Scary Monsters part two - exploring the issues with changing pension tax relief

26 November 2015
Our response to 'Strengthening the Incentive to Save' part two.

You've probably seen the "Workie" adverts by now. The big monster, symbolic of the big issue (auto enrolment) that really shouldn't be ignored, being completely ignored by all and sundry.

Now I know that some people are acutely aware that the deliberations being had right now inside Her Majesty's Treasury on the fate of pensions tax relief is a massive issue but I fear some do not. But it is an issue that certainly shouldn't be ignored.

Last month I explained some of the background to the HMT consultation on potentially changing (or possibly even stopping) pension tax relief and highlighted just one issue in moving away from a system based on EET at marginal rate of tax. Here is a link to the article which includes definitions of important stuff like what is EET, TEE and flat rate.

I promised that I would continue to highlight some of the issues and to shine a light on the potential social and well as practical considerations associated with a TEE model.

Time for TEE?

One of the options discussed in the HMT consultation called strengthening the incentive to save (you can find it here if you want to) was to remove all tax relief on contributions paid in to pensions i.e. pension contributions by individuals would not receive the benefit of any tax relief as the contributions would be made from taxed income and no uplift for tax could be given by providers.

In return the current Government would say that the quid pro quo for no longer getting this relief would be that pensions in payment would no longer be taxed as income as they currently are.

They would also put in a Government Contribution to provide some incentive to lock your money away but this would likely be modest relative to the current HMT relief spend.

This might sound plausible but there are huge issues in this once you start to pick through what it would mean. Just to highlight a few issues to get us thinking before we go into the detail:

  • What is to stop a future Government deciding that the cupboard is bare and that pension income does need to be taxed after all?
  • This would essentially mean an end to the benefit of tax free cash (as the cash taken would be free of tax anyway).
  • This completely changes the way pensions work and is likely to lead to millions having two types of pension saving one on EET and one on TEE. What would this mean for pension communications, customer understanding and efficiency of delivery?

So just thinking a few of these points through…

Societal issues

If a TEE framework was adopted, the Government would need to "promise" that future pensioners would no longer pay income tax on the income drawn from their pension pot. Many may see that as a good thing but remember those tax receipts do pay for something - the public services that often pensioners rely on like the NHS, Care and Personal Social Services.

During a period of significant demographic change, with the retired population living longer and relying on public services more and more, it is evident that the TEE system would come under huge fiscal pressure.

The reality would be that the new system which started off as TEE could ultimately become TET - that is to say a future Government would need to renege on the promise not to tax the pensions in payment. If it did not, the alternative may be more unpalatable to many - the services would have to be removed, cut back or perhaps paid for at the point of need and Generation TEE would end up not having had tax relief and getting taxed too! Realisation of this is likely to undermine the pensions framework and could perversely discourage pension savings - entirely the opposite of the stated intention.

In terms of social harm and potential for social unrest / disillusionment with ones lot, it is also worth pondering:

  • how long will it take the younger generation to work out that the promise of jam tomorrow will likely turn into jam never and that the money saved by the Treasury today in saved relief will be used to fix an economic problem they did not create?
  • will unions (and consumer groups) wake up to the fact that the Government's future pension proposition has just got significantly worse? How will they react?
  • will TEE lead to more future pensioners falling back on the state? The current EET framework puts a natural break on the spending behaviour of consumers as they reach retirement. The taxation of pension income encourages consumers to plan their spending, spreading it over their expected retirement.
  • The Australian Superannuation model allows largely tax free withdrawal from the pension pot built up after age 60 and the Australian Government and academics already recognise that the money saved is often not used for retirement income meaning more people falling back on the state. Many have actually earmarked their pot to pay off their mortgage and buying luxuries essentially meaning they drain their pot in the very early years. They are obviously free to do that if they wish without the prospect of tax repercussions due to having the pensioner tax environment the TEE model would purportedly bring.
  • To me this fuels enhanced lifestyle while in work at the expense of future financial security. I'm really saying you should not be encouraged to live a lifestyle beyond your means, be paying off your mortgage as you go along and not building up debts (if possible) and not have to blow your pension pot to do this.

These are really fundamental issues that have the potential to distort intergenerational fairness and to introduce moral hazard. It is essential that these points are not lost in any short term debate about budgets and current deficits/debt.

Practical issues

There are also a host of practical issues including:

  • A whole new ecosystem would have to be created to support the new pension regime. All employer systems would have to be changed, accountants and advisers software and practices would have to be amended and almost every part of pension providers systems and communications would have to be re-written.
  • Any change to a TEE system would serve to exacerbate the issue of multiple pots and increase the difficulty in communicating with customers about their pension benefits. Many providers would likely close one system to accrual and open a new pot for existing (as well as for new customers) designed for the new environment. Even if a provider was able to segregate the pot so that part ran on new rules and part ran on old rules (extremely unlikely) communicating effectively how their pot would be taxed and how the benefits would project would be very difficult.
  • So although most commentators agree that getting the consumer to understand their pension savings is at the heart of ensuring people save enough - TEE would result in making pension communication significantly worse.

This is naming but a few and when you start to get into the issues that would be associated with trying to make TEE work for any DB, hybrid, DC with guarantee for example it gets mind bogglingly difficult. Not just for mere mortals like me but for really clever people including those tasked with getting to grips with the possible options inside Government Departments. So much so in fact that many believe that if TEE were to go ahead, DB would have to be carved out in some way and remain in the EET regime. This would reignite the public versus private sector pensions debate once again with accusations that the Government were looking after their own (and public sector employee) interests while leaving less well funded private DC arrangements to carry the can.

I also promised a bit on market distortion too but as this article is already getting a bit on the long side, may I just invite everyone to think once again? So… if there is no tax relief on contributions (and is replaced by a much reduced incentive through a "Government Contribution") there will be billions less going into pension investments every year. I hope someone is thinking through what this would mean for markets, infrastructure projects and the like.

Perhaps something to have a further look at another time…

About the author

Ronnie Morgan

Strategic Insight Manager

Ronnie has worked in Financial Services for over 25 years with experience in customer service, pension scheme implementation, pensions policy and marketing. He's an Associate of the Chartered Insurance Institute, a Chartered Insurer and qualified to diploma level by the Personal Finance Society.

Last updated: 25 Nov 2015

This website is intended for financial advisers only and shouldn't be relied upon by any other person. If you are not an adviser please visit

The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London EC3V 0RL.