Will Treasury pensions tax reform put the brakes on Auto Enrolment success?

30 July 2015

The Chancellor’s summer budget also sounded the starting gun for potential reform of the pensions tax regime. HM Treasury published its consultation paper entitled ‘Strengthening the incentive to save: a consultation on pensions tax relief’ the same day as the Summer Budget. But what does the 23-page document tell us about which way the wind is blowing in the corridors of power and what changes are likely to be rubber- stamped once consultation process concludes at the end of the summer?

If you read between the lines of this document there is no doubt that the Treasury is worried about the rising cost of its annual pensions tax relief give-away that is of course increasing exponentially with Auto Enrolment bringing so many more employees into pensions savings. Since 2009/10 the Government has seen a jump in the tax relief it has paid out from about £30bn to nearer £35bn last year.

It continues to rise despite near continual falls in the Annual Allowance (the amount you are allowed to pay into your pension without incurring a tax hit) from £215,000 in 2006/7 to £40,000 today and the Lifetime Allowance (LTA) from £1.5m down to £1m. Following Pension Freedoms, once you have started accessing a pension flexibly your money purchase annual allowance (MPAA) for DC schemes falls to just £10,000. AA and LTA restrictions alone are projected to save the Treasury about £6 billion annually.

However if you include relief on both Income Tax and National Insurance Contributions (NICs), the government forwent nearly £50 billion in the last tax year (2013/14). You could also argue that the current pensions tax regime is in inequitable as higher rate taxpayers get much more benefit from tax exemptions than lower income basic rate taxpayers as contributions go into their pensions. And yet, when they come to withdraw these savings, they are generally taxed at the basic rate of 20 per cent once their incomes have fallen steeply in retirement.

The inequity of the current regime, as detailed in The Institute of Fiscal Studies (IFS) savings tax reform study and also reinforced by thinking from the Centre of Policy Studies (CPS) is clear. Michael Johnson at the CPS has long campaigned for a pension tax regime to be switched from the current Exempt-Exempt-Taxed system (or EET) to the Taxed-Exempt-Exempt (TEE) system of tax payment mirroring the system used for ISAs. He goes further to recommend that DC pensions be replaced by what he calls Lifetime ISAs, while occupational schemes become Workplace ISAs.

EET means that pensions contributions by both individuals and employers are Exempt from income tax, while employer contributions are also exempt from NIC (although total contributions are still subject to both an Annual Allowance and Lifetime Allowance).

It also means that pension contributions are Exempt from personal tax on investment growth while in accumulation, subject to lifetime allowance. Then finally they are Taxed on pension payments as income, except for 25% of the total sum which can be taken out as a tax-free lump sum.

After a great deal of deliberation the IFS concludes that the current EET system should be retained but that this should be accompanied by “the removal of the excessively generous and distorting treatment of employer contributions (i.e. allowance of NIC relief in addition to income tax relief on pensions contributions).

The IFS report adds: “The tax-free lump sum is an odd method of providing an additional incentive for saving in a pension.” The IFS favours replacing TFC with a reduction in tax rate paid on pension withdrawals.

It is impossible to know which way reform will go at this stage. However, the Government’s main dilemma is making sure they do not change the pensions tax regime so much that it derails the golden goose in UK pensions savings terms i.e. Auto Enrolment.

Anything that makes it more expensive for employers to stick with AE is a problem, especially as AE minimum contribution levels will rise anyway from 2018 to 8% of income (3% of which will need to be paid for by the employer) and increase further after that by all reports. In summary, the Treasury’s quest to boost the nation’s coffers (or at least reduce its deficit) short-term, cannot come at the expense of undermining the much more valuable and longer-term retirement savings success story that is Auto Enrolment.