The pain of relief

1 September Corporate Adviser

Of all the many reports published in the world of pensions, the two put out by Michael Johnson within the last year have gained considerably more traction than most. Pensions professionals will be wondering how many more of Johnson’s ideas the Treasury will take to heart - not least because some of them will have profound ramifications for the pensions industry itself.

The most recent offering from Johnson, who is a research fellow at the Centre for Policy Studies, is called Simplification is the Key, published in June. That paper can lay claim to being the origin of the £40,000 annual allowance for tax-advantaged pension saving. The Treasury’s adoption of ideas in that paper in the emergency Budget just two weeks after its publication has prompted many to question how much weight ministers are giving to the proposals in Johnson’s earlier paper, September 2009’s Don’t let this crisis go to waste - A simple and affordable way of increasing retirement income.

That paper proposed the replacement of personal accounts with the Flexible Retirement Saving Account, combining features of Isa and pension into a single flexible savings product. Of equal import are the proposals in Johnson’s June 2010 paper to reduce tax relief on pensions in return for a higher State pension.

Central to Johnson’s thesis is the idea that the cost of tax relief on registered pension schemes is so great - his paper identifies a net cost to the Treasury in 2008/09 of £27.1bn - that if the objective is to reduce poverty in retirement, then tax relief could be put to far greater use elsewhere.

Johnson sees himself as an outsider in relation to the pensions industry, having trained with JP Morgan in New York and only joining Tillinghast, the actuarial consultants, after 21 years in investment banking. The former secretary to the Conservative Party’s Economic Competitiveness Policy Group has taken a dispassionate look at UK pensions, and higher rate tax relief has ended up squarely in his sights.
So, following the success of getting his annual allowance proposal adopted in Whitehall, what priority does such a radical change as getting rid of higher rate tax relief have inside the Treasury?

“I would suggest that every government department has one priority - saving money. Priorities two, three, four and five don’t matter. Therefore, as soon as we start talking about pensions, we have to discuss tax relief. One obvious question to ask is what is the purpose of tax relief? In my earlier paper I tried to explain why higher rate tax relief is not a particularly smart idea. But we must be clear about which problem we are trying to solve. If tax relief is ultimately to reduce pensioner poverty, by encouraging more saving, then why not put an end to the £29.7bn we spend (2008-09) on upfront on tax relief and boost the basic State Pension by roughly 60 per cent?” says Johnson.

“There is a beautiful simplicity to this. That said, I would probably retain national insurance contribution relief on pension contributions, because this is the only supporting mechanism available to occupational schemes. The upfront tax relief saving is then roughly £22bn and this is an annual saving. In today’s framework of saving money, it is one thing to cancel an aircraft carrier and get a one-off saving, but curtailing upfront tax relief provides a saving that repeats itself year after year” says Johnson.

Perhaps the deal to be done between the Treasury and the people is to offer more flexibility over what one can do with pension assets, in return for less tax relief. From the perspective of occupational schemes, this would mean less regulation and less infringement through the accounting world, which currently import, unreasonably, a lot of risks and volatility on to the balance sheet” says Johnson. “We need to wind that clock back at least 15 years, and address the over-reaction to Maxwell.”

Johnson paints an attractive picture of why George Osborne should take the axe to higher rate tax relief. But what of the hundreds of constituency MPs who will have to explain the policy to their higher rate tax paying constituents? Surely such a radical policy would hit core Conservative voters harder than anybody else, exacerbating the ’pensions crisis’ in the minds of millions of higher earners? Abolishing pensions tax relief would be far more radical than the proposed changes to CGT that got backbenchers in such angry mood in June. So what chance does Johnson think there is of abolition actually happening?

“I think there is a very reasonable chance of tax relief being curtailed, but not ended. The maximum one should get should be 20 per cent of the contribution, irrespective of one’s marginal rate. The quid pro quo should then be a maximum income tax in retirement of 20 per cent, thereby retaining higher rate taxpayers’ interest in pensions. “But to be clear, this is multi-step process. Step one, one of the proposals in my paper, is a harmonised annual contribution limit for Isas and pensions, and I suggested £45,000 a year, within which there is a pension limit of £35,000. That has been basically bought by George (Osborne) and is in the Budget, which was very satisfying.

“Allied to that I have suggested that tax relief should initially be at the full marginal rate, so I am rolling back on the 2009 budget. Subsequently we should then take a much harder look at the entire tax framework, including the world of Isas, and work towards harmonising them, and as part of that, we should adopt 20 per cent relief for everybody.

“The question is then about what we do at the back end, because if you go back to those high-level questions, if our objective is to reduce pensioner poverty, it would be quite smart to remove all income tax on pensions. But getting there is a multi-step process. This, combined with getting rid of upfront tax relief, takes you into the Isa world; politically very attractive. Tax-free income for pensioners and a huge cashflow saving for the Treasury (with the demise of upfront relief). This would, of course, require some of the pensions industry to re-invent itself,” he says.

So how long does such a radical transformation take? “It would take at least 10 to 15 years to get there; one should not underestimate the transition challenge” he says. “One irony of pursuing simplification is that we may have to endure a period of more complexity as the ’old’ and ’new’ worlds co-exist. But in today’s world, that is an IT challenge rather than a deal stopper.”

Steve Webb has just put an annual contribution limit of £40,000 a year out for consultation. How long before higher rate tax relief is removed altogether, as Johnson proposes?

“12 months. Why not do it in the next Budget? At that stage retain the distinction between the Isa and the pension worlds and present the annual contribution limit as a harmonised limit. And then we can debate what the appropriate number is. What George did in his Budget was to give himself a range, which is sensible. In so doing, he has given himself flexibility to start cutting the (tax relief) cost by lowering that limit,” says Johnson.

“And there is a clear convergence of thinking. If you talk to many industry participants, as I have, be they providers or consultants, £35,000 is about the right number. But you can be certain that there is no cause that the ABI is fighting harder against than that, because of where it could lead to; a progressive lowering of such an annual limit for tax-advantaged saving. Ultimately, why not cut it altogether, which takes us back to the original question; what is the purpose of tax relief?” says Johnson.

It is one thing to talk about what should happen, but what does Johnson think, statistically, the chances of higher rate tax relief going within 12 or 24 months actually are?

“I think it is much higher than 50 per cent, and that percentage rises if we really have a double dip. One of the things to bear in mind is that most of the proposals in the whole pension space have long-term consequences and don’t deliver cash savings immediately. The Treasury needs cash savings immediately. Therefore we need something that is extremely simple. It can be either complicated, which makes it very hard and arduous, or it can be immensely simple, and getting rid of higher rate tax relief is immensely simple,” says Johnson.

Such a move would have a massive effect on the pensions industry, so surely would we not have heard a more vocal defence of the merits of higher rate tax relief by now?

“They know it’s coming. There is a groundswell of resignation that this is on its way. Talk privately to any consulting actuary, and he’ll tell you that higher rate tax relief is ludicrous. Perhaps more surprising, many in the industry think likewise. Flip it around and look at it from the Treasury’s perspective. When it gives a saver higher rate tax relief, it is co-investing with that individual and it rides alongside the individual with the success or failure of his investments. It starts getting its money back when the individual retires and starts paying income tax. But only one in seven of those who pay 40 per cent tax when working (thereby receiving 40 per cent relief) actually do so in retirement, so it’s a poor investment for the Treasury,” says Johnson.

Despite the radical nature of Webb’s proposals, he is quick to point out that support for something close to what he is talking about is already widespread across the political spectrum. While Johnson is keen to describe himself as apolitical, his contribution is particularly significant because it comes through a highly respected Conservative think tank, the Centre for Policy Studies, giving the appearance of finally bringing Tory thinking in line with what, at least, some individuals in the other main parties have been saying for some time.

“There is very little gap between where Steve Webb, Vince Cable and their colleagues are and where I am. And Baroness Hollis (Labour) and Lord Blackwell (Conservative) are in the same space, as are other highly influential and respected people, such as Frank Field. Over the last couple of years a convergence of thinking has emerged, irrespective of political hue, one of the benefits of the crisis,” he says.

So, with the potential for a double-dip, the cost to employers of auto-enrolment (and the cost of all the new tax relief that those contributions will attract), does Johnson think the Treasury has the appetite for the pensions reforms that are already in the pipeline?

“There is a big question mark over auto-enrolment and, separately, Nest,” says Johnson. “I am suggesting that the roll-out of auto-enrolment in the workplace should include Isa’s. Auto-enrolment is broadly a good idea and Iain Duncan Smith and Steve Webb have named the team to look at it again. I understand that that was also an invitation to look at Nest (but this is not entirely clear).”

“We saw in the last Labour Budget that they delayed the auto-enrolment process because of the tax relief costs associated with it. The delay was not to give employers more time; it was the cost. It would cost something like £1 to £2 billion per year to broaden the participants in tax-advantaged savings,” he says.

“The harder question is whether we ought to be looking at compulsion. Sooner or later, if the macro-economic picture deteriorates further, particularly with regards to the affordability of pensions, then savings compulsion should be more seriously discussed,” says Johnson.

So, given the fact that the Treasury is likely to be cool towards anything that is going to cost it more money, does Johnson think the auto-enrolment policy will fail because of the tax relief cost?

“I hope not. There are other ways of curtailing the cost of tax relief without stopping auto-enrolment,” he says. Which leads us back to the perennial question of that expensive higher rate relief.

Michael Johnson on…

“I got the job not because I was a member of the party but because I am somebody who can organise things. It does not mean I vote Conservative”

Nest: “I would get rid of it. Do something similar, but not another government-centric quango. It is probably going to cost £600m or £700m and it could largely be done by the private sector anyway.

Risk-sharing: “There is a huge future for probably 90 per cent of workers saving in a default fund environment that has a lot of elements that look like a with profits fund. We really want a sovereign with profits fund that is a sovereign welfare fund. Nest needs some reasons to exist. It could be the guardian of the nation’s sovereign welfare fund, a series of giant default funds. And pension provision would be driven by the performance of the sovereign wealth fund. This would generally reflect Osborne’s very early statement that “we are all in this together” because if the nations’ sovereign wealth fund does well then pensions do well, and if it does badly they do less well.

Public sector pensions: “Clearly something has to give. I envisage that we will probably end up with a hybrid world where there is a certain level with a fairly hard promise and above that there is a DC pit and the question is where does that level lie. One of the reasons Nest could exist would be if you compelled all of the public sector to participate in it.

Means-testing: “If you put state pension up to guarantee credit level slowly you are taking yourself out of the means-tested benefit melee and you create a virtuous circle. As you take people out by raising the state pension, the £8.6bn of pension credit payment collapses so you are suddenly freeing up the bulk of £8.6 billion per year which you can put straight back into the basic state pension and can raise it again. And you save on all the admin costs. I am working on a cunning plan with Patricia Hollis on this at the moment.

Political affiliations: “I consider myself to be apolitical. It is actually a disadvantage having had a job running Cameron’s policy group. I got the job not because I was a member of the party but because I am somebody who can organise things. It does not mean I vote Conservative.

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