Get ready for the pensions revolution!

12 October 2005

On April 6 next year – dubbed “A” day - the old regime will be swept away in the biggest overhaul of pensions for nearly a century.

The eight sets of rules that govern pensions today will be replaced by just one, in a long-awaited attempt to simplify the system. Savers will be able to put a wide variety of investments in their retirement fund, including residential property, wine, art, even vintage cars. And the government has bowed to pressure to relax the annuity laws so that people have more control over their money when they retire.

So what are the main changes – and how do you make the most of the new system to boost your retirement savings?

The tax relief on pensions will remain the same. So for every 78p you contribute, the government will make it up to £1. Higher-rate taxpayers can claim the extra 18p through their tax return.

Tax relief is the big attraction of pensions - and should make them a cornerstone of your retirement planning. Tom McPhail of Hargreaves Lansdown, an independent financial adviser, says: “Studies have shown time and again that pensions are the most tax-efficient way to fund your retirement. They should be the first stop for almost everybody.”

The tax relief means there are limits on the amount you can pay into a pension - and they vary depending on the type of scheme. But from April 2006, everyone will be allowed to contribute a maximum of £215,000 a year to any type of pension plan, rising to £255,000 by 2010, up to your annual salary. There will be no contribution limit in the year before retirement.

The new rules on contributions are generous – and may well exceed your current contribution cap. For example, if you pay into a personal pension now you can contribute between 15% and 40% of your earnings, depending on your age. But the earnings are capped at £105,600. So the maximum you can put into a personal pension is 40% of £105,600 or just over £42,000 a year.

You might also benefit from the new rules on tax-free cash. At the moment, company pensions allow you to take a maximum of 1.5 times your final salary as tax-free cash when you retire. After “A” day, you will be able to take up to 25% of the fund.

If you have topped up your fund with additional voluntary contributions (AVCs) you will also be able to take 25% of the AVC fund as a tax-free sum. At the moment, you must use all of your AVC savings to provide an income.

But there will in future be a cap on the size of your pension fund when you retire – and it will be a cap on the combined total of the various funds you might have built up over the course of your working life.

The lifetime limit is set at £1.5m rising to £1.8m in 2010. Now, that might sound a lot, but experts forecast that more people will be caught out by the limit than the government suggests. Labour estimates that it will affect 5,000 to 10,000 high flyers, but figures from various actuaries suggest the number could be closer to 600,000. A 30-year-old who earns just £40,000 and belongs to a final salary scheme could be hit by the 55% charge at retirement, according to Hewitt, a pension consultant.

If you breach the limit, the excess will be taxed at a hefty 55%. So if your pension fund is worth £1.6m and the limit is £1.5m, you will pay 55% tax on the excess £100,000, to give a bill of £55,000.

There are ways to beat the cap. Ask your pensions department or insurance company to tell you the current value of your fund and to estimate its value in April and at retirement to find out if you will breach the limit.

If you have a personal pension or you are a member of a money purchase company scheme, simply compare the value of the fund with the lifetime cap. If you are a member of a final salary pension, your fund value is calculated at 20 times your income at retirement. So, if a final salary pension pays £75,000 a year, then it is worth £1.5m.

You can register your fund with HM Revenue & Customs on “A” day or up to three years after to protect against the charge. There are two types of protection: primary and enhanced. You can apply for primary protection only if your fund already exceeds the cap – and safeguard any excess from the tax charge. So, if you registered £3m when the limit was £1.5m, your personal entitlement would be fixed at twice the limit and would rise with the cap. You can continue paying into the fund but if it grows faster than the limit you will have to pay 55% tax on any growth.

You can opt for enhanced protection if your fund is either below or exceeds the limit. It shelters the entire fund from the tax charge, including any growth. But you must stop all contributions. McPhail says: “You have to think very carefully before you elect to cease contributions to a scheme. It is not normally recommended unless you have a big fund and you are only a few years away from retirement.”

It is not just the amount you can save that will change on “A” day, but also what you have to do with the money when you retire. At the moment, most people have to buy an annuity with the bulk of their pension fund before they reach the age of 75. An annuity pays a guaranteed income for life, but annuity rates have been falling – and could fall even further. Once you have made the purchase, however, you are locked in and cannot switch to another deal. The other problem with annuities is that your family gets nothing if you die sooner than expected; the insurance company pockets the lot. Let's say you hand over £500,000 to secure an annual income of £30,000. If you died 12 months later, then your family would not get any money back.

Savers will be able to sidestep the annuity rule after “A” day by choosing an alternatively secured pension or Asp. Your pension then remains invested and you can draw an income from the fund if you wish. When you die, any remaining funds can be used to pay a pension to a surviving spouse, or children under 23 in full-time education. There are obviously risks involved: if you leave your fund invested it might not grow in value – at least not enough to make up for any income you withdraw. HM Revenue & Customs is also expected to hit any transfers into an Asp with inheritance tax.

The people who have most to gain from the new regime are wealthier savers who can take advantage of the greater investment freedom. But they also have the most to lose if they fall for some of the current hype. But most people should benefit from a simplified pensions regime. And who knows, maybe it will restore our faith in saving. All the government has to do now, is sort out the state system

What are the main changes?

You will be given greater investment freedom - so anything goes, including residential property, fine wine and works of art.

You will be able to contribute a maximum of £215,000 a year into a pension, up to your annual salary. There will be no contribution limit in the year before retirement.

There will be a lifetime limit on the size of your pension fund of £1.5m, rising with inflation. Anything above the cap will be taxed at 55%, although you can protect your existing savings.

You will not have to buy an annuity at the age of 75 if you take out an alternatively secured pension. But anything remaining in the fund when you die could be liable for inheritance tax.