Sententia November 2018

Shown below are the articles from the first issue of Sententia, from November 2018.

 

In this issue

/ Annual Allowance

The Annual Allowance wasn’t targeted in the Autumn budget, which came as a surprise to many. The Chancellor could yet reduce allowances to boost tax revenues. Advisers may consider this a good time to utilise the current allowances. This article explores the workings of the current £40k limit, and how to calculate any unused allowances carried forward from previous years so that clients can make the most of what’s currently on offer.  To read more about making the most of annual allowance, click here.

/ The Transfer Value Comparator Explained

The Transfer Value Comparator has caused controversy since it was introduced as a mandatory element of pension transfer advice in October 2018. What does it mean, how is it calculated, and how might an adviser explain it to their client?  Click here to read the full story.

/ Portfolio Performance Review

In times of market volatility investors can be nervous about short term losses, even though ‘weathering the storm’ can be part of a successful medium-to-long term investment strategy. Having the right tools to hand can help start a conversation. The Portfolio Performance Review tool is designed to answer the question ‘how have I done?’ To read more about how PPR can help you in turbulent times, click here.

 

Annual Allowance

Annual Allowance changes in the budget, or lack thereof

The relatively quiet Autumn budget announcement did not include the major overhaul of pension allowances that had been predicted by pundits. Other than tax-free personal allowance increases being brought forward from 2020 to 2019, (increasing £11,850 to £12,500 whilst the threshold for the higher rate tax will be raised from £46,350 to £50,000), and the change in lifetime allowance for pensions from £1,030,000 to £1,055,000, there was very little of note for investors.

Although the predicted reduction in Annual Allowance in order to raise additional funds for the NHS deficit did not happen, the possibility of a no-deal Brexit means we could still see an emergency budget with changes made to the pension allowances.


What is the Annual Allowance?

The Annual Allowance is a limit on the amount that can be contributed to a pension each year, while still benefiting from tax relief.

It was introduced in 6 April 2006 and since then has reduced significantly from £215,000 (2006/07) to £40,000 (2018/19). This limit has been a target for earlier budgets, but has not been reduced since 2014/15, which caused speculation around changes in the Autumn Budget. Many savers will be thankful that no changes were made.

A pension scheme member is subject to a maximum limit (Annual Allowance) of tax relievable contributions that they can make into a pension scheme each tax year. If this limit is exceeded the member could be subject to an Annual Allowance Charge based on the amount which is above the current Annual Allowance and any carry forward available, known as an excess amount. The charge is equivalent to the individual’s marginal rate of income tax and is calculated by adding the excess amount onto the member’s current earnings to calculate the charge payable across the relevant tax band(s).

The illustration below shows the history of the Annual Allowance to the present tax year.

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* 2015/16 tax year is split into two mini pension input periods. Referred to as the transitional period.

What happened in the 2015/16 ('Transitional Period')

The 2015/16 tax year saw the introduction of the Pension Freedoms and it was also the year in which Pension Input Periods (PIPs) were aligned to tax years.

To allow for this to happen two PIPs within the 2015/16 tax year were created, which are commonly referred to as Pre-Alignment and Post-Alignment, as explained below.

Pre-Alignment period: from the end of the last PIP until 8 July 2015, the maximum that could be contributed for this period was £80,000 (plus any carry forward from previous years).

Post-Alignment period: starting on 9 July 2015 and ending on 5 April 2016, this didn’t have its own allowance but instead was limited to carry forward from the pre-alignment period with a limit of £40,000 (plus any carry forward from previous years).

The key takeaway from this is that the maximum amount which can be carried forward into future tax years from the 2015/16 tax year is £40,000.


Carry forward

If the member has not utilised all of their Annual Allowance in any given tax year, they can carry the unused amount forward to use in future tax years. They can carry forward three previous tax years’ worth of unused Annual Allowance and they must first have gone above the Annual Allowance for the current tax year before they can look back at any previous years unused allowances.

The general rule for carry forward is that the member must…

  • have been a member of a registered pension scheme for the tax year in which the allowance was unused
  • have used all of the current Annual Allowance before looking back to unused allowances from previous tax years

If the client is utilising carry forward, it’s worth bearing in mind that the pension scheme has an obligation to notify the member where the annual allowance is breached, and must do so by 5 October after the tax year end. This isn’t the scheme attempting to shock the client; they’re just fulfilling their regulatory obligations, but it’s worth noting as this notification might be unexpected where advice has already accounted for carry forward.

How does carry forward work in practice? Here is an example.

Maxine is a member of a Personal Pension Scheme.

She utilised all of her Annual Allowance prior to the 2015/16 tax year.

She would like to know how much carry forward she has available for 2018/19 tax year.

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The total carry forward available to Maxine would be £10,000 - £2,000 (excess for 2017/18 tax year) = £8,000 available to carry forward to the 2018/19 tax year. Because carry forward can only reach back three tax years, if the £8,000 is not utilised within the 2018/19 tax year it will be lost when looking back for the 2019/20 tax year.


My client has an Annual Allowance charge to pay. What are their options?

1.    Pay direct

The Annual Allowance Charge can be paid directly to HMRC via self-assessment.

2.    ‘Scheme Pays’

The member can require the scheme to pay the tax charge due if the following criteria are met:

  • The Annual Allowance Charge exceeds £2,000, and
  • The pension input amount was more than £40,000

There could be benefits in doing this, depending on the circumstances, such as:

  • the client would not have to find additional liquidity (i.e. dip into savings or emergency funds)
  • the client may wish to reduce benefits within the pension scheme if they are approaching the Lifetime Allowance (reducing their overall value for LTA testing purposes)

If the criteria are met and the client notifies the scheme of their intention to use Scheme Pays, the scheme administrator and the member will become jointly and severally liable for the Annual Allowance Charge.

Keep an eye on future editions of Sententia for articles on the Money Purchase Annual Allowance and the Tapered Annual Allowance.

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The Transfer Value Comparator Explained

‘Savers 10 years away from retirement could lose nearly half of the value of their defined benefit pension if they choose to transfer.’ That was the headline when the Transfer Value Comparator (TVC) was introduced by the FCA in October. Advisers now face the challenge of folding the TVC into their advice process in balance with its predecessor, the Critical Yield.

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With the average transfer value being only 55%1 of the estimated replacement cost of the pension, a graph looking like the above will not be uncommon.

So what’s the real purpose of this comparison? Going back to the FCA’s policy statement:

The purpose of the TVC is to provide consumers with some context for the level of their transfer value to help them make an informed decision. That context is the cost of providing the same benefits as the DB scheme but in a DC scheme. 2

As most advisers would agree, nobody transfers from a DB scheme in order to buy back exactly the same benefits in a DC scheme. That would be like pawning your watch and then taking the money to a different shop and buying an identical watch. So why is the comparison done on this basis?

The FCA considered this in their consultation. An annuity is still the best match for a comparison to a DB pension. The critical yield, which the TVC has effectively replaced as the starting point for analysis, was also based on the cost of an annuity.

…the notional annuity purchase is being used as a proxy to determine the value that might be gained or lost by giving up the safeguarded benefits. We consider that this will be easier for consumers to understand than the critical yield concept and will help frame their decision. 3

So the TVC is evolution, not revolution. However, one key element differs considerably: critical yield was based on the actual charges that apply in the receiving scheme, whereas the TVC is based on prescribed assumptions. Because it’s not personalised, the TVC doesn’t meet the requirements for a personal recommendation – yet it’s the only mandatory element of Appropriate Pension Transfer Analysis, in which a personal recommendation is mandatory. In any case, the client needs to see the TVC, so it will provide a starting point for a conversation. Given the challenges of contextualising the graph, it’s no surprise that many advisers will want to start that conversation with an explanation of how the second column is calculated.

It might help to imagine a third column to the right of the second which exists in the calculation but not in the graph itself. The third column would show the estimated cost of buying the annuity at normal retirement age. This is calculated with reference to the usual Annuity Interest Rate assumptions – no different to the old critical yield calculation really, except for a minor adjustment to the rolling Gilt Yield average (to sharpen it up a little to market movements). However, in the case of the TVC, the cost of the annuity is loaded with an additional 4% which is designed to simulate the cost of advice.

The 4% annuity charge is intended to cover both the product and advice costs of buying an annuity. Firms have previously told us that 4% is an appropriate figure. 2

So, the (invisible) third column is the estimated replacement cost of the pension, plus 4%.

The second column is the third column discounted back to the present day. This is so that the annuity purchase cost is represented ‘using today’s costs’.

In the prescribed notes section of the TVC:

2. The estimated replacement value takes into account the returns that you could receive and any charges you might be expected to pay.

One could be forgiven for thinking that this means the TVC uses real rates of return and real charges to discount back to present day. However, in order to prevent advisers from ‘gaming’ the results with unrealistic investment scenarios, the growth rate has been suppressed to a ‘risk-free return using gilt yields’ and the charges reducing that growth have been fixed with a mandatory assumption of 0.75%.

Rolling all this into the calculation, the resulting discount rate could be considered very conservative. Much like the child of tall parents, the second column doesn’t stand much of a chance of turning out dainty. With a 4% expense loading and a discount rate that is almost halved by charges, the second column can easily loom over the first. The further from retirement the client is, the bigger the size difference is likely to be. Also, the critical yield is likely to be smaller when the client is a long way from retirement – so the longer the time horizon, the bigger the likely disparity between the TVC and the critical yield. For illustrative purposes only:

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Whether or not the TVC is realistic, it is at least consistent. Or is it? There are different ways to implement the COBS requirements. The term of gilts used in the ‘risk-free return’ needs to be ‘appropriate’. There are many ways to interpret this. Whilst differences in implementation across different analysis tools may be small, any differences will be magnified by longer terms to retirement.

1 Analysis from Royal London and Lane Clark & Peacock.     

2 FCA PS18-06

3 FCA CP17-16

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Portfolio Performance Review

During times of market volatility, advisers may wish to keep up to date with changes in portfolio performance and identify where clients are affected by short term movements. From August to October the market has experienced a high degree of volatility. This can largely be attributed to current events such as Brexit negotiations, trade discussions between the US and China, and falls in currencies and commodities such as the Chinese Yuan and Silver.

Such periods of volatility are common in the marketplace and we regularly see the market climb as often as it dips. In March of this year the FTSE slipped to 6,888 and just two months later was up at 7,877, displaying a climb of 14% within eight weeks. Market movements can offer opportunities for those investors who are not put off by fluctuations and who understand that such movements are not unusual.  

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Source: Yahoo Finance

The markets, especially in the UK, are reacting in part to Brexit negotiations and what may face the country in the event of a no deal Brexit. Following the approval of the withdrawal agreement from EU leaders at the Summit on Sunday, May has now returned to the UK to seek the approval of her MPs. The UK Parliament will decide whether to accept or reject the deal, in a vote which looks likely to be on 11 December at the time of writing. A vote in favour of the agreement is not guaranteed as MPs from Labour, Liberal Democrats, DUP and SNP have stated that they will not vote in favour of the agreement. There is still also speculation that a leadership challenge will be triggered after the vote if enough letters of no confidence are received.

On occasions such as these, clients might be more conscious of the impact such events might be having on their investments. It may help to be aware of the tools available via the platform to help you monitor client portfolios, and to help clients in their understanding.

Within the Novia Platform, we have our Portfolio Performance Review tool (PPR).  The tool looks at the performance of a client’s portfolio taking into account the client’s actual cash flow and works out the rate of return earned on the client’s money. 

The tool provides a ‘Money Weighted’ rate of return and it is shown against a benchmark of the adviser’s choice, including the ability to devise a composite benchmark. The results provide both ‘actual’ and ‘annualised’ rates of return.

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PPR takes into account all ‘money in’ (single contributions, regular contributions, transfer and Re-Registration) and ‘money out’ (regular income and ad-hoc withdrawals) during a specified time period and all charges are deducted from the client portfolio, including the fund charges (included inside the funds), Novia Charges, Adviser Charges and Discretionary Fund Manager Charges, where applicable.

It is designed to answer the question ‘how have I done?’ and can measure the success of switching strategies. The results can be particularly surprising, even when the review period is short, e.g., just a few months.

PPR can be found within the main platform, under ‘Client Maintenance’ tab. It should be noted that PPR is different to the Portfolio Scanner tool, which is found within the Research Tools and uses a ‘Time Weighted’ rate of return. This is a different calculation and gives a measure of past portfolio performance without taking into account cash flows and charges.

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Sententia is intended to provide information for professional Advisers only and is not intended for onward transmission to clients. Any statements and opinions expressed in Sententia do not constitute advice – Advisers must form their own opinion and seek their own compliance/legal advice before relying on the information provided in this document. Novia Financial plc is a limited company registered in England & Wales. Register Number: 06467886. Registered office: Cambridge House, Henry Street, Bath, Somerset, BA1 1JS. Novia Financial plc. is authorised and regulated by the Financial Conduct Authority. Register Number: 481600