM Treasury says it has "no plans" to change how DB schemes are valued for LTA purposes.
However, independent pension consultant John Ralfe (pictured above) believes the government should now review the factor.
He says they should go back to the advice the Treasury originally received when the factor of 20 was calculated and assess what this figure would be like if you used today's bond and annuity rates, increasing it accordingly.
He said: "LTA DB factors should be increased in line with the changes in annuity rates in recent years - something that would be technically easy to do."
Respondents to this article (below) suggest a number of alternatives for the status quo - including using a factor of between 28 and 30 to 1 at age 65 adjusted according for age, or scrapping the LTA completely and managing things through the annual allowance.
She said: "For members of DB pension schemes, who do not have an actual pot of money but are promised a specific level of pension, perhaps the lifetime limit makes more sense, since they have no control over the investments and the contributions are harder to measure due to fluctuations that occur depending on the scheme's assessed funding levels.
"With defined contribution schemes, the better policy would be to control the amount put in each year but then allow the pot to grow as well as it can, without penalising it if it rises strongly. Therefore, I would like to see the LTA abolished for DC schemes."
Four things we know about the LTA
Professional Pensions has looked through the House of Commons debates at the time the LTA factor was discussed in 2004. Here's what we discovered:
- The factor of 20 to 1 is based on a retirement age of 60, the age at which the majority of people took their pension a decade ago.
- There was huge debate over whether or not a single valuation factor should be used - as a single factor would be generous to those who retired early and mean to those who retired later. It was decided a single valuation factor would be less complex to administer.
- The valuation factor of 20 was decided as appropriate only after considerable consultation - and was only considered appropriate by actuaries if there was "appreciable margin" in the level of the lifetime allowance, which was set at £1.5m when it came into force in 2006 but has since been reduced to £1.25m and will drop to £1m from 2016.
- It was decided the factor should not attempt to accurately reflect market conditions at the time of calculation, as that would unnecessarily complicate retirement planning. The government at the time also feared such change could create an arbitrage opportunity between DB and DC schemes.
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