There has been a lot of talk over the past few months about yet more changes to pension taxation. Some commentators believe the Treasury is ready to remove tax incentives from pensions. Unlike many other rumours in our industry there is at least good reason to expect some changes. In July 2015 the Treasury began a consultation on pension reform. This consultation closed in September. The government has announced it intends to publish its response to the consultation in the 2016 budget.
The stated purpose of the consultation is to find the best ways to increase the incentives for people to save money in pension funds, hence the title of the consultation – “Strengthening the Incentive to Save”. It is also pretty clear, though, that the Treasury does not intend to increase the overall tax cost to the government from pensions, even though the consultation states that the government has a completely open mind on what reforms are needed.
In the consultation document the Treasury has stated that there is evidence that the amounts individuals are contributing to pensions may not meet their income expectations when they retire. This should not be news to any of us involved in pension planning!
The consultation indicates the contributions needed in order to make it likely an individual will be able to continue to enjoy in retirement a similar lifestyle to that enjoyed during working life. These figures were provided by the Pensions Policy Institute. As a percentage of salary, the required contributions are:
• 11% for low earners
• 13% for median earners
• 14% for high earners
Under current proposals, auto-enrolment will ultimately ensure employees have at least 8% going into their pension (4% from the individual, 3% from the company, and 1% from the government). This leaves a significant shortfall from the requirement, and it is this shortfall the government wants to address.
What the government hopes will happen is that changes can be made to the taxation of pensions which will encourage people to invest more in their pensions than the legal minimum but without increasing the amount contributed through the tax system. The believe further simplification of the pension system will help encourage people to put more into their pensions, although I think the experience of those of us in the industry is that this is unlikely to make much difference.
Currently the tax position of pensions is what can be called EET (Exempt – Exempt – Taxed). In other words, contributions and growth are exempt from tax but the money eventually taken from the pension is taxed. The consultations clearly shows the tax cost to the government of exempting contributions has increased significantly over the past few years.
The tax cost of contributions being exempt has been controlled through the use of lifetime and annual allowances, but this has still not reversed this trend. Some commentators have suggested one way making the system more affordable to the country is to change our system from EET to TEE (Taxed – Exempt – Exempt). In other words to tax the contributions, still allow the pension to grow free of tax, but then to allow the individual to take out the benefits completely tax free. This would more closely align the tax treatment of pensions with the tax treatment of ISAs – although pensions would still be more tax efficient than ISAs if they remained outside the inheritance tax regime.
A TEE system is most unlikely to encourage more people to invest more money into their pensions, which is the stated aim of the consultation. Why would anyone decide that now pension contributions are going to be taxed this means it is better for them to invest in pensions? It would also require grandfathering rules to avoid many people having the benefit of EEE, which would not be an affordable option for the government to consider. The consultation suggests simplicity is probably a key factor in encouraging people to save in pensions, although respondents have been asked to comment on this. Unless the results of the consultation are that a majority believe simplicity is irrelevant it seems unlikely they will wish to increase the complexity of the system.
I have reviewed the responses made to the consultation by the Chartered Institute of Taxation (CIOT), the Association of Taxation Technicians (ATT), and the Low Incomes Tax Reform Group (LITRG). These responses make clear that changes should only be made if they are really necessary in order to encourage greater saving, as every time the pension system is changed it causes a lack of trust by savers in the system.
The LITRG has proposed a single rate of relief on the contribution rather than the current system which gives greater relief to higher earners. The rate suggested is 33%, which they believe would be more or less tax neutral and which they feel would give the right encouragement to low and median earners to save more.
Other respondents have made similar proposals, with the suggestion of 30% being quite widely quoted.
Whilst anything could happen as a result of the consultation, it seems to me that single rate relief is the most likely direction the government will follow. This gives us a window of opportunity to encourage our high earner clients to invest as much as they can in their pension now. Although some commentators are suggesting the changes will be announced in the March budget but will not take effect until 2017 there is no guarantee that there will be such a delay or that there will not be interim arrangements to restrict relief in some way on large contributions.