EET migration to ISA-style TEE pensions looks attractive on the face of it but the devil is in the back office detail

4 November 2015

The Government’s consultation document (HMT CM9102) raises the possibility of substantial change in the taxation of pensions. The starting gun on these changes could be fired by George Osborne in his Autumn Statement on 27 November in just one month’s time!

We all know what this is about – reducing the country’s debt burden and eventually balancing the books. And there is a lot of money at stake: in 2013-2014 tax year alone tax relief on individual contributions to pension schemes from untaxed income added up to a £27bn tax relief loss to the Treasury.

If you add the other incentives to lock up our money for retirement including national insurance contributions (NIC) relief for employer contributions at £14bn; £7bn for not taxing investment earnings during accumulation; and finally £4bn for the tax free lump sum on withdrawal, there is a total of £52bn put up by the Government each year. And this figure is rising fast as Auto Enrolment hits its straps and baby boomers retire at the rate of 700,000 or more each year. It is understandable that the Treasury should level its fire at the largest of these numbers by thinking hard about taxing contributions on the way in rather than at decumulation.

So this explains why HMT is giving serious consideration to moving away from the current UK pension tax regime Exempt-Exempt-Taxed - abbreviated as EET – meaning that pension saving is Exempt from income tax (and), returns on pension savings are also Exempt from tax when they occur but pension income is subject to income tax (but not NIC) at point of decumulation.

Michael Johnson at the Centre of Policy Studies (CPS) has been the most vocal supporter of moving to Taxed-Exempt-Exempt, or TEE, which means that pension savings will be taxed on the way in, Exempt at point of saving or when asset returns rise as well when pension income is drawn.

This would bring pensions savings into line with the tax regimes of ISA as well as mortgage contributions. It seems to suggest simplicity and as ISA saving is currently going from strength to strength, you could be forgiven for thinking it will stimulate an uptick in saving for retirement. Michael Johnson’s team has the ear of the Treasury and providers are now beginning to look at what changes they would need to make in order to accommodate a switch from EET to TEE.

The economists’ verdict of this move is almost universally negative. The National Institute of Economic and Social Research (NIESR) study on this issue reports that it will negatively impact the level pension savings, hit consumption, incomes, productivity and GDP. It will also hit younger people’s pockets harder than older ones (mainly to do with people switching more assets from pensions into the more liquid asset of housing - further increasing prices and concentrating wealth into the hands of those that have the funds to play this expensive game). They even predict it will force increases of interest rates on the Government’s indefatigable debt mountain - now that really would be an own goal.

Macroeconomic black-marks aside, let’s look at the administrative challenges of moving to TEE. Like all changes of this magnitude, the problem is not just about implementing the new tax regime for future pension policies from April 2016/17, but managing legacy pension pots alongside the new ones. Firstly, taxing contributions in TEE is not straightforward, especially for employer contributions which are often pooled across groups of employees with different marginal tax rates, administration of which would become very complicated as a result.

More significantly, in the transition period (which for DB schemes may need to be as long as 60 years according to one provider I spoke with), providers would have to segregate savings built up under the current EET regime from those built up under the new tax regime. This ‘duel-running’ administration, as it is often called, could prove costly if not managed very carefully.

In our view providers which operate physical splits between asset types (uncrystallised versus crystallised assets for example) in which they literally migrate customers’ assets into different underlying funds with different risk profiles for example, may face considerable administrative upheaval. They may be having to administer up to four separate pots (2 governed by EET and a further 2 by TEE covering uncrystallised and crystallised assets).

They must also report meaningfully on this back to the customer – giving him a consolidated view of all assets and what income these funds are capable of delivering in retirement. For some already dealing with numerous legacy issues this will be an extra admin headache, meaning additional costs they could do without. Inevitably some of those costs will be passed back to the policy holder over time.

We have looked at how the changes could be applied in Imago. Providing funds are split on Notional rather than Physical lines it is relatively straight forward to create a new pension ‘arrangement type’ with new rules being applied thus accommodating TEE-governed funds when they take effect for new payments. But pensions administration does not begin and end in the back office. For example HMRC now demands submission on non-taxable income so RTI submissions will still have to be made at each decumulation event, even when tax is not due as in TEE-governed pots. Illustrations will need to be created to support each arrangement and accurate consolidated view provided annually -ideally delivered online going forward.

The other question is around mitigating tax at decumlation. It is entirely understandable that those with both EET and TEE pots will want to take their EET tax free cash lump sum first. Next they might cash up their TEE pots as there is no tax to pay on exit there either, while the bulk of EET pots will be kept intact for longer – potentially reducing the Government’s tax take substantially. It begs the question will the Government have to insist that you cash in your older EET pot first to help boost their ailing coffers? For that matter will future governments go further and introduce income tax on pension withdrawals – creating the nightmare TET tax regime? The existing government cannot prevent this change being made by future governments whatever they say.

The other question is, will different annual and lifetime allowances be instituted for EET and TEE pots? Another potential administrative horror story could surround pensions transfers and consolidation in a post-TEE reform world. In a world where your smaller pots do not follow you from employer to employer; combined with the fact that Gen Yers aged under 30 today are also unlikely to stay with one employer for more than four years; it is inevitable that people will want to reduce administrative costs and resulting paperwork by consolidating smaller pots into one or two larger ones.

But the shiny new larger one could now be governed by TEE. Will this mean that anyone consolidating will suddenly find themselves with a tax liability that they would not have incurred if they kept it in a myriad of poorer performing legacy EET pension policies? If so will the tax change actually discourage optimisation of pension savings?

One further consideration is that some life assurers are not geared to running ISA books. Will they have to buy in ready-to-go ISA admin systems to make sure they are ready to trade in new TEE pensions? If so they have high upfront implementation costs to contend with and then the complexity of resourcing and managing administration for two different systems for the same customer ongoing.

The ABI has proposed an interesting alternative of flat tax relief at 25-33%. The ABI’s figures based on this percentage range, and when applied to defined contribution (DC) alone, could yield sustainable tax relief savings to HM Treasury of around £1.3bn per annum when coupled with reductions to the Annual Allowance. Is that enough?

Finally, we are at the very point where employers and employees desperately need incentivisation to auto enrol and ideally pay more than statutory contribution amounts to build up sufficient pots to retire in comfort. Flat rate tax relief, perhaps repositioned as a ‘saver’s bonus’, surely seems a more sensible and sustainable approach - one that doesn’t risk de-railing the AE success story as smaller firms start to move towards their staging dates next year and micro businesses in 2018?

The Government seem to be running for cover on tax credits following defeat in the House of Lords this week jeopardising a potential £4.4bn boost to the Treasury. Let’s hope that they won’t press ahead with EET to TEE pension tax reform in their increasingly desperate quest to reduce the deficit.

Natanje Holt, Managing Director Dunstan Thomas Holdings Limited.