A Simple Plan

How to improve the pension tax system

Along with the State Pension triple lock, pension tax relief has been, and is, a major topic of conversation in the retirement space with many advocating reductions in tax relief for higher earners in order to increase reliefs for those currently receiving relief at the basic rate.

Since Pensions Simplification, the system has been tinkered with to the extent that we now have a complex morass of rules designed to reduce the cost of reliefs without any coherent strategy.

Historically, pension tax reliefs were given on the basis that contributions were deferred pay and the investment funds were tax relieved so as to improve the returns to savers. The tax reliefs given at outset were recovered when the income was finally taken in taxable form. The tax free lump sum was an anomaly but one which is so ingrained in the minds of savers that it is hard to see how, politically, this could be taken away.

However, since the 1980s, the pension tax relief system has been under constant attack by Chancellor after Chancellor. Nigel Lawson introduced the pensionable salary cap and later Gordon Brown attacked dividend payments. And there have been multiple changes to the rules in the intervening years that have increased complexity and reduced the attractiveness of pension saving. 

Then came pensions simplification which united the DB and DC tax regimes in the hope of providing a simpler pension system which could stand the test of time. The Annual and Lifetime Allowances were seen to be reasonable at the time and were set to increase with inflation so their real value wouldn’t be eroded. And bear in mind that the Lifetime Allowance was said to be the approximate amount of pension fund that a 60 year old would need to buy a pension of 2/3rds of the salary cap including spouse’s pension and escalation in payment. This was at a time when the Bank of England base rate was 5.0%.

The defined benefit conversion factors of 20:1 for fund to pension and 10:1 for contribution to pension are now hopelessly out of date and confer an enormous advantage on those with DB pensions. For example, someone with a defined benefit pension of ￡40,000 per annum would have an implied fund of ￡800,000 (20 x ￡40,000). The cost of actually purchasing that pension for a 60 year old (2/3rds spouses and RPI indexation) would amount to ￡2.35m at today’s annuity rates. Even with 3% escalation the cost would be approaching ￡1.9m.

So defined benefit pensioners not only have the comfort of an employer sponsored guarantee, but much more favourable tax treatment from the simplified regime.

Proposals for Change

When looking at the statistics, it becomes clearer where the cost of the reliefs given to pensions arise:

Source                                                                                      Cost (￡m)

Occupational Pension Scheme Contributions                          ￡22,800

Personal Pension Scheme Contributions                                  ￡  7,700

Investment Income on Pension Funds                                      ￡  6,700

Less Income Tax Received on Pensions in Payment              - ￡18,300

Employee NIC Relief                                                                  ￡  5,300

Employer NIC Relief                                                                   ￡11,200

                                                                                    Total       ￡35,400*

Of the ￡35.4bn net cost of pension tax reliefs in 2017/18, more than half (￡18.6bn) was in respect of employer contributions to occupational pension schemes, reflecting no doubt, the cost of contributions to plug funding deficits. Roughly 1/3rd (￡11.2bn) of the cost of reliefs is on employer’s NIC savings

The average contribution rate for a defined benefit scheme in the private sector is 25.6%~ of pensionable earnings (split 19.2% employer and 6.4% employee) whereas for defined contribution schemes the average is a mere 5.0%~, split 2.7% member and 2.4% employer.  As can be seen from these numbers, a large part of the cost of pension tax reliefs are from defined benefit pension arrangements. These schemes are in decline already and will continue to do so. The amount contributed and the reliefs available to them will reduce over time, so the high cost of pension tax relief will correct itself. 

So, what are my proposals for change? In relation to tax relief, I don’t believe that much is needed to be done. The majority of relief is given to DB occupational schemes and as these wither in value as people retire, die or transfer out, or indeed interest rates rise, the need for large contributions will diminish.

The main proposal is the removal of the Lifetime Allowance. This is a pernicious rule as it penalises those who exhibit good behaviour – people who monitor and manage their pension funds in order to maximise the value for their retirement. Limiting the tax reliefs given on pensions should be do-able through controlling the Annual Allowance (as has been done already).

The next change is the removal of the pensions taper on contributions. There are easier and less complex ways of controlling tax relief than this overly complex rule.

The final change is the separation of the pension regimes for DB and DC pensions. It is clear now that these rules are manifestly unfair. For someone in a DC pension to need almost three times the pension fund to provide the same pension as the notional fund for someone in a DB scheme is preposterous. Added to which is the fact that the DB pensioner bears few of the risks that apply to the DC pensioner.

Once the regimes are treated separately then rules can be applied to the specific cases of DC and DB pensions which more accurately reflect the circumstances in which these schemes now find themselves. After all of the initial excitement, it seems that Pensions Simplification has not lived up to its billing!

These three simple changes will bring great simplicity and clarity to pensions legislation and make it easier or those saving for their retirement to do so with a proper understanding of the rules that will apply to them.

Controlling reliefs will, in the long term, correct itself as defined benefit schemes’ liabilities are expunged. If any shorter term measures are needed, these can be handled through straightforward changes to the amount of the Annual Allowance.

* Source: HMRC Table 6 Cost of Pension Tax and NICs Relief (September 2019)

~ Source: Office for National Statistics Occupational Pensions Schemes Survey, UK  2018 Section 9.