By Mary Walsh, Board Member & Donal de Buitleir, Director of publicpolicy.ie

The Government has announced its intention to place a cap on tax relief for pension schemes that deliver income in retirement of more than €60,000.

The question arises how can this be applied fairly to different classes of pensioners notably self-employed and defined contribution schemes, defined benefit schemes in the private sector and unfunded defined benefit schemes in the public sector?

Multiplier

The mechanism used to date to cap tax relief for pensions has been to cap the maximum sum that may be accumulated in the pension fund. This cap is known as the Standard Fund Threshold (SFT) and at present is limited to a maximum of €2.3 million. For defined benefit schemes a standard multiplier of 20 times the annual pension promise is used.

The current standard multiplier has a number of defects

1. It is too low based on current interest rates thereby discriminating against those who do not have defined benefit pensions
2. No adjustment is made for the age at which the pension becomes payable, the position in relation to survivorship benefits or post–retirement increases.
3. A more appropriate multiplier for a defined benefit pension payable from age 66 (Current state pension Age) would be about 25¹ .

This would suggest that an SFT of €1.7 million (25*€60,000 + €200,000 tax free lump sum) would be necessary to give effect to the Government’s intention.

Grandfathering

The question will arise as to how people who have already accumulated pension rights in excess of the cap should be treated.

When the reduced SFT was introduced with effect from 7 December 2010, anyone whose pension fund had a capital value of greater than €2.3m on that date could apply to the Revenue Commissioners before 7th June 2011 for a Personal Fund Threshold (PFT). Once certified by the Revenue Commissioners, they could effectively retain their accumulated pension benefits.

Given the precedent it would seem fair to allow grandfathering of existing accrued pensions.

Variable Multipliers

The use of a fixed multiplier to value pensions regardless of the age at which the pension becomes payable, the position in relation to post-retirement increases and survivorship pensions needs amendment.

The following would appear to be appropriate

• Increase the multiplier by an appropriate actuarial adjustment for each year in advance of age 66, at which the pension is payable.
• Adjust the multiplier to take account of the position in relations to post-retirement increases and survivorship pensions.

Annual Limits

The imposition of a cap on the pension fund (SFT) would initially appear to obviate the need for current annual limits on the employee contributions allowable. These limits comprise an age-related percentage (ranging from 15% to 40%) of annual income up to a ceiling of €115,000. No annual limits are imposed on employer contributions. An annual limit in its current form would appear to discriminate against those who have irregular earnings or irregular employment as compared with those in constant full time employment.

However, in the absence of any restriction on annual pension contributions, it is likely that employees approaching pension age would have a significant motivation to defer current income by contributing to pension schemes, particularly where the related pension income could be taken by way of a tax free lump sum. Younger employees might also defer commencing pension contributions when faced with the possibility of making larger contributions in later life. Conversely, short-term residents could minimise Irish tax by increasing pension contributions for the duration of their employment in Ireland. A possible countermeasure, which might reduce tax avoidance without adversely impacting on the attractiveness of pension contributions would be to include employee and employer pension contributions (or imputed contributions in the case of unfunded and defined benefit pension schemes) as “specified reliefs” for the restrictions applicable to high-income individuals. These restrictions apply to incomes in excess of €125,000 and impose an effective tax rate of 30% but do not currently include pension tax reliefs to any extent.

Treatment of contributions to PRSAs and by the Self-Employed

No further restrictions are required other than those described above. The suggested scheme of pension tax relief would equalise the treatment of the self-employed and of employees in occupational pension schemes. This would have the benefit of removing the current discrimination against the self-employed whereby pension contributions are limited on an annual basis to the same amount as employee pension contributions, notwithstanding that employer contributions are not possible for the self-employed. This anomaly results in an employee being able to accrue a much larger pension pot by comparison with a self-employed person on the same income.

Private Sector Defined Benefit Schemes

The provisions outlined above in relation to the multiplier above should apply

Unfunded Public Sector Defined Benefit Schemes

The provisions outlined above in relation to the multiplier above should apply

Pension funds in excess of the Standard Fund Threshold

The options appear to be

1. Stop accrual once cap is reached and pay a non-pensionable amount which would be taxable in lieu of future accrual.
2. Tax the value of the accrual as it occurs
3. Claw back the implicit tax relief on retirement or when the pension is payable.

Option 1 While this may appear the cleanest solution, it may not be appropriate to link a contractual arrangement like a pension scheme with the tax relief and employers and employees should in principle be permitted to agree pension arrangements commercially.

Option 2 could impose significant hardship on lower-paid individuals who might not have the liquidity to pay the tax.

Option 3. At present when a pension pot exceeds the SFT or other limit, the chargeable excess is subject to an upfront income tax charge of 41 per cent, thus effectively clawing back tax relief which has been given.

The suggestion above to include pension tax reliefs in the high earner restrictions is, in effect, a variant of Option 2, with the impact confined to those earning in excess of €125,000.

Anomalies

Employees using PRSAs as their pension vehicle are currently treated more adversely than other occupational pension scheme members. This is because employer contributions to PRSAs – unlike employer contributions to occupational pension schemes (whether defined benefit or defined contribution) – are taxed in the hands of the employee as a benefit in kind, thereby rendering them liable to PRSI and Universal Social Charge. This is a clear anomaly and USC and PRSI should not be paid on employer PRSA contributions in circumstances where they are not payable on employer contributions to occupational pension schemes.

Notes:

¹ Source: Limiting Pension Reliefs Targets for 2014, Acuvest..