Staff who have the option of joining their employer's pension scheme are allowed to contribute up to 15% of their salary into their occupational pension and qualify for tax relief on the contributions. Council staff typically contribute 6% of their salary. However, they can take advantage of the unused tax relief by making additional voluntary contributions (AVCs).
An AVC provides a tax-efficient means of flexibly increasing retirement income. A free-standing AVC (FSAVC) is simply a savings facility taken out by an individual. By contrast, a group or in-house AVC vehicle is arranged by trustees of an occupational pension scheme for its members.
In-house contracts are offered by third-party providers such as insurance companies, banks, building societies and so on. These contracts are normally operated on a nil-commission basis, whereas FSAVCs incur high commission charges which can erode their performance. However, FSAVCs have the advantage of a wider range of investment options and continuity when contributors change jobs.
Although the Local Government Pension Scheme provides excellent benefits, many employees will not enjoy the maximum retirement benefits permitted under Inland Revenue rules. This is either because they had a break in their local government service, or they joined the LGPS too late to qualify for the full benefits.
However, to narrow the difference between employees' benefits under the LGPS and the maximum benefits otherwise possible under the tax rules, the scheme allows its members to enter into AVC contracts.
AVCs are granted tax relief at the employee's highest marginal rate and each salary payment automatically attracts this relief. Since each contribution is made before stoppages, those employees taking out AVCs enjoy full tax relief at source.
AVC investments are exempt from income and capital gains taxes. This enables an AVC account to grow faster than most other investment vehicles.
In addition, AVCs are portable. Employees changing jobs may transfer their AVCs with their LGPS transfer value to another occupational scheme or to a personal pension or contract.
At retirement, employees may use their AVC account to purchase benefits, including extra pension to remedy any LGPS benefits deficiency, or boost their AVC benefits or their dependants' pension if death occurs in retirement. Employees may also choose an open-market option, shopping around for the best provider from which to purchase benefits. A cash lump sum cannot be taken from an AVC account.
AVCs are subject to the same rules and regulations as the main pension scheme contributions. Like pension funds, contributors to AVC schemes are affected by the chancellor's decision to abolish the advance corporation tax (ACT) credits. Before the withdrawal of ACT credits, pension funds and AVC investors were able to reclaim taxes on dividends on UK shares.
Consequently, AVC investors in with-profits schemes are estimated to lose between 0.25% and 1% of their annual investment income. For a new AVC contributor this equates to a reduction in return of between 2% and 8% over the next 15 years. For existing AVC investors the loss could be as much as 15% over the same period.
Investors could mitigate some of these losses by switching to other asset classes, such as overseas equities, bonds or property. Growth rather than high-dividend shares could become more attractive. UK companies could increase dividends to compensate investors for the loss of ACT credits. Alternatively, if companies expect high growth, they may retain more of their profits instead of raising dividend payments.
There are significant variations in the performance of AVC contracts, which generally fall into these categories: with-profits; unit-linked managers' funds; deposit accounts; and lifestyle funds.
A with-profits contract offers some certainty, because investment growth depends on guaranteed annual bonuses which, once awarded, cannot be withdrawn or varied. The final value of this type of contract cannot be predetermined, because it depends largely on the final or terminal bonuses. Where a with-profits contract is unitised, the guaranteed bonuses may only apply on death or at normal retirement age. Unitised vehicles are becoming very popular among younger investors who like the flexibility of switching between unit-linked and with-profits funds.
Unit-linked contracts (mostly managed funds) which invest in a mix of assets offer no guarantees. Therefore, investors are exposed to more volatility. The value of the AVC simply depends on the market value of the underlying assets during the life of the contract.
A lifestyle contract is for a contributor who is unable or not inclined to actively manage his or her investment. The investment mix for a lifestyle contract depends on the age of the contributor.
Employers can negotiate terms with AVC providers for employees. An AVC savings facility established by trustees remains an asset of the trustees (but employers normally have no rights over membersÕ AVC accounts). Contributing members are denied access to their AVC savings until retirement, change of employment, transfer or death.
Before choosing a provider, trustees should check its financial status. It is important to examine the remuneration structure. A clear-cut scale of charges with no penalty for early retirement should be sought.
Sometimes, circumstances beyond an employee's control (ie redundancy) may trigger early retirement. Trustees or members choosing lifestyle contracts should therefore ensure that contributors can retire earlier than the normal LGPS retirement age.
It is important that AVC providers communicate with scheme members. Trustees should seek demonstrable high-quality administration and service. Proven knowledge and commitment to the AVC market and the operation of the LGPS should be asked for.