Advisers prepare for tax hits on personal pensions

High earners and their tax advisers expect to learn in the coming months whether vigorous lobbying will convince the UK government to raise a limit of 1.4m (€2m) on personal pension savings.

Critics of the proposed pensions cap, which could come into force in April 2005, say the government has wildly underestimated the number of earners it will affect.

Additional tax on pension pots above the cap could reduce the money invested in shares, where returns can be high and difficult to predict, while a switch into asset classes such as cash and bonds could keep pension pots beneath the cap.

Richard Birch, a tax consultant at Ernst & Young, says: "People will think much more conservatively, investing in cash accounts and gilts. How will that impact on investment markets?"

After the new legislation is introduced, investments in a pension pot above 1.4m would be taxed at an effective rate of 60% compared with 40% or less now. Anyone with a pension of more than 60,000 a year is likely to be affected.

Lobbyists are hopeful that the government will raise the cap in response to the high number of people threatened by it.

Paul McGlone, a principal at actuary Aon, says a typical 35-year-old earning 65,000 a year could be liable for the new tax. "The government estimates 5,000 people will be affected. We estimate that figure could be closer to 100,000," he says.

Pension advisers say employees are likely to demand higher pay to compensate for the charge and make large payments into pension schemes in the next 18 months because any alteration might not be retrospective. Some might try to avoid the tax by retiring before it comes into effect.

Christian Hardy, a pensions expert at Mercer Human Resource Consulting, says the new regime will reduce the advantages of waiving bonuses, when they are paid not as cash but as tax-free investments - often into a pension scheme. For high earners a single year's bonus could hit the 1.4m cap.

The proposal would have the greatest impact on staff who have been working for the same employer since 1989. At present they receive tax breaks on pensions of up to two-thirds of their final salary, however high. They also receive a tax-free lump sum equivalent to 1.5 times final salary.

Under the proposed changes, these people would also be subject to the new 60% tax rate. Hardy says some financial services groups are encouraging long-standing staff to pump extra money into their pension schemes before the changes take effect.

At first glance, the proposals should have a smaller impact on staff who joined a pension scheme after 1989. Their right to tax breaks on pensions equivalent to two-thirds of final salary operates only up to a limit of a 100,000 salary. This cuts the effective size of an annual pension to 66,600 - roughly the same as the level at which the new taxes would bite.

However, Birch warns many high earners in the City of London have pensions invested in vehicles called unapproved retirement benefit schemes, which partially avoid the impact of the 100,000 limit. They will therefore be hit hard by the new tax regime.

John Ball, partner at consultancy Watson Wyatt, says as tax breaks for pensions disappear staff will seek them elsewhere. Nevertheless, tax avoidance schemes, such as payments offshore into employee benefit trusts, are also under threat from the Inland Revenue

.

So an obvious solution, from an employee's point of view, is to ask for higher pay. Ball believes employers will come under pressure to increase cash compensation to their most valued staff.

Charles Cowling, a partner at Mercer, says: "Once you've reached the 1.4m pensions cap, cash becomes a logical alternative. People who were paying 20% to 30% of their salary into a pension scheme could now get that as a supplement to pay."

Cowling says a government proposal to increase the minimum age for drawing pensions from 50 to 55 could also prompt a rash of early retirements. Many might stop working before the proposal comes into force to avoid having to wait until 55 and to avoid the 1.4m cap.

"There is a distinct possibility that those between 50 and 55 will want to get out before this comes in," Cowling says.

Tax consultants say employers of high earners, such as investment banks, are worried by the proposed changes and are making plans.

The government is expected to give more details of its proposals later this year.