Row brewing over pensions loophole

The Inland Revenue plans to hit pension schemes with a 40 per cent tax charge if their members use a loophole to extract some of their tax-free cash before retirement. But millions could lose out as a result. Andrew Verity looks at the potential winners and losers in the argument. Britain's pounds 700bn pensions industry is heading for a row with the Revenue. Pension funds have accused the taxman's Pension Schemes Office, which controls how they are run, of threatening to use "an extraordinarily large sledgehammer to crack a very insignificant nut" in its efforts to close a loophole on pension benefits.

The Pension Schemes Office has warned the UK's pension funds it will slap on the charge when members transfer their money to another scheme in order to get around strict rules and take out cash immediately.

But the National Association of Pension Funds, whose members control more than pounds 320bn in assets, says the rule could penalise all members of a scheme because of the actions of just a few members.

The Pension Schemes Office has threatened to impose the charge, which goes with loss of approval of the scheme, to stop an abuse which it believes is becoming increasingly widespread.

Under the alleged abuse, the member transfers his part of a fund to a personal pension and the personal pension provider then pays a large commission to the adviser who arranges it, worth at least 5.2 per cent of the fund.

But the adviser will frequently pay back the commission to the client in cash, returning much more cash from the pension fund than is allowed by the Revenue's limits.

Revenue rules insist no cash should be taken before retirement, when the scheme starts paying out benefits. By taking cash from the adviser's commission, the member can circumvent the rule.

A pension scheme member is also normally blocked from taking more than 1.5 times his or her salary in cash. By taking some of the adviser's commission, the members can also get extra cash. For a minority of employees, this approach leaves them with far more tax-free cash at retirement. But the Revenue wants to slap on a charge to stop advisers circumventing it.

Pension funds say they are stuck between the rock of Revenue practice and the hard place of DSS rules. If the scheme tried to stop a member transferring, say the pension funds, it would be breaking the Pensions Act which gives members the right to transfer. But if the funds are not able to stop them, the commission could be passed to an individual after transferring, without the knowledge of the scheme he or she has come from. Thousands of other members could then be hit.

Steven Cameron, Scottish Equitable's pensions development manager, said: "The issue is that individual members can create a problem for the remaining members, even when they are entirely innocent. In theory, even large funds like ICI could be disapproved because of the actions of just one individual."

Pension scheme managers do not expect the Revenue to impose 40 per cent fines on large schemes such as ICI's pounds 5bn scheme. Smaller schemes where most members are also trustees are most likely to be hit.

But Bill Birmingham, benefits officer at the National Association of Pension Funds, said: "For a pension fund to be simply meeting a statutory requirement and then have its approval removed seems like cloud cuckoo land. Potentially, every single scheme in the country could lose approval."

Pension funds protest that if the 40 per cent penalty were imposed, they would be punished for a rule breach that they could do nothing to prevent. Chris Lewin, head of a pounds 1.2bn pension fund at Guinness, said: "If a member came to us and said `I want to transfer,' we would just arrange payment. When the occupational scheme has nothing whatsoever to do with the new pension, I cannot believe the Revenue would cut our approval."