Written by Munro O’Dwyer, Senior Actuary and Director, PricewaterhouseCoopers Pension Solutions Group

The introduction of a Pensions Cap in the 2006 Finance Act will have a significant but potentially overlooked impact on high earning executives.

The Finance Act introduced an additional tax on pension funds with a value of more than €5 million (unless an individual receives certification from Revenue that a higher limit applies). The excess over this cap is liable to an additional tax of 42%, typically payable when an individual reaches retirement. The usual income tax rules will also apply when any benefit is drawn in retirement – effectively resulting in double taxation on any excess. Pension arrangements are tax efficient up to the new limit but not beyond.

The Challenge For Employers

These changes will require a review of remuneration policies for higher earners. Where the amount of benefit delivered via traditional pension arrangements is effectively capped, alternative arrangements will need to be put in place to ensure that total remuneration packages remain competitive and serve to retain key individuals. One particular challenge is to find an appropriate replacement for defined benefit pension arrangements. Defined benefit schemes are most beneficial for older employees and employees with higher than average salaries and salary increases – descriptions which can reflect the most senior individuals in a company.

Munro O’Dwyer, Senior Actuary and Director with the PwC Pension Solutions Group explains “Pension benefits, particularly defined benefit arrangements, can often represent a significant contribution by a company to the long term wealth creation of their employees. The thresholds introduced will require that remuneration policy be reviewed to ensure that senior executives continue to be rewarded in the most tax efficient and appropriate way to ensure their long-term loyalty.”

Benefits in excess of the limits introduced can of course be provided in an alternate manner, possibly in the form of cash supplements, unfunded pension promises, long term incentive plans or share options. This introduces a number of new issues – while the value of pension benefits being provided through a final salary defined benefit scheme were typically not well understood, the alternatives to be considered may bring an additional level of transparency and clarity. Existing remuneration differentials between executives may be more difficult to manage in this new environment. Where benefits are provided via a short term mechanism such as cash supplements, these do not provide the same longer term incentive to executives to remain with their current employer as was provided through final salary pension arrangements.

When the taxation implications of the possible changes are factored in, there are many different issues that need to be understood, both from a company and individual perspective. With some careful thought is it likely that a financial solution can be delivered - that is, a solution that provides the individual with a total remuneration package that is equal in value to that which was provided prior to the introduction of the Finance Act pension limits. The delivery of an appropriate HR solution may be more challenging.

Take the example of long-term incentives or other share option / stock-based vehicles being used to compensate for any capping of pension benefits. While a high level of share ownership by executives is generally considered to be a positive feature of any remuneration program as this encourages executives to align their interests with the interest of shareholders in general, difficulties may arise for the executives who can find that a significant proportion of their total wealth is tied up with their employer. This will be in contrast to most other company shareholders who are likely to hold more widely diversified investment portfolios. In these circumstances it is reasonable that executives will seek (and be provided with) the ability to diversify their exposure.

Defining The Benefit

The issue is brought into sharp focus where the pension benefits, which are being capped, are defined benefit in nature. Defined benefit pension plans provide a significant level of certainty and security, as the level of benefit provided to an individual is not impacted by the performance of financial markets but is determined by reference to their final salary. This is a positive feature for individual executives as there is a significant element of their package which is effectively “guaranteed”. From the employer’s perspective, final salary defined benefit schemes by their nature target rewards at older individuals on higher salaries and those who expect significant increases – which implicitly means targeting their executive team.

Any capping in the level of benefits which can be provided through such schemes, may mean that a higher proportion of an executive’s total wealth creation is linked to the fortunes of their employer, and with so much of their individual wealth at stake then this may have unintended consequences, for example, on their motivation to take normal business risks where such risks may have a detrimental effect on the share price.

Creative Thinking

Now is the time for organisations and individual executives to start thinking about answers to the challenges introduced by the Finance Act. The solution may focus exclusively on pensions, or encompass the full reward package, but no matter which approach is followed it should take into account the needs of both employers and executives. Companies will want to develop a cost effective, competitive remuneration policy that serves to reward and retain their key executives and generate positive shareholder returns. These policies developed should take account of the needs of their individual employees, the changing pension environment and tax implications, in the context of the various reward mechanisms available

In the context of wider executive remuneration policies, pension arrangements should be considered as providing a tax-effective means of delivering €5 million of “total long term wealth”. O’Dywer adds “Employers also need to consider those currently affected and those likely to be impacted in the future. This has a greater impact for employers beyond the pensions area, notably in the areas of HR and remuneration policies, employment law and wider taxation issues”.

Preserving A Higher Cap

Where the Revenue Commissioners agree a pension fund valuation (to be submitted to them before the 7th June), they will issue a certificate to the individual stating the amount of that individual’s personal fund threshold.

When an individual takes a benefit from their pension arrangement – typically when they reach their retirement age - this personal fund threshold certificate is then required to be included as part of the submission to Revenue when the liability to tax on any chargeable excess is being calculated.

When an individual takes a benefit from their pension arrangement – typically when they reach their retirement age - this personal fund threshold certificate is then required to be included as part of the submission to Revenue when the liability to tax on any chargeable excess is being calculated.

When an individual takes a benefit from their pension arrangement – typically when they reach their retirement age - this personal fund threshold certificate is then required to be included as part of the submission to Revenue when the liability to tax on any chargeable excess is being calculated.

For most businesses pensions represent a very significant cost, yet the benefits provided are not typically well understood. The potential impact of the Finance Act changes, including a combination of the financial and tax exposures, and the impact on rewards for employees, would suggest that it should be high on the list for consideration for the employees concerned and their employers alike.