Shaping the new models for pension tax relief


“We believe the pension tax relief system will be fair and affordable and we will not propose any further changes to the system during the next Parliament.”

This was the pledge made by the Conservatives in the run-up to the election, having already decided to cut the lifetime allowance from £1.25m to £1m next April and reduce the annual allowance for higher earners to fund a £1m inheritance tax threshold.

Yet three months later, Chancellor George Osborne has set the cat among the pigeons once again with the release of a consultation which could see a radical overhaul of the current model of pension tax relief.

The “strengthening the incentive to save” green paper, published as part of the summer Budget, sets out the case for pension tax relief reform but largely leaves it to the pensions market to come up with the answers. The Treasury argues any changes to the pension tax system should meet four key principles: they should be simple and transparent; allow individuals to take responsibility for retirement saving; build on auto-enrolment; and be sustainable.

Against this backdrop, the Government has already moved to curb the almost £50bn annual cost of pension tax relief by tapering the annual allowance. From April 2016, the annual allowance will be gradually reduced for those with “adjusted annual income” over £150,000. This will take into account individual and employer pension contributions, and will see those with adjusted income of £160,000 given an annual pension allowance of £35,000, moving down to £10,000 for those with adjusted income of over £210,000.

Helm Godfrey chairman Danby Bloch says: “At first I despaired that the industry was in for yet another slew of radical changes. How often could the Government pull the old plant out of the pot, turn it upside down and still hope it would grow?

“But I did begin to sympathise with the logic. Let’s face it, nearly £50bn a year is a stonking amount of tax and National Insurance contribution relief for pensions, especially if, as the green paper claims, some two-thirds of it goes to higher and additional rate taxpayers.”

Tisa director general David Dalton-Brown believes the consultation is a positive move from Osborne, as it means financial services firms are in a position to influence any reform.

He says: “The Chancellor has to strike a balance. It would have been very easy for him to have made swingeing changes to pension tax relief early on. We know taxing pensions is a very attractive target but there are unintended consequences if the Government gets this wrong.”

Pensions as Isas

The Treasury has not set out many ideas for reform, but one of the more radical proposals Osborne has alluded to is to tax pensions like Isas. This would involve moving from the current exempt-exempt-taxed model, where pension contributions are exempt from income tax, employer contributions are exempt from NICs, and pensions are taxed when accessed minus the 25 per cent tax-free lump sum.

The Institute for Fiscal Studies says this idea would be a huge overhaul if implemented. It argues the current approach to taxing pensions is overly generous, so reforms would need to tackle this imbalance.

Senior research economist Stuart Adam says: “The consultation suggested as part of the Isa-style option there would be a Government top-up. This would be be an opportunity to make that top-up fairer across the board.”

But LEBC divisional director of longevity Nick Flynn thinks upending the taxation model in this way would be a step too far for the Government.

“This would be another nail in the coffin for tax relief as we know it. People live in the now, and that is why people are attracted to paying into their pension – they get the tax relief now and the money grows. If you lose that incentive, why not just put it in an Isa?

“It could destroy pensions completely if it happened, but I don’t think the Government will be that radical.”

Alternative models

A flat rate of tax relief of around 30 per cent, as first suggested by former pensions minister Steve Webb, would meet the Treasury’s “simple and transparent” objective. There is also support for this idea among advisers and the pensions industry.

Bloch says: “The tax incentive for basic rate taxpayers to save for their retirement needs to be clearer and probably greater. At the very least a flatter system of relief might bring more money into pensions.”

Dalton-Brown agrees. He says: “If the Chancellor decides to make a change, we will strongly advocate taking some of the saving made from reducing pension tax relief and using it to incentivise lower to middle-income earners to save into a pension.”

He gives the example of someone who manages to reach a target of saving 5 per cent of their salary, with the Government then giving them a bonus as a reward.

But Adam believes reform should be concentrated on making pension tax relief less generous, as pension freedoms are already enough of an incentive.

He says this could be achieved by limiting the amount of tax-free cash, perhaps by allowing 25 per cent of a pension pot to be taken tax-free up to a certain amount. Adam also argues there is a case for charging NI on employer contributions, given that this relief cost the Government £14bn last year.

The consultation is a wide-ranging one, so is likely to have received some diverse submissions by the time it closes on 30 September.

Tisa’s response will include a call for the lifetime allowance to be scrapped, a push to simplify pensions jargon and consider whether new joiners to auto-enrolment schemes could start contributions at a lower level than existing members.

Flynn says making the pension tax system simpler would be a major differentiator. “I’ve sat with pension scheme members and had to explain they have to claim the higher rate tax back, or discussed the option of salary sacrifice, and they look at me like I’m crazy. Pension freedoms only came in April, and clients are yet to get their head around that, so to change the system again is hard work from a communication perspective.”

As with previous recent Budgets, the summer Budget presents a financial planning opportunity – Bloch likens it a “buy now while stocks last” deadline what with the upcoming reductions in both the lifetime and annual allowances.

Adam says what savers and the pension industry needs is stability in the system, particularly given the level of change imposed by the coalition government and the Labour government before it.

He says: “The Conservatives said they would not propose any changes to the pension tax relief system, and yet here we are. The problem we have is the constant tinkering, a lot of which has moved pension taxation in the wrong direction.”

At a glance: Shake-up to pension tax relief

From the summer Budget

  • A gradually decreasing annual allowance for higher earners, moving from £40,000 for those with adjusted income of up to £150,000 down to £10,000 for those with income over £210,000
  • Aligning pension input periods with the tax year
  • Proposal to “tax pensions like Isas” and move to a taxed-exempt-exempt model

Alternative models

  • Flat rate of tax relief set at around 30 per cent
  • Government top-ups to encourage pension saving among lower earners
  • Liming tax-free cash
  • Scrapping the lifetime allowance

Martin Tilley Cut Out Medium

Martin Tilley: Planning for higher earners dealt a serious blow

The reduction in tax relief on pension contributions for those earning over £150,000 was widely expected. So it was inevitable that salary sacrifice would need to be considered and this has been brought into the equation through a tapered annual allowance.

The first point to note is that the measures introduced will apply to not only those earning above £150,000 but potentially anyone whose base income is above £110,000. Initial estimations predict the changes will impact 300,000 individuals earning over £150,000 and potentially treble that number when taking into account those with base earnings above £110,000.

In effect, any attempt to reduce an individual’s earnings to beneath the £150,000 threshold by way of a salary sacrifice pension contribution has been thwarted. The Treasury has also announced it intends to monitor salary sacrifice to identify any abuse.

Although the changes will be implemented from April next year, any attempt to circumvent them in advance by implementing a contractual change in employment terms is also caught by the inclusion of anti-avoidance rules that will apply so any salary sacrifice set up on or after 8 July will be included in the threshold definition.

The proposals are even more complex than the headline measures announced in the manifesto and do nothing to aid the easy understanding of relief for higher earners.

Martin Tilley is director of technical services at Dentons Pensions Management