Losing interest

Many entrepreneurs plan to fund their retirement by selling their business- something one or two have come to regret recently. EN examines the cases for and against saving in a pension scheme.

In 2006 selling pensions to entrepreneurs was fairly easy. The Government had just changed the rules on tax relief, enabling one-off contributions of more than £200,000 to be made into “approved” pension schemes – contributions which would then be topped up by higher-rate tax relief at 40 per cent. For entrepreneurs, many of whom have a fluctuating income and variable financial commitments, this was ideal*.

The unappealing requirement to hand over your entire pension pot to an insurance company aged 75 and have it give you back the interest in the form of an annuity† remained, albeit tempered by the slightly more attractive option of “alternatively secured pension” which enables older pensioners to keep hold of their capital but carries a viciously punitive tax charge. But the tax relief was still compelling enough for advisors to make a strong case for using a pension scheme at least to cover your likely fixed outgoings.

In any case, the lifetime allowance for total pension fund size – set this year at just under £1.7 million – only equates to an index-linked annuity for a 60 yearold man of about £65,000 a year, or less if he takes the 25 per cent taxfree cash option. But, importantly, this limit could be reached quickly, building up a pension with just a few years’ adhoc contributions.

The 2009 Budget has changed all that. As the skid row state of the Whitehall finances became apparent the Chancellor suddenly realised that the 1.5 per cent of UK pension savers earning more than £150,000 were trousering 25 per cent of all the tax relief. That many of these individuals were also bankers probably helped seal their fate.

So, as of April 2011, those earning more than £150,000 (who will from next year pay 50 per cent tax on any income above that level), will have the tax relief on pension contributions cut – on a tapering scale that will see those earning £180,000 or more receive just the basic rate of tax relief (20 per cent).

Annoying enough – but there’s worse to come. In a bid to make sure those it is targeting don’t just cram the maximum possible into tax-relieved pension schemes in the interim, the Treasury introduced – effective immediately from Budget day, 22 April 2009 – a cap on the amount of tax-relieved contributions that can be made by those earning more than £150,000.

Those in that bracket can now only receive higher rate tax relief on £20,000 or their normal level of regular contributions – whichever is the higher. Any contributions above that level will now be subject to a tax clawback, effectively reducing relief to 20 per cent.

The effects, we hear, have been dramatic. One senior financial advisor at a large local firm, who was concerned about going on the record for fear of sounding “anti-pensions – which I’m not,” told us, “Since the limits changed in 2006 a lot of people have been looking at their portfolios, deciding that they have a lot of other liquid assets like unit trusts, and we have seen some significant pension contributions.

“The changes brought in this April have brought that trend to a halt.”

So, entrepreneurs saving for a pension can now join cannabis smokers among the ranks of those who were briefly allowed to do something they liked by New Labour before it got cold feet and performed a hasty U-turn.

And don’t think you can get around the new rules – either post-2011 or during the transitional period – by paying yourself predominantly in dividends. The Treasury includes these along with savings interest in its definition of “income”.

In any case, tax relievable pension contributions were already limited, in 2009/10, to the lower of £245,000 or your taxable income for the year: so reducing your earnings to a few thousand and paying yourself a fat dividend instead was never going to work if you wanted to make a hefty pension contribution.

One entrepreneur who would know about this is Rob Davenport, the 40 year-old managing director and controlling shareholder of Hydebased Shawston Piping Solutions. He has no conventional pension scheme, he explains, because he has always paid himself in dividends.

That’s not to say that he isn’t providing for his eventual retirement. Following his first “material payday”, which came when he made a partial exit of the business on an earn-out in advance of the capital gains tax changes in April 2008, he ditched the “one size fits all” wealth manager provided by his bank and appointed financial advisory firm Xentum to manage his portfolio.

This investment portfolio mainly consists of equities – mostly UK-listed – although it also includes “a couple of residential properties”.

The equity fund is, he says, “Very dynamic – there’s a lot of buying and selling.

“So when the cost of oil came down we got into the transport sector, then got out again at the top, and have recently moved into mining. Our equity fund has outperformed the market by 18 per cent, so I’m quite pleased with it.”

These investments do not benefit from the tax relief available to approved pension schemes. He has, however, invested in mainstream pensions in another, unexpected, way.

Back when this correspondent was a young(ish) finance reporter in the early noughties he covered the launch of stakeholder pensions. He recalls dissenting voices at the time who claimed that those who would do best out of the scheme weren’t the low-paid target market but rather the children of wealthy individuals who would make contributions on their behalf and – thanks to the effect of compounded investment returns over half a century – effectively secure their retirement before they had even left school. Many were sceptical about this, but Davenport appears to have proved them wrong.

Acting on Xentum’s advice he has set up stakeholder pensions for his two young children into which he pays a couple of hundred pounds each month and which, he says, “When they are older they will be able to self-invest and use to fund a business or whatever. It’s also a good way of passing money down the generations without liability to inheritance tax.”

Quite how much those children will be able to invest in a business is questionable – the rules for selfinvested personal pensions only allow five per cent of the fund to be invested in the policyholder’s own company. They may well, however, be able to use it to buy premises.

Davenport is able to make these contributions thanks to a loophole intended mainly to help stay-at-home mothers keep making pension contributions. Under this measure basic rate tax relief is added on to the contributions made on behalf of non-taxpayers – even children – on pension contributions of up to £2,880 per year.

But that’s for his kids. He says that the effective compulsion to buy an annuity at age 75 would put him off pensions “on an emotional level”, though he doesn’t rule out investing in such a scheme if in future his method of remuneration means he starts paying enough income tax to make it worthwhile.

But convincing someone that they should pay into a scheme that only gives 20 per cent tax relief on contributions despite the likelihood that any income taken from it will be taxed at 40 per cent isn’t going to be particularly easy.

That said (and before we start getting letters, this still isn’t financial advice – just an observation) even at 20 per cent, the addition of tax relief to contributions and the fact that any growth in the fund is exempt from capital gains tax means that, theoretically, a pension vehicle should be the fastest way to build up the biggest pot of cash from the investment of a given sum in any given basket of assets. And on retirement you can take 25 per cent as a tax-free lump sum.

ISAs are, believe some, a more flexible option – you don’t have to wait until pensionable age (currently 50 but rising next year to 55, so if you’re at the lower end of that age range and plan to draw on your pension you need to get your skates on) to get your hands on your money and there are no restrictions on how it can be used. While you pay into an ISA from taxed income, any growth is tax exempt, as is the cash when you withdraw it.

The other tax-efficient option is to go offshore, but for that specialist advice really is essential.

If you do decide the tax advantages (and insulation from your creditors should anything go wrong with your business) stack up enough at least to make some savings in a pension scheme, the kind most advisors would like you to take out is a self-invested personal pension (SIPP).

The fees associated with this mean it’s only really viable if you have – or will quickly build up – a larger fund (into the tens of thousands), but a SIPP does allow you to invest in a wider range of assets than you would under a normal personal or occupational scheme. These include: stocks and shares traded on a recognised stock market; unit trusts and investment trusts; insurance company managed funds; deposit accounts; commercial property; and unquoted shares, in certain circumstances.

Normal personal pensions now tend to offer more fund choices than you could possibly want or need so it’s probably only worth going to the time, effort and expense of using a SIPP if you plan to take advantage of the ability to invest directly yourself/ appoint your own discretionary fund manager or you want to buy commercial property within it.

Buying your office with your SIPP is, we understand, more talked about than carried out. One good reason for this could be the reduction in borrowing limits imposed from April 2006. Before this date it was possible for a SIPP to borrow up to 75 per cent of the value of a commercial property in which it was to invest. Now, however, the amount it can borrow is limited to 50 per cent of the pension fund’s value – usually a much smaller figure.

We wouldn’t often say this, but there could be a lot of entrepreneurs who might otherwise have geared their retirement savings to the maximum to buy their premises in 2006 and are now thanking Gordon Brown for his parsimony. But it cuts both ways, and they’ll have just as much trouble raising the funds to make a great investment at the bottom of the market.

One way around this issue could be a new species of SIPP being marketed as a “family” product. Life insurance firm Axa Winterthur is probably the biggest company to have developed such a product. Its head of pensions development, Mike Morrison, explains that while the product is a personal pension contract and governed by the same tax rules as, for instance, a stakeholder pension, it allows members to pool their assets.

He says, “It can be used by families, directors of a company or any other group of people who are willing to act on a pooled basis with their investments.

“This could, for example, give them access to a discretionary fund manager. It is also easier to buy commercial property in a pooled arrangement, and can be used to facilitate the transfer of a business property between the generations if, for instance, a father is retiring and his children are carrying on in the family business.”

With flexibility, however, comes an element of complexity. While investments in such an arrangement are pooled, each member owns a fixed proportion of them. And, where different generations are involved in a family scheme, different types of asset (high upside/ high downside equities for the youngsters, less risky bonds for the older members) will have to be held within the scheme in proportion to the members’ stake.

So it’s not necessarily the easiest option. But, done cleverly, it might just save you quite a bit of tax – though it still doesn’t entirely get rid of the problem of having either to buy an annuity or face a whopping tax bill at age 75.

But, whether or not you choose to use a formal pension, some form of retirement saving outside the business is prudent. According to Morley Rowe, a regional director at financial advisorsy firm Tenon, “People who have built a successful business expect it to be worth something. We have, sadly, seen some clients who relied too heavily on the ability to sell their business at the right time.

“In the last 12 months we have seen some whose plans have had to change dramatically because it’s not just a question of building up a good business – you need to have a buyer.”

Not only that, you need to have a business that still exists, or is worth something meaningful. EN has come across too many examples of businesses with owners in their 50s or 60s who five years ago could have expected a healthy payday but have now seen their life’s work fall into the hands of the administrators.

A pension might not be perfect but at least you can’t dip into it to prop up a dying business. There will be a few people this year who wish they’d realised that earlier.

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