Pensions tax relief might survive the forthcoming Budget relatively unscathed. Here we set out the issue and some of the arguments, and why many in the pensions industry would be pleased if the recent reports are correct and the Chancellor decides to leave well alone.

Why is this an issue?

The Government has long viewed the cost of pensions tax relief as significant and needing to be managed: in 2013/14, the Government gave up nearly £50 billion of income that it would have received were it not for tax relief on pensions. Furthermore, the greater part of the relief (more than two-thirds) goes to higher and additional rate taxpayers[1].

Hence the Government is examining whether the benefit of tax relief, as an incentive to save money for retirement, justifies the cost to the Exchequer.

What might the outcomes be?

The Government's green paper in July 2015 was keen to stress that the Government has a completely open mind on this point. Even if no action is taken in the forthcoming Budget, it is likely that this issue will be reconsidered in future. The foreseeable possible outcomes are the following:

  • continuation of the status quo
  • tax relief to be abolished altogether
  • tax relief to be at a fixed rate instead of marginal rate

We set out in the following sections some thoughts on each of the above.

Reasons to carry on with the status quo

Not least, continuing with the status quo would allow employers and trustees the stability of not having to redesign their systems and benefit structures, but there are also reasons why it is justifiable from a policy perspective.
Strictly speaking, tax relief does not "cost" the Government anything: it does not require it to spend any money, but is simply a limitation of the amount of money it takes out of the pockets of employees and employers. That is a distinction which is unlikely to impress the Treasury, however.

While the value of tax relief given by the Government is undoubtedly rising, this will be offset by increasing longevity: as pensioners live longer, their pensions will remain in payment, and therefore taxable, for a longer period also.

Furthermore, tax relief was arguably never intended to be an "incentive" to saving; it was merely to ensure that pension savers were not taxed twice on income that is only taken once: income that has been put away for pension provision should, on this logic, only be taxed when the pension fund actually provides them with an income. The current system achieves that.

As for the greater part of the relief going to higher and additional rate taxpayers, that is the inevitable consequence of a progressive tax system. Because higher earners are taxed at a higher rate, the corollary of that will be that they have more to gain from any relief. Also, the ongoing tightening of the lifetime and annual allowance regimes is reducing the extent to which higher earners benefit from tax relief.

What about employees - isn't the status quo confusing?

It is often argued that the current system is confusing to members, who do not appreciate the value of the tax relief and therefore it fails to deliver value-for-money as an incentive to saving.

In reality, any failure to understand the current system is likely to be a consequence of (a) poor communication, and/or (b) lack of member interest in pension provision.

The concept of tax relief is not difficult to understand or to explain to an employee: any part of your income which you use to pay into a registered pension scheme is untaxed, with the amount that would have been taken in tax instead going into the pension scheme. We see many schemes that explain this, often describing it as being effectively the same as a Government top-up to one's pension pot.

Suitable caveats in the small print can be included to reflect the fact that the above is a rather broad-brush summary, but the point stands: tax relief is not all that difficult to understand if the scheme or employer explains it clearly. Of course it also requires the employee to take the trouble to read and think about the explanation that he is given - however good the communication, there needs to be engagement on both sides, and that is the case whatever system in place.

Abolition of tax relief altogether

The most radical option is to do away with tax relief altogether and replace it with a system more akin to Individual Savings Accounts (ISAs), where the income that goes into the pension pot is taxed, but the subsequent growth and eventual pension paid out is exempt. This is often referred to as a "TEE" (Taxed-Exempt-Exempt) model as opposed to the current "EET" (Exempt-Exempt-Taxed) model where contributions and growth are exempt but the pension in payment is taxed.

Some commentators have therefore recommended the replacement of the current tax relief with a system more akin to ISAs, with, as an additional incentive, the Government paying an additional amount into the savings vehicle[2].

This solution does have its attractions: it is easy to understand, experience suggests that ISAs are popular whereas pensions are (rightly or wrongly) viewed as confusing and suspicious, and it does not favour higher earners, if the Government incentive is set at a flat rate.

Also it would deliver an immediate fiscal benefit to the Government, in that the part of the savings journey that is taxed is brought forward in time (from EET to TEE).

Reasons not to go down the ISA route

Many in the pensions industry would argue that such a radical change is not called for, as follows.

As noted above, the current tax relief system is not that complicated. The complexity comes from the annual and lifetime allowances, which are nearing incomprehensibility as more and more forms of restriction and transitional protection are loaded onto them to try to reduce the costs of tax relief going to high earners . See New protections as lifetime allowance reduces to £1 million for more on the forthcoming LTA reduction.

Any problems the pensions industry has of being seen as opaque and not wholly trustworthy will not be solved by another radical shake-up. What is needed is continuity: retirement saving is a long-term business and people will feel safe participating in it if they feel that the system will be stable for long periods. Constant change has the reverse effect.

Such a system would require savers to trust that a future Government will not try retrospectively to tax the ultimate pensions which they had been promised would be exempt. While they should be able to have confidence that this will not happen, some scepticism would be understandable, especially as the demographic trend is towards an ever larger (and therefore costlier to the state) population of retired individuals and a relatively smaller working-age population to support them.

Flat rate of tax relief

In view of the above, it would not have been a surprise if - as reports in the media had previously suggested - the Government were to decide to keep the EET (Exempt-Exempt-Taxed) model but to give tax relief at a flat rate rather than at the individual's marginal tax rate. This looks attractive in addressing the Government's concerns, in that it avoids the worst of the issues identified above, and also avoids higher-rate taxpayers gaining disproportionately from the relief.

The effects of this will depend to a great extent on what the flat rate actually is, but press reports suggested that serious consideration was being given to rates somewhere between 25% and 33%.

What would the effect of flat rate tax relief be on members?

For basic rate taxpayers, they would get all their current relief and more, if the flat rate of tax relief is set above 20%.

Higher (and additional) rate taxpayers would have to choose between maintaining their current level of pension saving and their current level of take-home pay. Most scheme rules define contributions by reference to a percentage of (gross) pay. Therefore, maintaining contributions at this level would affect their take-home pay, and, by extension, their attitude to retirement saving and their level of engagement with registered pension schemes as a vehicle for such saving.

What would the effect be on schemes and employers?

Although the concept of flat-rate tax relief is simple enough, implementing it would be another matter. The likelihood is that the detail would have been complex, with schemes and employers being forced to engage with a new set of highly complex legislation, only 10 years after the last radical overhaul and having faced many changes and proposed changes during the time in between.

We set out below some of the foreseeable implications.

  • Many employers with occupational pension schemes operate a so-called "net pay arrangement" to provide tax relief, which broadly means that the pension contribution is made before PAYE is applied. That has the advantage of simplicity, and ensures that tax relief is effectively granted at the individual's marginal rate - because the income that is used for pension contribution purposes is not subject to the tax calculation.
  • However, such an arrangement does not work if the tax relief that is intended to be given is different from the PAYE rates of income tax that are applied. Flat-rate tax relief would therefore mean switching to the more burdensome "relief at source" method.
  • Any legislation bringing in such a system would need to include complex anti-avoidance provisions. Experience shows that the anti-avoidance provisions for any tax change are what cause the difficulties in practice.
  • Defined Contribution (DC) benefits have the simplicity that the amount of value that is added to the member's pension, at the time when a contribution is made into it, is equal to the value of that contribution. For Defined Benefit (DB) benefits, that is not the case: the contributions are not directly linked to the value of the benefits, which are determined by a formula in the Rules. Applying flat-rate tax relief to DB benefits therefore creates the possibility of an extremely complex system for employers and trustees to get to grips with.

Other options

The above demonstrates that a flat rate of tax relief is not a pain-free way for the Government to raise money from pension savers.

If the Exchequer needs to reduce the cost of tax relief, notwithstanding the comments made at the start of this piece justifying the status quo, then the one aspect of the current system that is undeniably a tax giveaway is the 25% tax-free cash on retirement. It would take political courage to abolish that, however, not least because it is simple and understood by many, and so its loss would be highly unpopular.

The policy logic behind the annual and lifetime allowances is also due for review, after so many changes. There is a logic to setting an annual allowance, to limit the extent to which pension saving needs to be tax-advantaged (the purpose of the allowance should be to identify the dividing line between where saving becomes something to be incentivised, and where it becomes mere tax planning). There is a growing body of opinion that the lifetime allowance is no longer needed[3], and that is a persuasive argument especially now that the annual allowance has been so drastically reduced, including the introduction of tapering for higher earners.

The Government could therefore achieve its objectives of limiting the cost of tax-advantaged pension savings by:

  • abolishing the 25% tax-free cash in respect of future savings
  • maintaining an annual allowance but abolishing the lifetime allowance
  • continuing to allow tax relief at the marginal rate of tax

We suspect that the political implications of the first bullet point would be sufficient to deter any Chancellor from considering it for too long. In which case, there is a respectable argument that the status quo is the best option. The news reports over the weekend suggest that this is the conclusion the Chancellor has now reached.

Even if this turns out to be the case, it will no doubt come back onto the agenda at some point, either with this or a future Government. In the meantime, there are still other areas one can foresee being considered for change. For example:

  • Were flat-rate tax relief to have been introduced, the Government may well have legislated to remove the national insurance advantage from salary sacrifice altogether. Otherwise, higher-rate taxpayers might enter into arrangements with their employers to reduce their salary and for the employer to make higher contributions, such that the level of tax relief effectively returns to 40%[4].
  • Even if tax relief does not change, there is a strong possibility that salary sacrifice arrangements in their current form may not survive for much longer.
  • Employer-financed retirement benefit schemes (i.e. unregistered pension schemes) may also be targeted, as they provide a means of providing retirement savings above the lifetime allowance.

Conclusion

The Government's decision on this matter will therefore be awaited with interest by employers, trustees and members, all of whom have a stake in this. Once the Budget is announced our experts will provide commentary on the likely implications.

Footnotes

[1] HM Treasury, Strengthening the incentive to save: a consultation on pensions tax relief
[2] Michael Johnson, Centre for Policy Studies, An ISA-Centric Savings World
[3] Research conducted by AJ Bell, 14 October 2015
[4] IEA Briefing