May 2007

Personal accounts

Suits you sir!

The Government has taken a number of steps to address the "pensions crisis" over recent years. Most recently, the Pensions Bill in November 2006 set out proposals for the reform of state pension provision. In December the Government published a White Paper setting out its proposals for a new scheme of "personal accounts", which it hopes will be up and running in 2012.

A consultation period ran up to 20 March 2007, giving interested parties the opportunity to comment on the proposals.

Key features

The main features of personal accounts are:

- Personal accounts will in effect be a large, defined contribution, pension scheme

- Employees aged between 22 and state pension age will automatically be enrolled if they earn above £5,000

- There will be contributions of 8% based on annual earnings between £5,000 and £33,500, made up of 4% from the employee, 3% from the employer and 1% from tax relief

- Additional contributions will be allowed, up to a maximum of £5,000 a year

- There will be a choice of investment funds

- Retirement will be possible from age 55

- 25% can be taken as a lump sum with the balance used to purchase an annuity

- There will be no transfers in or out, at least in the short term

- Employees (but not employers) can opt out

- However, employers already offering "good" pension schemes may be exempt

Set up

A Personal Accounts Delivery Authority will be set up. This will be an independent body which, prior to 2012, will advise on the detailed design and commercial strategy for the implementation of the personal accounts scheme. At some time prior to implementation, the Delivery Authority will hand over the reins to the Personal Accounts Board, which will be responsible for the ongoing management of the scheme.

Eligibility

Employees who are not automatically enrolled will be able to opt in to membership and, providing they have sufficient earnings, also benefit from the employer contribution.

Individuals who are self employed or are "economically inactive" (e.g. individuals who have responsibilities as a carer) can also elect to contribute to the scheme, but will obviously not benefit from any employer contributions.

Employees will be able to opt out of membership. However anyone that does opt out must be re-enrolled every three years, or whenever they start a job with a new employer. This is designed to force individuals to consider their financial circumstances on a regular basis.

There is concern that saving in a personal account may not be in an individual's best interests due to the interaction with means tested state benefits such as the pensions credit. It has been questioned whether certain categories of individuals, such as those close to retirement, should be automatically enrolled into the scheme. Every individual's circumstances are different however and excluding those close to retirement from automatic enrolment may not necessarily be in their best interests. What is essential however is that sufficient information is given to individuals to enable them, and those advising them, to make an informed choice about whether to opt out or remain in the scheme.

Contributions

Anybody enrolled into the personal account scheme will be required to pay a minimum contribution of 4% of their earnings that fall within the PAEB.

This band will initially be set with a lower level equal to the lower earnings threshold (currently £5,035) and an upper level equal to the upper earnings limit (currently £33,540). Thereafter, the PAEB will increase in line with average earnings.

In addition, the employer will also be required to contribute 3% of the individual employee's earnings within the PAEB.

An additional 1% will be added in the form of tax relief on the individual's contribution.

To help employers with the transition to the new scheme, the level of contributions for both the employer and the employee will be phased in over the first three years (that is, 1% employer contribution in the first year of personal accounts, 2% in the second year and 3% in the third).

Investments

Individuals will have the opportunity to select where contributions paid by them, or on their behalf, are to be invested.

The actual investment options will be determined by the delivery authority and are likely to include;

- A default fund (probably with a lifestyling option)

- A small number of low cost bulk funds

- A wider choice of funds, including ethical, environmental and social funds

The Government believes that a charging structure equivalent to an annual management charge of 0.3% per annum can be achieved in the long term, although other charging structures may need to be considered in the early stages.

The charging methodology should be set out in legislation, with the delivery authority and Personal Accounts Board being responsible for the level of charges. The use of an annual management charge would appear to be the most sensible approach to ensure that there is no cross subsidy between members. Care must be taken however to ensure that low charges are not the main focus.

Benefits

The benefits available to personal account holders will be similar to those available to members of existing registered pension schemes, including;

- Retirement between age 55 and 75

- Up to 25% of the resulting fund can be taken as a tax free lump sum

- The balance of the fund must be used to provide an annuity

- Small funds may be able to be commuted on the grounds of triviality

The main difference is that no transfers into or out of the personal accounts will be allowed, at least not until 2020. This is to prevent personal accounts being diluted as a result of transfers to other registered pension scheme and also to prevent significant monies leaving existing pension arrangements.

Given that the intention of personal accounts is to increase the level of income for the significant proportion of the population who have little or no pension provision, it is surprising that the option of a tax-free lump sum will be available. The removal of this option, as well as reducing the level of tax relief available (which could be used to subsidise the running costs) will hopefully give a greater incentive for employers to retain their existing pension provision, or encourage them to offer "normal" pension schemes to their staff so a tax-free lump sum can be provided.

Exemptions for existing occupational pension schemes

The intention of personal accounts is to target those individuals who do not currently have access to a good work based pension, not to replace such pensions. One of the key considerations for the Delivery Authority, therefore, is to minimise the impact that personal accounts will have on existing pension provision.

It is therefore proposed that employers who offer "good" pension schemes will be exempt from having to enrol their employees into personal accounts. In order to benefit from this exemption the following conditions must be satisfied;

- Employees must be automatically enrolled into the pension scheme

- There must not be an excessive waiting period before an employee is enrolled

- The scheme must offer a minimum level of benefit

The minimum level of benefit will depend on the type of scheme, as follows:

Defined contribution - there must be a minimum contribution of 8% of salary, with at least 3% of this coming from the employer, and a default investment fund must be offered.

Contracted out defined benefit - as contracted out defined benefit schemes already have to meet a minimum benefit test (the reference scheme test) in order to contract out, it is proposed that these schemes will automatically meet the minimum benefit test. Note that contracting out via protected rights is not expected to be available by 2012.

Contracted in defined benefit - these schemes will meet the minimum benefit test provided they provide an accrual rate of 1/120th of final salary. This being the benefit that the Government Actuary's Department has estimated would be provided by an average contribution rate of 8% a year.

The requirement to automatically enrol employees into the occupational scheme, and the requirement that any waiting period must not be excessive, may well have cost implications for employers. This is because employees who would not normally apply for membership of a scheme will have to be automatically enrolled. The Government is therefore consulting on whether these requirements can be phased in, and what waiting period would be acceptable.

It should be noted that, where an employer offers a contract based pension arrangement, such as a group personal pension or a stakeholder plan, it seems that, although they might meet the required level of contributions, exemption may not be available. This is because it is, apparently, illegal under European legislation to enrol an individual into a contract automatically. The Government has previously consulted on this issue, but none of the potential solutions at the time will meet the proposed automatic enrolment requirements set out in the White Paper.

As part of the consultation on the White Paper the Government sought further views on how these arrangements may qualify for an exemption from the personal accounts requirements.

It is a matter of wait and see for the thousands of employers who have set up stakeholder arrangements to comply with the Government's previous attempt to widen the pensions savings net before knowing whether they will have to make alternative pension arrangements for employees.

Andy Yates
Technical Manager
First Actuarial