Chancellor George Osborne is preparing to break the link between income tax and top-ups to pension contributions in favour of a 25 per cent flat rate of relief.
Osborne is due to use his March Budget to respond to last year’s consultation on a potential revolutionary change to the pension tax relief system.
Money Marketing now understands the Government’s current preferred option is a flat rate of relief set at 25 per cent, redistributing the top-up towards basic rate taxpayers and savings billions for the Treasury.
But experts say the changes could see employers run into problems if higher and additional rate taxpayers are put off contributing to pensions.
Others warn the Government’s aim of creating a simple system will not be achieved by the model as savers will be misled by “buy two, get one free” marketing.
So who would be the winners and losers from the new system? How much will the Chancellor bag in savings? And will simplifying the regime actually boost contributions?
Industry insiders say a 25 per cent rate of relief now “feels like the direction of travel” after months of heavy lobbying appears to have persuaded the Government to abandon a move to the taxed-exempt-exempt model.
Although the Treasury would enjoy an enormous upfront tax windfall from the pensions as Isas approach, there were fears workers would lose all incentive to save into a pension.
Replacing rates of relief based on marginal rates, with 25 per cent applied on gross contributions, would also produce billions in savings. This equates to a 33.3 per cent top-up to contributions paid from post tax income.
Former pensions minister and now Royal London director of policy Steve Webb has been a long term backer of a flat rate that redistributes relief to low earners. Currently basic rate taxpayers make 50 per cent of all contributions but only receive 30 per cent of relief. In contrast, higher rate taxpayers receive 50 per cent of relief but make only 40 per cent of contributions while 20 per cent is given to additional rate payers who contribute just 10 per cent.
Webb says: “If this is true, it is welcome the damaging pensions Isa has been dropped.
“A flat rate of 25 per cent – perhaps represented as a 33 per cent top-up on net contributions – would be of modest benefit to millions of ordinary savers but would impose large cash losses on many higher rate taxpayers.
“If so, we should expect to see other measures as part of a Bud-get package, such as a big rise in the threshold for paying higher rate tax and possibly a bold move on the lifetime allowance to wrongfoot his critics.
“The Chancellor faces a difficult balance between deficit reduction and limiting the losses amongst those just earning enough to pay higher rate tax.”
Thinktank the Pensions Policy Institute says a single rate of just over 30 per cent would keep the cost of tax relief equal to the current system, with 25 per cent resulting in a £6.1bn saving. This takes into account contributions to defined benefit schemes.
HM Revenue & Customs figures put total tax relief on all private pensions at £34.3bn, falling to £21.2bn once tax on pension payments are taken into account.
Auto-enrolment will add to the bill, which has already increased by £5bn since 2008/9, as millions of people are brought into the pensions system for the first time.
But while setting relief at 25 per cent is likely to be promoted as a “buy two get one free” deal, experts say in reality this will not be the case.
The Association of British Insurers is championing a “savers’ bonus”, promoted as a £1 top-up for every £2 saved.
But Willis Towers Watson senior consultant David Robbins says: “There is a catch: the Government would be offering £3 in your pension pot for the price of two, not £3 of spending power in retirement for the price of two.
“This saver’s penalty is usually smaller (depending on the size of the top-up and the individual’s circumstances), but trying to hide it would risk derision.”
Dentons Pension Management director of technical services Martin Tilley says: “Saving is incentivised by simplicity, understanding and trust. Unless we get a clear, factual, warts and all announcement at the Budget, free of headline-grabbing spin, the Government will not have achieved the incentive to save, which was the headline for the consultation. Or was that a spin exercise too?”
Modelling provided by Old Mutual Wealth for Money Marketing shows how a 25 per cent flat rate would impact on savers with a combination of tax bands pre- and post-retirement.
It reveals a rate set at 25 per cent would raise the effective tax take on every group apart from people who are basic rate taxpayers in work and in retirement.
Old Mutual Wealth pensions technical manager Jon Greer warns: “A flat rate of relief of 25 per cent would mean some higher rate and additional rate taxpayers would be taxed twice on the same income. A rate of 30 per cent would be tax-neutral for higher rate taxpayers who also paid higher rate tax in retirement.
“The incentive for these individuals to pay into a pension would be the employer pension contribution. If the employer was willing to provide a cash alternative in lieu of their pension contribution it could mean these higher rate taxpayers shun continued membership of their pension schemes.”
Aegon regulatory strategy director Steven Cameron agrees 25 per cent would be a “more significant change” that would “raise questions with some higher rate taxpayers as to whether pension saving is still the right thing to do”.
He says: “That would be a very adverse outcome, bearing in mind the numbers of middle earners who are higher rate taxpayers.”
Cameron adds Osborne may announce a flat rate in the Budget but is likely to keep the Government’s preferred level close to his chest until the new system takes effect.
He says: “We are working on the basis it will not go live in April 2016 because while providers might have managed to make the changes there is no way employers and HMRC would be able to make the adjustments in those timescales.”
It also remains unclear how defined benefit schemes – which account for the majority of all pension tax relief – will be treated.
Experts have argued a different regime would need to be applied but the Government will have to tread carefully to avoid being seen to favour one system over the other. The issue is further complicated by the fact almost all DB schemes open to new members are in the public sector.
TUC pensions policy officer Tim Sharp says: “The Government should avoid cutting tax relief for DB pensions as this will increase the cost of providing these schemes – on which millions of workers are relying for income in retirement.
“We think a flat rate approach could be more effective than the existing system in helping those low and middle earners who most need support in saving. But there may need to be a different system for DB. That doesn’t mean changes have to penalise DB. Doing so could even provide a perverse incentive for employers to provide lower quality schemes.”
A Treasury spokesman says: “The government launched a wide-ranging consultation on the system of pensions tax relief last summer. We have not decided on whether or how to reform the system and are considering all options, including retaining the current system. This consultation is now closed. We are considering the responses and will respond at the Budget.”
Steven Robinson, managing director, Clarke Robinson & Co
This is aimed at the masses of higher rate taxpayers where Osborne can save tax. It is a sop giving a boost to ordinary savers as they are caught by auto-enrolment in any case and so have less need of an incentive.
If a flat rate is set too high and is too generous for higher earners, then people will save more and that will actually cost the Treasury money. I would not put it past the Chancellor to make any changes effective immediately. The industry might want a lead in time, but that would give people the opportunity to exploit the old system.
Tim Page, director Page Russell
Why can’t they just leave the system alone? This has been building for a while. The tax relief bill stands out as being extremely high and you could see why the Chancellor feels he cannot ignore it. I would hope the quid quo pro would be either cancelling the move in the lifetime allowance down to £1m or, better yet, removing it completely.
The flawed flat rate pitch
The highest flat rate of upfront tax relief on pension contributions being discussed is 33.3 per cent. With that, anyone could forgo £100 of post-tax income and get £150 in their pension.
The Association of British Insurers says this “could be presented as a top-up of £1 for every £2…that savers contribute”. Another cheerleader, Steve Webb, says it would send out “a buy two, get one free message”.
It is unclear how enthused savers would be by this message. After all, the pound-for pound matching contributions offered by employers are frequently left on the table.
More importantly, there is a catch: the Government would be offering £3 in your pension pot for the price of two, not £3 of spending power in retirement for the price of two.
That is because, in order to receive what the ABI wants to call a “saver’s bonus”, employees would have to agree that income on which they had already paid tax could be taxed again. This “saver’s penalty” is usually smaller (depending on the size of the top-up and the individual’s circumstances), but trying to hide it would risk derision.
How much is £100 from post-tax income, topped up to £150, really worth?
Where all withdrawals beyond the 25 per cent tax-free lump sum fall within the personal allowance, the saver would indeed get one £50 free, after tax, for each two £50s they contributed.
With 20 per cent tax on withdrawals, the saver ends up with £127.50. Two £50s were put aside, so 55 per cent of £50 was free.
A 40 per cent tax on withdrawals leaves £105. Post-tax income bought two £50s to spend in retirement, so the true “bonus” is £5: not one £50, but one-10th of £50.
This is no “buy two, get one free” pensions revolution. It’s a “buy two, get one – or eleven-twentieths of one, or one-10th of one, or potentially something else if tax rates change – free” pensions revolution.
If advocates of flat rate upfront relief yearn for a catchier strapline, I sympathise. My preferred option – leaving things alone – does not have that either. Only the pension Isa does (because its smaller top-up is supposed to be the end of the matter, with no tax due in retirement). Flat rate fans should concede the point, not present the opportunity to use a specious sales pitch as an argument in their model’s favour.
David Robbins is a senior consultant at Willis Towers Watson