Tom McPhail is head of policy at Hargreaves Lansdown.
Not for the first time, the prospect of an impending budget has prompted an outbreak of speculation around the possibility of pension tax reform. This is not to say the speculation is unfounded: this is the first time in around 15 years a government has the opportunity and the means to undertake meaningful reform of what has become a bloated and inefficient system, riddled with inconsistencies and inefficiency. The Chancellor should announce in the Budget a consultation to review the options available and then press on with reform as quickly as possible.
Many of the myriad problems with the system are the result of previous governments’ unwillingness to make tough choices. I’ve set out here a brief summary of the reasons why change is needed, why I think now is the moment to do it, and what the options for reform might look like.
The Conservative Party manifesto had already identified two specific problems which need addressing; the Tapered Annual Allowance, which has been landing high-paid workers, including key high-paid public sector employees such as doctors with punitive tax bills; and the net pay tax relief administration system adopted by some employers, which results in lower paid employees missing out altogether on their free government-funded tax relief top up to their pension.
The Pensions Policy Institute estimates that around 64 per cent of pension tax relief is enjoyed by the 17 per cent of the population paying higher or top rate income tax. It is hard to regard this as socially equitable; to give the least support to the most needy individuals and to give the most support to the wealthiest few.
This approach only makes sense when viewed through the logic of deferred taxation, whereby tax relief is granted now to avoiding taxing money paid into a pension until the ultimate withdrawal of that money in retirement, when income tax is then levied on the withdrawals.
When viewed as an incentive to save, though, tax relief clearly makes no sense to most people. Research by the pension scheme B&CE in 2015 showed that of people actually in a pension, 74 per cent either didn’t know how tax relief worked or weren’t even aware it existed. The Government is spending tens of billions of pounds a year (roughly £30 billion to £50 billion, depending on how you want to measure it), on a scheme which is largely unappreciated by the population.
Other problems are mounting up. The Lifetime Allowance, the cap applied to limit the overall amount that can be saved in a pension without extra tax charges kicking in, now acts as a penalty on those who have saved prudently or invested wisely. It cannot be right to penalise savers just because their investments have performed well.
Conversely, on death, pension funds pass on largely tax free, thereby creating a gaping hole through which tax revenues can leak.
Retirement saving among the self-employed is alarmingly low, with just 31 per cent currently actively saving in a pension.
The Money Purchase Annual Allowance cuts the maximum amount you can pay into your pension, from £40,000 a year down to just £4,000, once you choose to draw income from your pension. This would be fine if everyone stopped work in their 60s and stayed retired.
But they don’t; in fact the concept of ‘retirement’ is becoming redundant. Increasing numbers of people pass through a transitional process of tapping into their pension savings in their 50s, whilst managing an ebb and flow transition into retirement and not becoming fully economically inactive until their 70s. Currently this happens largely by choice, increasingly in the future it will be by necessity.
Into this muddled environment has arrived a Conservative government with a very different agenda from the one that reviewed pension taxation in 2015. Then, the review initiated by George Osborne ran aground on the rocks of opposition from the right-wing press and from a pensions industry that couldn’t see beyond its short-term interests.
Now, the world is very different. Auto-enrolment has transformed retirement saving, bringing ten million new savers into the fold and their employers are on the hook to pay for it, whether they want to or not. The 2015 Pension Freedoms which revolutionised the choices available for retirement income withdrawal also now demand people make more decisions. The challenge is no longer about getting people into pensions, it is about persuading them to engage with their savings and to save more.
Meanwhile, we have a Conservative government with a very different focus compared to the past. It recognises the need to address the interests of voters in those ‘Red Wall’ seats in the Midlands and North. Voters who in the main are not higher earners, who aren’t much interested in the principles of deferred taxation but who would know a good deal if it was presented to them. The challenge is to craft a good deal out of the existing system.
Unfortunately, you can’t touch pensions policy without upsetting someone. Any redistribution will mean losers as well as winners. Given the real winners today are the high earners (but not the very high earners, who have largely given up already and left the field), and members of final salary schemes, this is where opposition is likely to come from.
Employers are also likely to find themselves being asked to pay a little more; whilst employer pension contributions are still very generous in pockets of the economy, largely a legacy of the final salary system, for most of the ten million new joiners in the auto-enrolment system, employer contributions are around the statutory minimum of three per cent of pay.
So what changes could we see? To simply scrap higher rate tax relief would be an act of fiscal hooliganism; it would punish the high earners and severely undermine such self-employed retirement saving as does still exist, whilst doing nothing for lower earners. Subtler options include moving away from tax relief altogether, either in favour of a flat rate top up, or a combination of more generous employer contributions, combined with higher Treasury top-ups applied selectively. We think it is possible to create a new system where, in effect, every £1 paid into a pension by an individual would be doubled, either by their employer, or by the government.
Other aspects of the system potentially up for grabs include: imposing Employer’s National Insurance on their contributions, worth over £11 billion a year; introducing a death tax on pension funds; scrapping tax relief on workplace employee pension contributions (after all, why give tax relief if employers are doubling your money anyway?); or reducing the tax free lump sum at retirement, which would seriously undermine confidence in the system for the future.
Given the complexity of the system, the first step should be to open a consultation for review.