It is often the case with tax policy that the good guys get clobbered in an effort to stop the minority of those who exploit the rules in a way that was not intended. And so it is for the proposed money purchase annual allowance reduction from £10,000 to £4,000 per annum.
Its aim is to minimise the potential for individuals to get a double dip of tax relief by cashing in pensions before recycling the proceeds back into a new scheme. With this in mind, it might seem reasonable for the Government to seek to remove this loophole. But reducing the MPAA is a classic case of sledgehammer and nut.
The policy is likely to affect a great number of people who are, and always have been, doing the right thing. It will also have a significant impact on employers operating good pension schemes.
Consider a workplace pension scheme where the employer pays 6 per cent and the employee pays 4 per cent of salary. The proposed reduction in the MPAA would mean that anybody earning over £40,000 who accesses a pension flexibly would find they could not claim relief on all of their contributions.
In fact, the contributions could still be paid but the individual would be subject to a tax charge they would have to meet from their own pocket. Scheme pays does not apply for the annual allowance charge in this situation. So either the employee gets hit or the employer has to fiddle around with its benefit rules, possibly limiting the pension contribution and offering an alternative benefit.
We have seen this already with tapered annual allowance and it is not pretty.
“Reducing the MPAA is a classic case of sledgehammer and nut.”
We are told that this is not a bad policy because only a few people (3 per cent) pay more than £4,000 per annum and the limit is well above what would be payable under automatic enrolment. That may be, but is the point not that we are trying to get people to save more?
The industry consensus is that you need to save somewhere between 12 per cent and 16 per cent of salary to get a decent retirement income. And that is if you are young. Those nearing retirement and looking to catch up may need significantly more.
Retirement patterns changing
We could just tell people who would be affected that they should not access their pensions flexibly – at least not until they have finished saving. But that flies in the face of how retirement patterns are changing and how people are using pension freedoms.
The ability to drawdown benefits from one pension arrangement while still accruing entitlement in another is very popular and allows income to be tailored to meet the varying needs of the new retirement. Such a sharp reduction of the MPAA will reduce this flexibility for many still building up retirement assets.
So what is the answer? The existing tax-free cash recycling rules provide a good starting point but will require additional reporting to HM Revenue & Customs to be effective. These rules look at how contribution patterns change before and after pension benefits have been accessed.
The challenge for HMRC is that, while it should know when a pension has been accessed, it does not always know what contributions are made by or on behalf of an individual. It does for personal pensions but not for trust-based plans. I must admit I find this surprising. Surely, given the cost of tax relief, we would expect our tax authorities to have greater visibility of who is getting it.
The other challenge with this policy is that I suspect many out there have triggered the MPAA but have not told their current provider. While they are obliged to do so, the reality is that some will have not – not because they are dodging tax but because they simply do not understand the rules.
HMRC having better information on contributions would allow it to ensure the annual allowance rules are policed more effectively, meaning less tax leakage and avoiding nasty surprises for individuals.
It feels like this is a more sensible approach for the long term than constraining those who are already saving at a decent level and wanting to take advantage of pension freedoms. Even if we decide that reducing the MPAA is the only option, we should certainly consider whether such a sharp reduction is necessary and whether it is realistic to introduce the policy with such short notice.
Richard Parkin is head of pensions policy at Fidelity International