Forget Workie - is pensions tax relief the scary monster of pensions?

30 October 2015
Our response to 'Strengthening the Incentive to Save' part one
Who is Workie?

'Workie' is the face of the Government campaign to inform employers of their auto enrolment obligations.

Watch a video clip of Workie on YouTube.
Watch now

I don't really think Workie, the Government's latest attempt to get small and micro employers engaged in auto enrolment should be ignored, but it's important to stress that getting the tax incentives right is absolutely crucial to both workplace and individual pension savings.

I do have empathy for the Government on the tax incentivisation issue as they do have some monster problems to wrestle with, and some fundamental decisions to make. 

To give you an idea of the interrelated issues:

  • The Government already has a big deficit to contend with and is constrained by pre-election promises not to raise certain taxes or make cuts in certain areas.
  • Pension tax relief is estimated to cost the Treasury upwards of £20bn per annum (though there are significant issues in coming up with an accurate estimate)
  • The cost of the relief is projected to rise as more people are automatically enrolled and the opt out rate is much lower than initial Government estimates predicted
  • There is a growing recognition of the need to increase contributions to above the levels currently going in to pensions (particularly the most recent generation of DC schemes). Increasing the contributions would have a knock on effect to the cost of the tax relief
  • There are a number of commentators calling for the amount of pension tax relief to be distributed more equitably between higher and basic rate tax payers.  Currently a significant proportion of the relief goes to higher rate tax payers.

You can see from this non exhaustive list of issues why the Government believes the time is right for a rethink of the pension tax relief system. 

While the current system has much to commend it, I'd see it as highly unlikely that the EET system will be maintained without some other tax changes to help offset the cost.

So what are the likely runners and riders and how do they stack up on key criteria set down by the Government? 

 SimpleTransparentEncourage more savingBuild on AESustainable
Flat rate*
Yes – simple message of pay 2 and get 1 free.  This only works where the rate is 33%. Any other rate erodes simplicity of message.  Would have some technical challenges to overcome. 

Yes – builds on the current system of reliefs and governance.

Yes but for basic rate tax payer only.  Again this is dependent on the rate being 33%.  Can show this is still a fair deal for most higher rate tax payers too if PCLS is maintained.

No – any change to model at this stage is distracting.  Is easier to change than move to TEE model.  Post staging would be optimal time for any significant change.

Yes if combined by other measures to ensure effective tax relief is limited. Maintains tax flow from retirees.
TEE*
Unknown.  ISA comparison not easy to read across – ISA designed for different purpose (short to medium term savings). Would need to add complexity to repurpose P-ISA in any case (e.g. to limit withdrawal – could end up more complex)  

Cash ISAs commonly used where charges may not be seen as transparent.  It could be argued that retail funds do not currently have the same level of regulatory scrutiny and governance as pensions

Not proven and public may not trust any "promise" that funds won't end up being taxed later.  There would be less going into the pot too unless "incentive" at same rate as current reliefs

No – significant distraction at critical time.  Goal posts changed half way through the biggest intervention into retirement savings in decades.  Would stifle other developments


No – may help treasury now but stores fiscal problems for the future. No tax revenue from pensioners when money is needed to support the higher level of services they consume. If there is no tax on withdrawal there is nothing to prevent people taking whole fund at 55.
Also unsustainable from provider perspective as need to maintain two pension systems.

EET*
Can be made more simple through improving comms.  AE comms has shown the way with rebadging tax relief as Government Contribution. Pensions have been simplified by "freedoms" too.

Yes – model is known and engrained in policy.  Strong and improving governance in place.

Can encourage more saving if communicated better. The relief is valuable and we should be able to get this across.

Yes – no distraction as any change would be incremental.  Allows providers to invest in improvement to their proposition and service delivery.

Yes if other measures already available (e.g. LTA) are used as appropriate constraint.  Maintains tax flow from those in retirement.  There are other options for constraining the relief bill.

* read our handy definitions below

While this may provide a summary of the main proposals and some high level opinion (there is only so much you can put in a table) it glides over much of the detail and some key issues. 

I'd therefore like to provide a deeper insight into some of the main issues over the coming months, starting with: 

Flat rate

A taxing problem (and an opportunity) in moving to flat rate relief of say, 33%, for all levels of tax payer.

Auto enrolment and relief at source

A common way for members of pension schemes to get their tax relief is through the system known as relief at source (or RAS). 

Here the level of contribution made is grossed up by the basic rate of tax (higher rate payers can claim the difference in their tax return) and normally providers invest the higher amount in the pot immediately (later reclaiming the tax due from the Government). 

It should not cause any significant problem (relative to some of the other proposals) for providers to change their systems to increase the rate they gross up the contributions by.

There is a potential problem for auto enrolment (AE) minimum contributions.  To ensure increased tax relief (for basic rate payers) turns into increased savings, changes would need to be made to AE minimum contribution levels.  For example:

Current basis (marginal rate), AE minimum 

Date (phasing)Employer cont.Member cont.Govt cont.Total
10/12-09/17 1% 0.8% 0.2% 2%
10/17-09/18 2% 2.4% 0.6% 5%
10/18 onwards 3% 4% 1% 8%

If alterations were not made to the minimum levels then although the cost to the member reduces, there is no increase in the amount of saving (which is a key priority):

33% relief, no change to minimum

Date (phasing)Employer cont.Member cont.Govt cont.Total
10/12-09/17 1% 0.67% 0.33% 2%
10/17-09/18 2% 2.01% 0.99% 5%
10/18 onwards 3% 3.35% 1.65% 8%

To ensure that in any move to a flat rate of relief above the basic rate then the AE minimum levels should be changed as follows:

Proposed basis

Date (phasing)Employer cont.Member cont.Govt cont.Total
10/12-09/17 1% 0.8% 0.4% 2.2%
(+0.2)
10/17-09/18 2% 2.4% 1.2% 5.6%
(+0.6)
10/18 onwards 3% 4% 2% 9%
(+1.0)

In the proposed basis the overall total contribution increases due to increasing the gross level of the member contribution while keeping the net member contribution stable. 

This increases pension saving without increasing the cost to the member.  Should any change away from marginal rate be considered we would propose that this could be done from October 2017 to allow time for employers and providers to update systems and communications messages.

Between now and 2018 it is also important that we start the debate and build consensus around increasing the minimum level of employer and member contribution.  A practical next step could be:

Future basis

Date (phasing)Employer cont.Member cont.Govt cont.Total
? 4% 5% 2.5% 11.5%

The 1% increase in member contribution can be justified by significant increase in Government contribution and a corresponding increase in their employers contribution.

Flat rate and net Pay

Any change away from the EET system at marginal rate would cause specific problems for arrangements which work on a "net pay" basis. 

The net pay basis is where the pension contribution is deducted and passed on to the provider before the member is taxed and therefore they receive tax relief at their marginal rate (20/40/45% as appropriate) via the workings of their employer payroll – they are simply taxed less.

In any switch to a flat rate of tax, it is easier to see how those who are higher or additional rate payers could make a tax charge through their self assessment to account for the fact that they achieved 40/45% relief through pension contributions being deducted before tax. This would however result in many more people having to submit tax returns at a time when the Government is trying to reduce their use. 

It is much more difficult to see how to construct a system to ensure those who only obtain effective relief of 20% through the net pay arrangement would achieve the desired circa 33% rate.  Significant change would therefore be needed to the net pay system.

It could be argued that if changes were to be made to the tax system in any case that the net pay system (at least for DC schemes) could be retired and all DC pensions should move to the Relief At Source basis.

There are already anomalies in the net pay versus RAS systems - RAS allows individuals who have no taxable income to pay contributions and receive the benefit of basic relief tax at source. For those who have contributions deducted from salary under a net pay arrangement then non-tax payers get no tax relief on their contributions.

Devil in the detail

As you can see from just delving into one of the potential issues involved in a move away from the current EET marginal rate system there is a huge amount to be considered. 

It is therefore important for Government (and indeed all those involved in the pensions and long term savings industry) to think carefully about the interrelated issues, ensure they are understood, solutions found and importantly allow an appropriate amount of time to implement any changes properly.

Next time

Next month in part two of this series, I'll cover why TEE has no merit in incentivising saving but could cause social unrest, market distortion and the doubling of our pension communication problems.

Some handy definitions

Contributions to pensions are exempt from tax when they are made, but taxed when they are paid out to the individual.

Exempt: Pension contributions by individuals and employers are exempt from income tax, and employer contributions are also exempt from National Insurance contributions (NICs) (although total contributions are subject to both an annual allowance and a lifetime allowance).

Exempt: No personal tax is charged on investment growth from pension contributions while in accumulation.

Taxed: Pensions in payment are taxed as income, but individuals are able to take up to 25% of their pension fund as a tax-free lump sum on retirement. 

The pension system would still be able to work largely on the current EET principles but the rate at which tax relief is given would be changed from marginal rate (20/40/45% relief as appropriate) to whatever the defined flat rate is for all levels of tax payer.

There would be specific problems that would have to be addressed to make the Flat Rate work within the current EET system.

Taxed: Pension contributions by individuals would not receive the benefit of any tax relief.  The contributions would be made from taxed income and no uplift for tax could be given by providers.

Exempt: No personal tax is charged on investment growth from pension contributions while in accumulation.

Exempt: Pensions in payment would no longer be taxed as income

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: 20 Nov 2015

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