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A defining moment for QROPS

By now many readers will be aware that A-Day (6 April 2006) produced some radical changes regarding the rules governing transfers from UK registered pension schemes. This article explains what's changed.

From 6 April 2010, individuals who wished to migrate from the UK were able to transfer their UK pension funds to an overseas pension scheme, provided it was a ‘Qualifying Recognised Overseas Pension Scheme’ (QROPS).

There are numerous benefits to be gained in transferring a UK pension to a QROPS and we shall remind ourselves of these later. All too often however, articles on QROPS transfers emphasise the caution which should be exercised when considering a pension held in a Defined Benefits Scheme (DBS), and quite rightly so. A DBS provides an individual in their retirement with an income based entirely on their earnings and length of service with the company operating the DBS. Such a scheme often comes with guarantees attached such as a pension income guaranteed for life, where statutory annual increases of up to 5% can apply. They can also provide the highest level of financial security for surviving spouses and civil partners. These considerable benefits mean that there may be relatively few cases in which a QROPS transfer would be considered to be best advice.

Having said this, unfortunately nothing is ever so cut and dried. It is important to consider how safe the DBS is and whether or not it will be capable of delivering on its promises. At the end of the day, when deciding whether or not a pension should be transferred from a DBS, it is important to gather all of the relevant facts in order that an informed choice can be made. As always, it will be impossible to eliminate the element of risk as we shall see below.

As a QROPS is a personal pension, its performance in the future is very much dependent upon the value of its underlying assets. When the pension fund is exhausted, so too is the member's income (unless of course an annuity is bought). With a DBS, the employing company carries all the risk in meeting the guarantees it has promised to its member. It is important to remember however, that as much as it sounds advantageous to leave this risk with the employer and not yourself, this does not, in any case, mean that you can afford to put your feet up, especially in the current climate! Unfortunately, many of these seemingly gold plated pension schemes are dying out fast, mainly due to their high running costs. Furthermore, every pension fund is based on stock market performance, and falling share prices have hit the assets held by many of the schemes, forcing employers to try and prop the schemes up themselves.

On 4 June 2009 it was reported by the Times that Barclays had become the first leading UK employer since Rentokil Initial some four years earlier to announce plans to close its final salary pension scheme to existing members. On 18 August 2009 the Daily Mail reported findings of a study which had been conducted by a firm of consultants called Watson Wyatt. Their investigation found that half of the UK's companies researched will have closed their generous defined benefit pension schemes to existing members by 2012. The report stoked further fears over the extent of Britain's pensions crisis after it was also reported that almost all blue-chip companies admitted earlier in 2009 that their final salary schemes were unsustainable.

Fast forward to 11 February 2010, when it was reported that Telecoms company BT had agreed to pay off a £9bn deficit in its pension scheme over the following 17 years. Despite this however, the Pension Regulator said it had "substantial concerns" over the plan although it has not stated publicly the nature of those concerns. The pension scheme had been in deficit since the 1990's but this ballooned from £3.4bn in 2005 because the company finally had to accept that it would be much more expensive to fund pensions in the future than they had otherwise thought. They have now had to take on board the fact that pensioners are generally living another two years longer than was previously believed at the time of the scheme's valuation, in 2005.

The slashing of tax relief on pension contributions for high earners as from 2011, cutting the tax relief on contributions for those earning more than £150,000 from 40% to 20%, has sparked outrage among high earners in the City and has led to predictions of an exodus from the UK. It is likely that many more people will be caught by the restriction on higher rate relief than first anticipated. If the anti-forestalling legislation is anything to go by, all pension contributions including employer contributions and the value of the accrual of final salary related benefits will count as relevant income for the purposes of testing the £150,000 - £180,000 limit. For high earners caught by these new provisions, registered pensions are unlikely to be an attractive means of saving for the future, particularly if they end up being taxed at 50% on most of the benefits but only 20% relief on the way into the scheme.

When these measures were first proposed in the pre-budget report of 2009, industry experts were already saying that such an attack on pensions tax relief could send the wrong message to both scheme members and employers. Rob Warren, Director of Regulation at IFF Research, was quoted as saying: "What has yet to be seen is the impact of the tax change on lower-paid employees' rewards. Senior executives who have previously maintained a business final salary pension scheme may no longer see the incentive to do so. As they are forced to shift to alternative investments, the unintended consequence could be an accelerated decline in the number of defined benefit schemes available to others, which could have a devastating impact on ordinary people's future income."

Likewise, Alex Waite, a pensions adviser from Lane Clark and Peacock, was quoted by the Observer newspaper on 26 April 2009 as saying: "If a managing director is not personally able to gain any benefit from participating in the company pension scheme, it is only human nature that their attitude towards the whole scheme will be affected. Given the delicate state of the UK pension system it seems rather unfortunate to, in effect, remove the personal value of pension arrangements from those people who are often the decision makers for everyone else's pension."

So how can you tell if a DBS is in trouble? What are the warning signs? There are a few indicators to look out for.

How well the scheme is funded? A company's pension funding position is of major significance being the pension pot for all of its member employees. The company is, in effect, investing on each member's behalf and in turn, it is carrying all of the risk.

Is there a deficit? If the company becomes insolvent and the scheme is in deficit, an individual will almost certainly lose some, but not all, of their pension rights because the Pension Protection Fund in the UK does not guarantee full pensions. For members who have retired but have not reached the normal pension age of their scheme, they will receive up to 90% compensation. However these 90% compensation levels are subject to a cap which is recalculated every year for new pensioners.

Are any pension bribes being offered? This is a very strong sign that the scheme is seriously struggling. A large number of firms, many of them in the FTSE100 of Britain's biggest business, are thinking about offering cash bribes to workers who agree to quit their final salary schemes. Known as an ‘Enhanced Transfer Value’ (ETV) the pension trustees pay a lump sum called a transfer value into an alternative pension scheme. The deal, in theory, is supposed to be equivalent to the final salary benefits that the member is giving up, and is typically coupled with a cash lump sum on top from the employer to tempt people. Whilst such deals may initially appear attractive, they can leave an individual worse off.

An increase in retirement age. You may have been told that you were entitled to take benefits from age 60 but now this has been pushed back to 65. Could this be a sign that the company's pension scheme is struggling to meet its commitments?

Have staff recently been asked to increase their personal contributions to the scheme? A possible sign that the scheme is suffering a shortfall at some level.

A scaling back of the accrual rate. The accrual rate is the rate at which future benefits in a defined benefit final salary pension will accumulate, based on a formula linked to the scheme member's pensionable earnings. This formula is usually expressed as a fraction of final salary such as 1/60th or 1/80th, and the pension benefits at retirement age will increase as the length of service increases. For every year a defined benefit scheme member is working they are earning a percentage of their final salary. However some company schemes have cut back on this future accrual, meaning that for every year an individual is working, they are naturally then earning a smaller percentage of their final salary.

A frequent replacement of pension scheme trustees and actuaries. If there is a high turnover it is very likely that the trustees and the company are having regular disagreements over the scheme's management.

Clearly it is important that an individual seeks advice if they have any doubts over the future of their DBS since it may prove advantageous to transfer out to a QROPS if they are about to leave the UK or have already left. Taking a holistic approach to pension planning is vitally important and there are many factors to consider. Transferring a pension to a QROPS means that an individual is able to design a succession plan, ensuring they can secure benefits after death to their spouse and any children. On top of this, an individual can take control over his or her pension and, with a QROPS, there is a wider choice of investments available with no limit to the size of funds which can be accumulated.

When a UK pension is transferred to a QROPS and the member has been non UK resident for over five tax years, then depending upon the jurisdiction where the QROPS is based, the member may have a choice of taking a higher tax free lump sum than what would otherwise be allowed in the UK. For example, the Isle of Man allows a tax free lump sum of up to 30% once the member is outside of the reporting period. Once the individual decides to draw their pension income it is paid out of the pension investment fund, and the remainder of the fund value is available to whoever the member nominates, totally free of Inheritance Tax.

Tax is an important consideration. Even though the member might be non-UK resident, any pension coming from a UK registered pension scheme will be subject to UK income tax. It is therefore important to understand if the member's new country of residence has a double taxation agreement with the UK. Some QROPS jurisdictions also tax the pension income at source, but many others do not. It is equally as important to consider the tax position of where the QROPS is based, as well as the client's country of residence in order to avoid any double taxation.

QROPS schemes are probably the best opportunity expatriates have had in a very long time. Not only do they maximise potential benefits but they also increase flexibility. So even if an individual's pension is held in a DBS, as long as the member receives professional advice and is in a position to be able to weigh up the pros and cons of the proposed transfer, a QROPS may still be worthy of consideration.