Self-Directed Pension Funds
Self Directed Pension Funds (ISA) offer the tax efficiency of pension arrangements combined with control over the underlying investments.
A Self Directed Pension Fund is any pension arrangement where the member has control of the underlying investments. Up to 5 April 2006, such arrangements were available either as a Self Invested Personal Pension (SIPP) or a Small Self Administered Scheme (SSAS).
A SIPP was a personal pension with widened investment powers and a SSAS was an occupational pension scheme where the members were trustees and able to control all investment decisions. These distinctions are still used today but are technically incorrect as all arrangements are registered pension schemes, governed by the same rules. The arrangements are now either trust based arrangements or contract based arrangements and can be employer sponsored.
Contract based arrangements
With this type of arrangement a provider will run one large scheme that incorporates many individual contracts. Every member will have their own contract, with benefits earmarked for the individual.
The provider will act as trustee and make the investment decisions under the direction of the member who pays his fees. The role of scheme administrator is carried out by the provider who ensures that the scheme adheres to all legislative requirements.
Trust based schemes
These are closely related to SSASs, although it is now possible for a broadening of the arrangements that can be run on this basis.
These schemes will have a trust deed and rules. At present, most of these schemes will have previously been SSASs and will continue to have the same deed and rules as before, with minor amendments.
Most schemes will be employer sponsored arrangements, like SSASs, but this need not necessarily be the case in the future and new trust based schemes can be established without being employer sponsored.
Members will usually be trustees, although this no longer needs to be the case and it is possible to have just a professional trustee. It is still sensible, however, for all members to act as trustees so as to benefit from certain exemptions from regulatory requirements as laid down by the Pensions Act 1995.
The key difference compared to contract based arrangements is that the benefits are not specifically earmarked to individuals and there is one communal fund that provides benefits to all members. There may, however, be only one member in certain circumstances.
What are the tax benefits?
There are four main tax advantages of any registered pension scheme:
- Payments into a registered pension scheme will usually attract tax relief
- The investments within the arrangement are free from income and capital gains tax, although the tax credit on UK dividends cannot be reclaimed
- A portion of the benefits can be taken as a tax free cash lump sum at retirement
- Benefits paid out upon death are usually available as a lump sum free from all tax, including inheritance tax
Tax relief in respect of contributions
There is no limit on the amount of contribution that can be paid into the scheme, only a limit on the tax relief available.
For individual contributions by the member, tax relief is limited to an amount equal to their earnings within the tax year, subject to an annual allowance (£235,000 for the 2008/09 tax year). Tax relief is available on contributions up to £3,600 gross regardless of an individual’s earnings.
Employer contributions are unlimited, although an employee will be taxed at 40% in respect of contributions above the annual allowance. In addition, the employer may need to justify that the level of contribution is wholly and exclusively for the purpose of their business in order to receive relief in relation to the contribution.
What investments can be made?
It was initially proposed that registered pension schemes could invest in any asset. Restrictions have, however, now been imposed to prevent investment in residential property and investments that can be used for the benefit of members.
The usual scheme investments are:
- managed or collective based funds
- government securities
- commercial property
- unquoted shareholdings – although certain limits do apply that differ depending upon whether the scheme is employer sponsored or not and on the nature of the company
- loans to the employer – only in respect of employer sponsored arrangements.
The underlying investments are chosen by the member and purchased by the trustees. Often a specialist investment manager or financial adviser provides guidance in respect of this.
It is possible for the scheme to be involved in a transaction with the employer or the member providing all transactions are at arms length supported by third party valuations where appropriate. This allows assets to be sold to the arrangement and bought back later in order to make best use of the tax reliefs available.
Investments in business premises
It is very common for such schemes to invest in property that is subsequently rented to the member’s business. This must be commercial property and the transaction must be at arms length.
The purchase of property for the use by the company can effectively act as a sale and leaseback but with a benign landlord. Assuming the property was used in the business, the rent would be tax deductible for the company but would not be taxable when received by the scheme as investment income.
As well as the usual investments ’self investment’ is allowed by HM Revenue and Customs (HMRC) for company sponsored arrangements. At present, they are most likely to be arrangements that were previously SSASs. Self investment includes:
- a loan to the employer on a commercial basis. The amount of the loan is limited to 50% of the fund assets and it must be for a bona fide business purpose. A loan must be secured and can be for a period of no longer than five years. Interest must be charged at a commercial rate (usually 3% over base rate)
- the purchase of shares in the sponsoring company. A scheme can purchase shares in the employer using up to 5% of the fund. Where there are associated employers, it can use 5% of its fund to purchase shares in each employer up to a maximum of 20% of the fund.
It is possible for a registered pension scheme to borrow in order to purchase investment assets (particularly property). The amount that can be borrowed is equal to 50% of the fund (the fund value net of any existing borrowing). For example, a scheme with a fund value of £100,000 can borrow an additional £50,000.
Borrowing arranged prior to 6 April 2006 may be at a higher level and, if a scheme has existing borrowing, it may need to wait some time before future borrowing is allowed as existing borrowing will be taken into consideration for the calculation.
The benefits available are governed by the overall legislation concerning registered pension schemes and are generally the same for both types of arrangement with the exception of a scheme pension which is an option available for those in trust based schemes. This allows for the scheme to commit to pay an income directly based upon an annuity rate calculated by an actuary. The funds are retained by the scheme which effectively underwrites the income. There is no flexibility and the level of income is the amount that the actuary determines can continue up to death. In the event of death, the funds are retained by the trustees and can be reallocated for the benefit of other members. HMRC has indicated that it will tax such reallocation of funds but the rules to do so are not yet in place.
Self directed pension arrangements provide the tax advantages of registered pension schemes with added control and flexibility of investment choice. There is a need to consider whether it is beneficial to establish a trust based or contract based arrangement and advice will be required depending upon your individual circumstances.
Please note that the legislation is relatively new and it has been amended a number of times since enactment. There are still certain areas of the legislation that continue to change and the information detailed within this factsheet is based upon our present understanding of the legislation. It is possible that future legislation and the relevant tax rates may change.
Who shall I contact?
If you have any concerns over the way in which the legislation changed or about providing benefits under the current regime, please contact your Independent Financial Advisor or Find an IFA.