Executive pensions – do you know your limits?
In the past, pension benefits used to form a substantial proportion of top executives’ total remuneration. This was not just because their entitlements were based on higher salary levels than employees generally but also because these executives had more generous percentage employer contributions or accrual rates. Moreover, the full value of directors’ pension rights was not always apparent because of incomplete disclosure in companies’ accounts.
The combination of controversy about executive pay levels and the Government’s wish to reduce the costs of tax reliefs has now led to severe restrictions on the value of executive pension benefits.
Corporate Governance Code and investor guidelines
The July 2018 UK Corporate Governance Code, which applies to all companies with a premium listing, requires that “pension contribution rates for executive directors, or payments in lieu, should be aligned with those available to the workforce”.
In its November 2018 Principles of Remuneration, the Investment Association (IA) supported this provision, interpreting it to mean “the rate which is given to the majority of the company’s workforce”. The IA went on to announce on 21 February 2019 that the Institutional Voting Information Service (IVIS) will:
• ‘red-top’ companies which pay new directors, appointed from 1 March 2019, pension contributions which are not in line with the majority of the workforce; and
• ‘amber-top’ companies where any existing executive director receives a pension contribution of 25% of salary or more.
The Directors’ Remuneration Report Regulations now require listed companies to disclose in their annual reports the value of all pension-related benefits, including payments made in cash or otherwise in lieu of retirement benefits and benefits from participating in pension schemes. The Remuneration Policy approved by shareholders must include the maximum pension benefit and, if this amount is exceeded, the directors who authorised the payment may be liable for any resulting loss.
Annual contribution limits
Changing tax rules may have had an even more dramatic impact. From April 2015 the annual limit on tax-relieved pension contributions for a member of a registered pension scheme has been reduced to £40,000 (or 100% of taxable earnings, if less). This ‘annual allowance’ includes contributions by the employee, employer or any third party to a money purchase/defined contribution (DC) arrangement and additional accruals to a defined benefit (DB) scheme. If the limit is exceeded, a tax liability arises (the ‘annual allowance charge’).
Individuals can, however, carry forward any part of the £40,000 allowance which was not used in the previous three tax years, provided they were members of the pension scheme in those years.
Since April 2016, the standard ‘annual allowance’ has been reduced for high earners with an ‘adjusted income’ (which includes total taxable income plus employer pension contributions) of more than £150,000. The annual allowance is ‘tapered’ from £40,000, for those with ‘adjusted income’ of up to £150,000, down to £10,000, for individuals with an ‘adjusted income’ of £210,000 or more.
Those who have already drawn from DC schemes
Since April 2017, there has been a substantially lower ‘money purchase personal allowance’ of £4,000 for individuals who have already drawn money from their DC pension schemes under flexible access arrangements. This is to discourage people from obtaining additional tax relief by reusing funds which have already received tax relief. This £4,000 allowance cannot be topped up with unused allowances from earlier years.
In addition to the annual contribution restrictions mentioned above, there is a ‘lifetime allowance’ which limits the total value of pension benefits which an individual can draw without an additional tax charge to £1,030,000 (2018/19). This includes the value of all an individual’s pensions, through DC and DB schemes, but not the State Pension.
For DC schemes, including personal pensions, the value is the pension pot used to fund retirement income and any lump sum. For DB schemes, the expected annual pension is multiplied by 20 and any lump sum is added to the total. So an individual on a 60ths accrual rate and 40 years of service would exceed the lifetime allowance if his final salary was £78,000 (40/60 x £78,000 x 20 = £1,040,000).
Any pension pot worth more than the allowance is subject to a tax charge of 55%, if paid as a lump sum. If paid as a pension, the tax charge is 25%, but the gross amount is also subject to the individual’s marginal tax rate.
Some executives have preserved a higher earlier level of ‘lifetime allowance’, for example at £1.25 million by taking out Individual Protection 2016 or Fixed Protection 2016. Those with Fixed Protection, in particular, need to ensure that they do not build up any further pension benefits after 5 April 2016. They should have opted out of automatic enrolment and any life assurance cover may have to come from a different source than the pension scheme.
What should companies be doing about this?
It is clear that the days of generous executive pensions are now over. It is becoming standard practice for companies’ contribution rates to executive pensions to be equalised with the majority of the workforce. This can be achieved easily for new appointments and promotions. For existing executives, the contribution rate is part of the employment contract and cannot be reduced except by mutual agreement. However, companies will wish to note that the IA Principles of Remuneration state that shareholders expect contribution rates for incumbent executive directors to be reduced as soon as possible and that no compensation should be awarded for this change. Recent press reports suggest that the major UK banks have adopted this approach.
This reduction in pension entitlement will change the balance between the fixed and variable elements of remuneration. Depending on their remuneration strategies, companies may choose to readjust this new balance by modifying other parts of the total package.
In cases where the statutory annual and lifetime allowances prevent executives from receiving even the standard workforce pension contributions, the practice of paying cash in lieu of pension is likely to continue. In determining the size of any cash alternative, companies should take into account the extra employer’s NICs costs of cash payments (in comparison with pension contributions) and whether the payments will increase entitlement to bonuses and other benefits.
This article is intended to draw attention to possible implications arising from the variety of restrictions on building up pension benefits for executives. Please note that MM&K’s consultants are not pension experts and you should obtain advice from an appropriate professional adviser before taking any action on any of the issues discussed.
For further information contact Mike Landon