Flipping the pensions tax system on its head could be the final nail in the coffin for defined benefit schemes, add complexity to automatic enrolment and put the UK out of step with Europe.
As part of last week’s Summer Budget, the Treasury published a 12-week consultation on reforming the pension tax relief system.
Chancellor George Osborne says the aim of the reform is to “incentivise more people to take responsibility for their pension saving” but commentators point to the nearly £50bn annual cost to the Exchequer of lost income tax and National Insurance contributions.
The consultation leaves every option open but will Osborne be able to resist such a sweet honey pot as he seeks to cut the national debt? Money Marketing investigates the implications of reform.
Final nail for final salary
In his Budget speech Osborne said he was “open to further radical change”, adding that “pensions could be like Isas – you pay in from taxed income and it is tax-free when you take it out and in between it receives a top-up from the Government”.
However, the accompanying consultation also weighs up “less radical changes”, including retaining the current system and “options in between”.
Hargreaves Lansdown head of pensions research Tom McPhail says: “His speech and the consultation looked like two different things. It begs the question, to what extent has Osborne already decided what is going to happen?
“It could be the case he has a preferred direction of travel and underlying philosophy about this – small Government, small taxation, small relief – but genuinely does not know what the answer looks like and is consulting to see where it might take him.”
Moving away from the current model of upfront tax relief and taxed pensions in payment, known as exempt-exempt-taxed, would give Treasury coffers a huge short-term boost.
But experts say switching systems could have devastating consequences for already struggling defined benefit schemes.
Corporate pension consultancy Hymans Robertson partner and head of DB Calum Cooper says moving to taxed-exempt-exempt would create a “perfect storm” and lead to the rapid closure of schemes.
He says: “In the extreme case DB liabilities will be in excess of £2trn this year and the journey to settle the deficit is around £900bn. If the deficit contributions that scheme sponsors make were no longer tax exempt, it will cost potentially £200bn to £300bn more to clear deficits.
“The DB world is already suffering from relatively low long-term interest rates, which has pushed deficits up, and the end of contracting out means DB schemes are already going to get a lot more expensive as we go into this year’s valuations.”
Hymans predicts up to 250 schemes could be closed entirely – to new members and future accrual – in the next nine months if the Government signals it plans to overhaul the entire system. According to the Pension Protection Fund, there are 1.8 million active members of DB schemes, while only 22 per cent of schemes are still open to new members.
And Fidelity Worldwide Investment retirement director Alan Higham says the Government would be forced to carve out DB schemes from the proposals for fear of a union backlash.
He says: “You could put an argument that says let’s leave DB as it is. The reality is the vast bulk of DB schemes are for public sector workers and if you introduce a consistent policy of taxing contributions up front, all public sector workers in DB schemes will see a cut to take home pay.
“It doesn’t make any sense to reduce take home pay in public service, it would be a huge fight the Government would have with the unions and they would lose. You’d see every public sector employee in the country on strike and they’d stay on strike for as long as it took. Of course, if the Government did carve out DB they’d get absolutely slaughtered in the press as it would give well paid civil servants a huge tax advantage.”
Any changes to tax relief are likely to come at the same time as the final, smallest employers approach their auto-enrolment staging date.
Old Mutual Wealth retirement planning manager Adrian Walker predicts a pension tax overhaul in April 2017 is most likely, the same month firms with fewer than 30 employees will have to comply with their duties. Walker says switching systems would not be insurmountable, even for the smallest employers, as long as the changes were signposted well in advance, but others warn the incentive to save into a pension could be severely weakened.
McPhail says: “If you take away the tax relief, why would I want to lock my money up in a pension? Even with an employer contribution, that’s not enormously attractive. In order to persuade people that it’s worthwhile you might have to force employers to substantially increase their contributions – effectively substituting tax relief with an employer contribution.
“It’s a similar principle with the living wage, getting employers to pay extra.”
Standard Life head of pensions strategy Jamie Jenkins says removing relief hits the logic of enrolling someone into a pension.
He says: “Auto-enrolment is predicated on a couple of conditions. There are employer contributions and you get tax relief. You don’t get that combination in any other product so it seems alright to put people into a pension without asking them because it’s so obviously beneficial for the vast majority.
“If you took away the benefits and said this is pretty comparable to an Isa or a bank account, it’s not so obvious to put people in without asking them.”
Against the grain
European efforts to harmonise pensions across member states could also come unstuck if the Government pushes ahead with the proposals.
The European Commission is openly in favour of EET and ETT models. It says it supports deferred taxation “since contributions to pension funds diminish a person’s ability to pay taxes and since it encourages citizens to save for their old age”.
The Commission adds: “In addition, it will help member states to deal with the demographic time-bomb, as they will be collecting more tax revenues at a time when more elderly people may call on the state for care.”
Earlier this month the European Insurance and Occupational Pensions Authority launched a consultation on plans to create standards for pan-European pension products.
Eiopa says a “harmonised legal framework” should ensure a level playing field between providers, remove existing barriers to cross-border business and encourage people to save through multiple “pillars”.
But law firm Eversheds senior associate Tim Smith says: “Most tax systems in the EU are EET, clearly if the UK took a decision to change and was then out of step with the EU it would make it more difficult to develop a pan-European pension plan.
“One issue would be if someone was saving in the UK and then moves to another EU member state, they’ve already paid tax on the way in and clearly wouldn’t want to pay tax on the way out as well. So immediately you’ve got an issue of double taxation and that would need to be addressed in a pan-European system.”
The option in between a move to TEE and no change is to introduce a flat rate of tax relief, an idea promoted by former pensions minister Steve Webb and increasingly favoured by the industry.
Under this system, relief would be redistributed towards lower and middle-income earners while the Treasury would make a saving, though far less than TEE would bring.
Cooper says: “It’s not obvious that the barrier to saving is lack of understanding of the tax system. If the aim is to redistribute, the flat rate would do that and if we want to increase engagement, we can use inertia – that would be better than ripping up the system.”
McPhail agrees: “Some kind of flat rate incentive around 30 per cent feels like the most logical middle ground between the current system and the nuclear option.”
But Tisa director general David Dalton-Brown says the market has misread Osborne’s comments.
“What makes Isas so successful is that consumers fully understand them, the language used is easy to understand, where as pensions’ jargon is complex. I believe he’s trying to say pensions should be easier to understand and use.”
Tim Page, director, Page Russell
With a prize of £50bn a year of tax relief saved up front there is a huge incentive for the government to push forward with these plans. I’m sure the pension providers are tearing their hair out at the thought of running yet another type of pension alongside their existing ones. Simplification is now a distant memory. Maybe the government is thinking that by the time auto-enrolment is fully implemented there will be less need for the upfront tax relief to incentivise people to save in pensions.
Tristan Brodbeck, director, Tristan Brodbeck Financial Planning
What on earth is Osborne up to? There are three reasons people don’t save enough for retirement: they don’t have enough surplus income; they’re confused because the pension system is changed every fortnight by politicians; and they buy a house instead, because the property market’s juiced up by these same politicians.
Making pensions more like Isas is entirely missing the point, since it has never really mattered where you save, it’s how much and for how long that’s critical.
Yet again, the latest Budget has introduced the prospect of further fundamental change to the UK pensions system. Hot on the heels of auto-enrolment and freedom and choice, we now face the prospect of another radical overhaul which could see the system of pensions tax relief turned on its head. In principle, I have no objection to a taxed-exempt-exempt (TEE) system if we were setting up a pension system from scratch. Many countries operate a TEE system without issue. However, changing the rules when you are already well into the game risks creating havoc by introducing a huge amount of additional complexity into an already complex system.
Moving from the current Exempt-Exempt-Taxed (EET) system of tax relief to a TEE system would create significant administrative difficulty for pension plans and providers who could be required to operate the two systems side by side for a generation or more. Savings built up under the current system and those built up under the new would need to be ring-fenced to ensure that they were taxed appropriately. This would be a major challenge especially in the low-cost environment within which most schemes are now required to operate.
In addition, someone will have the unenviable task of trying to explain to members that their savings in pot A will be taxed on the way out (although some may be taken tax free) whereas their savings in pot B have already been taxed. Trying to work out the most tax efficient way to take their savings will be a monumental task for savers, making the job of bodies like PensionWise even more challenging.
Moving to a TEE system would also put the UK out of step with most of Europe and it would significantly undermine EIOPA’s plans for the creation of pan-European Personal Pension Plans, which were trumpeted in the day before the Budget announcements. Most countries in Europe operate a system of deferred pensions taxation and this approach is supported by the European Commission. If the UK were to break rank it would make establishing pan-European pension arrangements much more difficult. For example, who would collect the tax if someone built up pension savings under an EET system and then moved to the UK? How would double taxation be avoided if someone built up pension savings in the UK and then moved to a country with an EET system?
One particularly interesting feature of the Budget is that it suggests that the Treasury – rather than the DWP – may now be playing the leading role in the development of UK pensions policy. This carries the risk that UK pensions policy is developed as much to assist short term deficit reduction as it is about developing a stable long-term savings environment.
Tim Smith, Senior Associate, Eversheds LLP