A maze of complex caps and exemptions has fuelled calls for change, but could reform prove too costly?
The combined weight of varying forms of tax relief on pension savings is an undeniable burden on the government.
In fact, figures indicate that ministers gave up just under £40bn in pension tax reliefs in 2016 and 2017 alone.
Pressure on government budgets and greater publicity post-pension freedoms have seen a myriad of structural changes to pension reliefs over the past few years.
Controls including a reduction in the annual allowance to £40,000, now tapering to £10,000 for high-earning individuals, and a lowered money purchase annual allowance have left consumers confused about where to put their hard-earned savings.
Advisers say the responsibility lies with providers and regulators to communicate tax traps and incentives to the public so they can be well prepared for retirement.
In the meantime, advisers have the tricky job of navigating the maze of caps and exemptions.
Money Marketing has taken a look at the past and possible future of pension tax relief, and the role advisers must play to meet client objectives.
Managing director, Technology & Technical
Clients often don’t know there’s a lifetime allowance and there is no obligation on The Pensions Regulator to tell people they are likely to blast right through it. This especially applies to men, who have often worked right through with no break.
Under pension freedoms, people should be able to get money out so they stay under the lifetime allowance, but often you can’t touch the money without tax penalties.
The annual allowance is easier for advisers, but it’s always a shame to have to tell people to stop putting money into their pensions.
Somehow, they’re always caught out by either one cap or the other.
A cluttered space?
The annual allowance was as high as £80,000 five years ago, but now sits at £40,000 on the total amount of contributions that can be paid into defined contribution pension schemes, along with the amount of benefits that can be built up in a defined benefit scheme, annually for tax relief purposes.
For those people that continue contributing after making a flexible withdrawal, the MPAA puts a limit of £4,000 on all of the contributions that they or their employer pay.
Tapering of the annual allowance applies to individuals when limits on threshold income and adjusted income are both exceeded, cutting the allowance by £1 for every £2 of adjusted income over £150,000.
There has been confusion, however, over how exactly to calculate the tapered annual allowance since its introduction in 2016, not to mention tougher questions over whether or not it is counter-intuitive to tax individuals trying to boost their retirement savings.
Research from Prudential this month found the number of people declaring annual allowance breaches more than doubled in the 2016/17 financial year.
The same research showed tapered annual allowance tops the list of new client queries at advice firms.
Managing director, Essential Wealth
I have helped a number of new clients recently where their main concern has been their pension annual allowance position.
It has all become far too complicated for individuals and they are often also facing unexpected tax bills.
The group most impacted by the dual caps are young high earners, because they are often absolutely nowhere near the lifetime allowance cap. Even so, they are severely restricted on tax-efficient contributions.
I feel that having just the lifetime allowance cap, rather than both, or a combination of the two would be sufficient enough for everyone.
The government quashed calls to scrap tapering in last year’s Budget, however, which Technical Connection head of pension strategy Claire Trott says was the best chance to simplify the pensions space.
She adds: “It’s disappointing tapering wasn’t scrapped and the contribution rules weren’t simplified in general, but no change is probably better than added complexity and hopefully it allays fears of a raid on pension tax relief, at least in the short term.”
Individuals need simplification to understand tax and advisers need a clearer path to plan for them.
Quilter chartered financial planner Tracy Crookes says the lifetime allowance – the limit on the amount of benefit one can contribute to a pension scheme without an extra tax charge applying – needs urgent reconsideration to achieve this. It would also bring some much-needed trust to the industry, she continues.
Crookes says: “It causes individuals to be caught by a tax charge where their investments have grown in excess of the lifetime allowance, or to their protected lifetime allowance where they have claimed one of the protections available. What causes confusion is the multiple allowances and the constant changes.
“My issue with the lifetime allowance is that the state pension age is now a moving target.
“It means investors need to save hard to be able to have any hope of retiring before their state pension comes into payment.”
Different rules for different people?
An argument over whether different pension provisions should apply across professions reared its head again recently following reported discussions between health secretary Matt Hancock and the Treasury.
Hancock is said to have backed the idea of a potential exemption to standard lifetime allowance rules for doctors, with the argument the already sparsely-filled profession struggles to recruit because of pension arrangements.
Head of Chase de Vere Medical – a specialist advice business for doctors – Andrea Sproates says she has seen a steady increase in enquiries from medical professionals about opting out. But while Sproates believes doctors have it tough, their situation is not unique.
She adds: “Opting out is never the best option. Doctors’ benefits can grow at a quicker rate than people in private pensions and it’s not fair to have different rules.
“It is unfair for anyone in DB schemes because they don’t have any control over their input.
“Double tax benefits were part of the incentive to attract doctors to the NHS in the first place, but the recruitment issues stretch to teachers and senior nurses as well who are also hit hard by lifetime caps if they are promoted but stay on the same scheme.”
Advisers need to continue to make these clients aware of the potentially negative impacts of leaving a scheme when faced with daunting tax bills, she says, noting: “They could miss out on employer contributions or find they lose valuable death benefits which are so expensive to buy privately.”
Royal London head of business development Clare Moffat says high-income earners are not necessarily hard done by when it comes to pensions.
She adds: “These charges aren’t a punishment for bad behaviour; they are simply the mechanisms HM Revenue & Customs uses to claw back any tax relief the member has enjoyed which exceeds annual or lifetime limits.”
Crookes agrees high-income earners would likely see the first benefits from any increases to caps.
She notes: “They are the most likely to be able to make use of the available allowances, so I don’t support different caps for different professions. It would just cause a bigger issue and a broader social divide.”
Should pensions be the priority?
Investors under 40 have the option of the Lifetime Isa, which allows savings of £4,000 a year with an additional 25 per cent government bonus.
A total of 166,000 Lisa accounts were opened in the 2017/18 tax year, with average savings amounting to £3,100.
Crookes says: “These are accessible to all and are a great asset to any investor toolkit.”
Using collective investments paying interest or dividends is another option for advisers to present to clients to help minimise the impact of pension tax charges, Crookes adds.
She notes: “This gives the opportunity to utilise any personal savings allowance and the current dividend allowance of £2,000.
“If advisers can manage these investments carefully, the capital gains tax exemption can be utilised each tax year.”
Enterprise investment schemes and venture capital trusts, which invest in start-up companies with the benefit of offering a large range of tax reliefs, may now be a riskier choice that some people will look towards for tax minimisation, instead of pension contributions.
In an unstable market such as today’s, getting reliable performance from EISs and VCTs may be increasingly difficult. Crookes says: “Only people with a higher level of risk should even consider EIS and VCTs.
“They do provide the 30 per cent income tax relief, subject to a few rules, but only if investments continue to meet conditions.”
Advisers who deal in investment bonds can also use them as an opportunity to boost pensions with more regular income for withdrawals which are not normally liable to capital gains tax.
At present, 5 per cent of any investment is allowed for withdrawal for up to 20 years, without added taxation.
Advisers should also not let volatile Brexit markets put them off investing client assets in offshore bonds in the next few years, according to some experts.
Crookes says: “Unlike onshore bonds that suffer life fund taxation, offshore ones benefit from gross roll-up, meaning they don’t suffer any tax, much like pension savings, so they can provide the opportunity for investments to grow in a very tax-efficient environment.”
Staying in a scheme could be the best option, even with added tax
More people than ever are facing the lifetime allowance and annual allowance charges. Pension saving statements arrive and clients call up their adviser in a panic, saying: “I need to leave the scheme as I have an annual allowance tax charge.” Or they find out they will have a lifetime allowance tax charge and have the same reaction, or want to retire early to prevent a charge.
Whatever clients think about these tax charges, the same rule applies to them and any other tax, including income tax.
It all comes down to the numbers and the net benefit. Are clients better off staying in the scheme or leaving the scheme?
This is complex and advisers have to help their clients understand that this is something which usually needs to be considered every year. It requires a process and calculations. But what is really important to say is there’s nothing inherently wrong in paying one of these charges.
This isn’t just a decision based on the member either. Spouses and beneficiaries can also be affected when a member decides to leave the scheme, as the death benefits might be reduced.
We’ve looked at quite a few case studies. They included a lifetime allowance case involving a member of the NHS scheme. Although there are detailed calculations, the theory is that if the member remains in the scheme for five years, the cost of membership will be £38,319 after tax relief. But that will generate an additional £7,416 of pension after payment of the lifetime allowance tax charge and that is for the rest of their life – potentially another 20 to 30 years. Even if paying higher-rate income tax, that still means £108,113 if the member lives for 20 years. Pay £38,319 and get £108,113 back. Why would you opt out? The pension to a spouse would be higher as well.
It is a numbers game. But the key is helping clients to understand that they haven’t done anything wrong and that even allowing for the tax charge, they may be better off staying in their pension scheme.
Clare Moffat is head of business development at Royal London
Looking ahead, it would seem many experts just want to see the pensions space decluttered and the introduction of a single cap on taxable benefits.
While many want to see the lifetime allowance gone, Trott says the confirmation that it will tick up to £1,055,000 in the autumn Budget marks a positive step.
Despite this, she adds: “There is still fear it will be cut yet again to help raise the tax taken at retirement, and more trust in pensions will be lost if this happens, at a time when company pension scheme members are on the rise.”
Meanwhile, its removal could still lead to some troublesome knock-on effects.
Crookes says: “The concern then is that would lead to a review of other areas, like withdrawing the 25 per cent of savings tax-free, which is a long-time leading incentive to even save for a pension.
“My clients want to save for retirement and are being discouraged and prevented from doing so, but are expected to self-fund if they need long-term care. They would prefer the opportunity to do this with savings rather than risk losing something like their home, which could be the case if things were tough.”
Aegon head of pensions Kate Smith agrees that the main consideration is consumers are not put off pension saving. She says: “The government should be thinking long-term and have joined-up policies working across the board.
“Ultimately, any changes made now are set to impact a generation of pension savers, many of whom are only just beginning to save into a pension.”