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How to get most value from directors’ pensions

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Thursday August 16, 2012 at 10:00am
Andy Parker was invited to contribute to a new book being produced by the Institute of Directors, to be published later in 2012. Here’s a sneak preview of his Chapter focusing on directors’ pensions, exploring the full value of pensions investments for directors and owner managers.

For owners and directors of small businesses a pension may seem like a luxury impossible to afford. Company owners often overlook the significant benefits available through Small Self-Administered Schemes (SSAS) and a Self Invested Personal Pension (SIPP). The additional flexibility inherent within this type of pension often provides the solution to otherwise difficult business problems. Perhaps once the true financial benefits are understood they become less a luxury and more a necessity.

In this article we explain how a 67 per cent return can be achieved on investment into your pension and how pension funds can be used to release much needed capital for your business.

Pensions – first principles

A pension fund in its simplest form is a bank account with some tax benefits attached. For a 40% tax payer each contribution into a pension will give an immediate return of 67 per cent, guaranteed and paid by HMRC plus whatever investment return is provided each year. Compare this to a return of 1 or 2 per cent from the building society.

This is how the 67 per cent return is arrived at. An individual pays £8,000 into a pension. The pension fund is credited with a further £2,000 claimed directly from HMRC. Hence the fund is immediately worth £10,000. As a higher rate tax payer a further £2,000 is deducted from the individual’s personal tax liability when the pension contribution is entered on the tax return. Hence a net £6,000 investment (£8,000 - £6,000) produces a £10,000 investment. Return (£10,000/ £6,000) -1 x 100 = 67 per cent.

With the right investment strategy you would expect to see growth in the value of your investments too. So, returns are likely to be in excess of this 67 per cent, making pensions an affordable and tax efficient way to save for retirement.

A flaw in the plan: pension vs business sale

Many business owners assume that their income in retirement or “pension” is going to be provided by either the sale proceeds of their business or by downsizing their family home. The problem with the former is the uncertainty around business valuation at the time of sale. The business is only worth what someone can afford and is willing to pay for it. Unless the business owner can be easily separated from the business this could be surprisingly less than expected. The problem with the latter is often people don’t want to downsize enough to release sufficient capital for retirement.

With a pension at the point of retirement you will have built up funds tax efficiently and you will also have the flexibility to take this income in a way that is most tax efficient for you. The money from any business sale therefore comes as a bonus and the family home does not have to be sold to fund future expenditure.

Using the pension fund for the benefit of the company

If your pension fund is already held in a SSAS, or indeed is transferred into a SSAS, then your company can borrow up to 50% of the value of the fund; say to purchase an asset or fund working capital. There are rules around suitable security being provided, commercial rates of interest being paid to the pension fund and repayment over 5 years but this can be a lifeline when other funding sources are difficult or expensive to come by.

A SIPP can invest in private company shares and other esoteric assets such as intellectual property (such as website domain) or patents. In other words cash tied up in the pension can be used to buy assets for cash from the director’s company thus providing liquidity to the company and unlocking pension cash. Third party valuations are required.

An asset that is commonly sold to a pension fund is commercial property, either held personally by the director or by their company. The benefit here is the cash in the pension fund has already attracted tax relief and it is then available for use by the company or the director personally. If there are insufficient funds within the pension fund then a SSAS or SIPP can borrow from a bank to fund asset purchase. The maximum borrowing works out at 50 per cent of fund value.

Another common situation is where a company has large taxable profits and also an unencumbered commercial property. In this situation a percentage of the value of the property could be transferred into the pension fund. This so called in specie pension contribution will also be deducted from the company’s taxable profits. Another proportion of the property can be transferred in future years of high profits until all of the property is held in the pension fund.

Although the tax benefits of making pension contributions are compelling there are two other significant benefits to business owners in making in specie contributions. Firstly they do not deplete cash as the asset is transferred to the pension and is still available for the company to use (on payment of a market rent or lease to the pension). Another highly compelling reason is the asset in the pension fund is removed from the business risk. Pension assets are not normally available to creditors on a company winding up making this a very effective insurance policy.

Dispelling some myths about pensions

The Government want us to save for our own retirement and so provide tax benefit to this type of saving, in essence that is all a pension is. For those funding for retirement or exit from business from age 55 or older they generally make good sense. They are of little use if you need the funds below this age. When looked at in this way there are urban myths and frustrations with pensions rather than absolute disadvantages.

One urban myth around pensions is the fund is lost on death. This is the case if you purchase an annuity on retirement (subject to any guaranteed period) however there are plenty of ways in which an income can be taken in retirement without this disadvantage. Phased drawdown and scheme pension can have particular tax benefits in certain circumstances.

Another urban myth is that pensions lose money and are worth less than the funds put in. The reality is a pension can invest in cash paying deposit interest if you are happy receiving a return below inflation. See my chapter on pension investments which expands on this further.

Another often quoted disadvantage many have is the fund cannot be accessed until the individual is aged 55 or over. Hopefully the examples above demonstrate how the cash can be accessed which is really what most people are interested in.

Not only are contributions tax free but growth in the fund is too. When taking pension income 25 per cent of fund value at retirement is taken tax free and the balance is taken as an income taxed at the members tax rate in retirement (without national insurance deductions). Many will be sheltering tax at the higher rate when accumulating pension but paying tax at basic rate when taking pension income.

Some see the limit on the withdrawal rate from pensions as a disadvantage but the government do want to ensure that the pension will fund the member for the rest of their natural life so they don’t become a burden on the state. However flexible draw down now means those with secure pension income over £20,000 per annum have no restriction on the amounts they can withdraw above this limit.

Is SSAS or SIPP right for you?

If you are thinking of setting up a SSAS or SIPP:

  1. Obtain a valuation of all of your pension funds and details about pension contributions made by or for you in the last 4 years.
  2. Be clear about what you want to achieve, e.g. purchase commercial property, save tax, protect key business assets or enhance company cash flow.
  3. Consider whether there are any unencumbered assets that can be used for pension contribution or surplus company cash that can be paid into the pension.
  4. Have to hand latest company accounts and estimate of profits for the current year.
  5. Find a caring competent financial advisor specialising in this area. Each case is different but there is usually a way to get things done more efficiently in finance. Your advisor will firstly write to your existing pension companies to ensure there are no guaranteed annuities or tax free cash greater than 25 per cent on any of your existing pension funds.
  6. Sit down and listen to the benefits and disadvantages of the advice being given and make a decision.
Andy Parker is owner and managing partner in the Birmingham based firm Parker Chartered Accountants and Financial Advisors. He is a well-respected accountant, originally training with Deloittes, who has the added advantage of having worked at FD level in industry. The core of his practice is represented by small and medium sized firms and their owners and directors, with whom he works to maximise profits, minimise tax and prepare for a secure financial future. Andy is a Chartered Financial Planner, one of the few Chartered Accountants in the country to be dually qualified.

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Parker Chartered Accountants and Financial Advisors is the trading name for PLW Advisors Ltd (Registered No. 10396831), and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here