Chancellor George Osborne’s bold plans for pension tax relief reform could be coming unstuck as new hurdles appear to block pensions as Isa reforms.
The Treasury’s consultation closed this week amid growing criticism of the Chancellor’s most radical proposal, moving from an exempt-exempt-taxed system to taxed-exempt-exempt.
Expert warn the Government may face a battle in European courts and even a “catastrophic” stockmarket collapse if it goes ahead with some of the options being discussed such as a “big bang” one-off tax charge.
But while there is strong resistance to the plans – and growing support for a flat-rate system – there is fear among the pensions industry the nuclear option is still on the table.
Even critics admit flipping the system to TEE could best meet some of the Government’s key requirements for any reform; establishing a simple and transparent model; boosting responsibility; building on auto-enrolment and being sustainable.
Opposition to the ‘pensions as Isas’ concept have focused on the added complexity of running parallel systems, but as Treasury discussions with the industry have developed other problems have emerged.
Tisa policy strategy director Adrian Boulding says the Government could run into legal challenges if it attempts to impose TEE.
Research published by the Pensions Policy Institute in September found half the working age population – 19 million people – are ineligible for automatic enrolment.
Of these the PPI found certain groups of employees, including those with ethnic minority backgrounds, women and people with disabilities are far less likely than others to meet the qualifying criteria.
Boulding says the findings suggest workers who do qualify for auto-enrolment, but only just above the £10,000 earnings trigger, are also likely to be from these demographics.
He says: “If you extrapolate that, and look at the people earning over the threshold who have been automatically enrolled, these are the people who stand to lose the most from a taxation switch from EET to TEE. So at the moment those low earners are getting relief on the way in, and no tax on the way out. But if we moved to TEE, they won’t get relief on the way in and they won’t get taxed on the way out.”
Currently people who earn below the starting rate of income tax but who are contributing to a pension receive a tax boost of 20 per cent. If they continue to receive income under the threshold into retirement, they will also pay no tax.
However, if upfront tax relief is abolished as part of a switch to TEE they would see their pot size cut by a fifth overnight.
Boulding says: “The groups particularly badly hit by a move would be the low earners who are just above the threshold.
“European law means Governments cannot make changes that disproportionately affect women, disabled people or ethnic minority groups. That law might therefore stop a move to TEE.”
Independent regulatory consultant Richard Hobbs says: “I would think that clumsy pension reform which tended to disadvantage minorities would be a candidate for scrutiny under the European Convention on Human Rights.
He adds: “While it tends to be the Home Office that is taken to court, there is an obvious precedent for this in financial services. Since 2012 insurers have not been allowed to give lower rates to a woman than a man just because they are more likely to live longer. The court said that was discrimination and now women get better value for money than men.”
“Big bang” tax hit
Working groups run by the Treasury on the reforms have discussed the possibility of a one off tax hit to tackle the problem of having to run two systems at once, Money Marketing understands.
When the consultation was launched in July, critics jumped on the difficulties of running separate tax systems side-by-side when one of the Chancellor’s stated aims was to simplify the system.
However Treasury-led industry debates have raised the possibility of a one-off tax charge levied on people with savings in the current system, to bring them into the new regime.
Money Marketing understands the Government was initially exploring forcing customers and providers to facilitate the charge, but now appears to be favouring a voluntary approach should TEE but adopted.
This could be rolled out in the same way as the pension freedoms, where providers are not compelled to offer the new option but customers are free to move to exercise their rights.
A Morgan Stanley analyst note, published in September, estimates a “big bang” exercise of moving to the new system would produce a tax windfall of up to £114bn.
While a charge on private pension savings would deliver a monumental boost to Treasury coffers, experts warn it could spark a “catastrophic” stock market collapse and even lose the next election for the Tories.
Aegon regulatory strategy director Steven Cameron says: “Our biggest concern will be it will be extremely hard to consolidate, if everyone was forced to move to the new system the amount of money that would come out of markets would be so massive there would be a stockmarket collapse.
“And it would be extremely unpopular with voters. TEE remains possible but a bulk move is not a realistic option.”
A senior insider at a major life company adds the Government would struggle to determine how much to charge individuals, including around half of people who do not pay tax at all in retirement.
He adds: “A voluntary levy would be even worse. You would have the grandfathered regime, as well as all that complexity around balancing charges.
“If you are 60 you might go for it, but if you are 30 or 40 do you really want to change and then wait and see what the next government might do?
“It’s a big leap of faith for people and there would be significant gaming of the system. Those who would benefit would do it, and those who wouldn’t would stick with the old rules so it might not even bring in the amount of tax that the Chancellor might be hoping.”
DB sticking point
How to deal with defined benefit pensions as part of any changes has been a sticking point since the debate began.
Tax relief on DB represents the lion’s share of spending; Aviva head of financial research John Lawson estimates this totals £25bn or 72 per cent of all relief.
Despite potentially delivering the biggest Government saving, some have argued working out how to limit tax relief for DB is too complicated and should be carved out. As most open schemes are in the public sector, there is also a high chance of widespread strike action.
Aegon’s Cameron says leaving DB as it is will lead to further division between the public and private sector and severely restrict the Government’s ability to make savings.
He suggests creating a new calculation to turn employer contributions into a figure to work out a benefit-in-kind tax charge.
He says: “Under a single rate of relief, applied to both employer and employee contributions, the consequence for DC will be their employer benefits are treated as a benefit-in-kind and taxed at the difference between employees’ marginal rate and whatever the agreed single rate is. That’s quite easy in DC schemes because you know how much an employer has contributed.
“In DB you don’t know exactly how much is paid in. But based on certain assumptions we can work out how much it tends to cost to accrue an extra year’s worth of final salary benefit.
“How much an employer pays will depend on investment returns, salary increases and lots of other factors. But you could come up with a broad calculation to equate a defined benefit into an employer contribution, purely for the purposes of determining a benefit in kind tax charge, then there is consistency with the approach in DC schemes.”
AJ Bell is against the “fool’s gold” of a flat rate. Instead it suggests splitting the tax regime, with the lifetime allowance scrapped for DC and the annual allowance binned for DB members.
Consultancy Towers Watson is in favour of leaving the tax system as it is, though senior consultant David Robbins concedes this is the path the Government is least likely to choose.
He says: “You’ll struggle to find anyone supporting TEE in the industry but that’s not surprising seeing as insurers change on a percentage of funds basis.
“But if the Government want to make some kind of big change, for all its flaws, at least TEE fits with the Chancellor’s simplification agenda and he would have a story to tell.
“There’s no real simplification in a flat rate, it’s just a redistribution. And if you want to redistribute, then there are better ways to achieve that. Flat rate EET only looks like the right answer if your priorities are keeping tax revenues in the future, and redistributing in someway. It’s not the right answer if you want to do anything else.”
Morgan Stanley says TEE, without the one-off tax charge, is its best guess at what the Government will pick. It says the simplicity of the model, clearer incentives and the Chancellor’s fondness for radical reform, make it the base case assumption.
All eyes are now on November’s Autumn Statement, the most likely time for the Chancellor to signal his intent.
Ed Fairey, managing director, Fairey Associates
I’d like to see the system stay broadly the same but removing the restrictions on the way in, through the annual allowance, and abolishing the lifetime allowance which simply punishes investment performance.
But if there must be change, I think the two-for-one, flat-rate model works. We already have significant inequality between DB and DC schemes and at some point that must be sorted out. Whatever they do it ought to be treating both systems equally and not exacerbating the already wide divide.
Alistair Cunningham, director, Wingate Financial Planning
My head tells me that tax relief will be abolished and “pension freedoms” will be offered to all. My heart hopes this is not the case and we continue to have a regime which encourages long-term savings, but I think the lure of slashing tax relief and plundering peoples’ pots at any age will be too appealing. If TEE is adopted, fewer people will bother saving; particularly if it becomes effectively an Isa.
The politics of the pensions tax consultation
“Politics is the only career in which you can actually get stuff done”. That was George Osborne’s reply to friends who queried his decision to stand for Parliament, according to Janan Ganesh’s biography.
The Chancellor’s foreword to the pensions tax consultation expresses a hope that this “stuff” could include enabling people to take more responsibility for their retirement savings by simplifying the support that the government provides. His earlier pension changes had similar justifications: it’s easier to plan for retirement if you understand what State Pension you can expect, and making people buy annuities could put them off saving in the first place.
People involved in policymaking at any level are there because they think they can improve things. Even when the best you can do is to avoid making things worse, acknowledging this is not a recipe for job satisfaction. Policy reviews begin with the dice loaded in favour of change.
Idealism and institutional bias therefore point to significant change. So might a desire for revenues and political calculation.
Before the election, the Conservatives said that tax rises were not needed for fiscal consolidation. The July Budget tweaked this approach: the Chancellor set out some measures and said the remainder would be announced in November, “largely” comprising departmental spending cuts. So the door has been opened to getting some of the money from pensions tax relief. This could include bringing forward future tax revenues under the Pension ISA model.
Recent reports make a flat rate of upfront tax relief the frontrunner. Unlike with Pension ISAs, savers would still have to think about tax when weighing up the adequacy of their pension pots, and the financial gains to saving through a pension would continue to depend on unknown factors such as future tax rates and thresholds. Flat-rate upfront relief does not deliver the transparency gains that the Chancellor seemed to find attractive. Instead, the Government might tell a story about making tax relief “fairer”.
When a policy change redistributes resources from one group to another, the danger for politicians is that the losers are more aggrieved than the winners are grateful. But some of the people earning over £50,000 who lost child benefit thought this “fair” and the Government may hope for a similar reaction. Jeremy Corbyn’s election as Labour leader could change the political risks and rewards here: perhaps Conservative strategists will reflect that irritated professionals have nowhere else to go and that the beneficiaries include moderate Labour voters newly open to persuasion.
There are lots of reasons to believe that major change is inevitable. All that’s left is the not-so-small matter of coming up with something workable.
David Robbins is senior consultant at Towers Watson