Craig Mackinlay MP - New proposals to encourage pension saving

The document from HM Treasury published in July 2015 “Strengthening the incentive to save: a consultation on pensions tax relief” has been out for consultation for some time, with replies sought until 30th September 2015. We should be able to glean the direction of travel that HM Treasury is considering within. This paper is in response to that document and the multitude of published views across various think tank bodies such as the IEA and industry professionals.

It is a well written document which lays out recent trends in pension savings, the effects of increasing life expectancy, the impact of pension freedoms that came in from April 2015 and the new State Pension coming in from April 2016. It also considers increases to retirement age which has seen feverish campaigning, particularly by Women against State Pension Inequality (WASPI). Further increases to state pension age beyond the 1995 changes came from the Turner Commission’s Report on Pensions of 2005, enacted into an acceleration of State pension Age extension within the 2011 Pension Act to reflect a more rapid increase of life expectancy than previously forecast.

It would be fair to say that recent years have seen little short of a pensions’ revolution, across state, public and private sector pensions. Whereas decades ago, the UK had a healthy pensions outlook, much of which was underpinned by the certainty (for employees) of Defined Benefit Schemes (aka final salary schemes), Gordon Brown’s changes to dividend taxation in 1997 preventing pension schemes from being able to reclaim Advance Corporation Tax, the implicit tax credit on dividends took a significant slice out of schemes’ income and future compounding growth. The cost of this raid  was calculated in 2006 by Terry Arthur, a fellow of the Institute of Actuaries, at £150bn. The 1997 changes can fairly be blamed as the start of the end of final salary schemes within the private sector, adding to the pressures that increased life expectancy and lower investment returns (often UK Govt. bond interest) brought to such schemes as well. Not unexpectedly, but somewhat shamefully in the national context, the growing pensions overhang within public sector schemes was kept within the “too difficult box” for close to two decades, until recommendations of Lord Hutton’s 2011 report were finally implemented in 2015 into new career average arrangements, higher employee contributions and less generous accrual rates. Auto-enrolment is forecast to increase dramatically the percentage of the population building a personal fund, but low investment returns and suppressed annuity rates means a meaningful retirement income needs to be founded on a substantial fund, unlikely to be built sufficiently on minimum statutory contribution rates within Auto-enrolment as proposed.

Budget 2015 (July) changes to dividend taxation will seal for good any opportunity to revisit the arguments for reclaimable dividend tax credits, as the whole concept of them falls away entirely under the new dividend tax regime after April 2016.

Further tax restrictions to Lifetime Allowances (amounts able to be held tax-free within a pension fund) and tax efficient annual contribution allowances, whilst estimated to have saved the public finances £6Bn per year, have added complexity and confusion. This lays, in summary, the backdrop to the Treasury’s consultation document and this paper. It would be fair to say that to get to pension reform you wouldn’t want to start from here. There is a perfectly reasonable argument that could be advanced that questioned entirely the role of the state in trying to manipulate the tax system towards behavioural change regarding pensions and many other areas. An argument that says there should be no tax relief at all, linked to lower taxes throughout the personal tax system allowing people to make their own decisions with more disposable income left in their own hands, but realistically that is unlikely to happen, with more meddling undoubtedly on the agenda.

Therein is the great problem with pensions over the past 20 years: shifting sands, tinkering and uncertainty by the government as to its direction. For the pension investor, the great questions to be answered personally “will there be another change of direction?”; “is putting good money away today worthwhile for a hopeful return in the future?” Little wonder that many who are able have chosen ISAs as their preferred choice; obviously no tax saving on the way in, but total freedom to cash in at any time without limit, and the (hopeful) certainty that future income streams will be tax free. Others may have chosen the route of “buy to lets”. Again the ability to cash in at any time, growing rental returns that are generally index linked, and the moderate long term expectation of capital growth. Budget 2015 (July) changes casts doubts on this route with phased restrictions to deductibility of finance charges. New entrants are likely to be deterred further by the new 3% stamp duty surcharge from April 2016. Readers will by now have a reasonable inkling as to my preferred retirement income strategy. But I digress, the main purpose of this paper is to consider what, if any changes are desirable to influence positive behaviour towards pension independence and affordability to the public purse in any changes to pension tax relief.

The start point is the consideration of the current system of “Exempt-Exempt-Taxed” (EET). Exempt from tax by relief on the way in, exempt from tax on income during the accumulation period, but taxed as PAYE income on the way out and forming part of the income mix within a taxpayers retirement tax affairs, having no unique tax feature to that income and with 25% of the accumulated fund allowed tax free upon retirement. This well-trodden system has been subject to restriction as to the size of the Lifetime Allowance, introduced at £1.5 million in 2006, increasing to £1.8 million by 2010, and now marching back down the hill to £1 million from 2016 to rise again later by inflation. Further, the annual amount that can be invested, receiving full tax relief at the highest marginal rate (up to 45% above income of  £150,000, or even 60% in the band above £100,000 of taxable income to £100,000 plus 2 x the personal allowance: £121,800 for 2016/17 tax year) has been successively restricted from £255,000 per year in 2010/11 to £40,000 today, but again this is not the end to the complications in the tax system relating to pension contributions, with Budget 2015 (July) introducing tax relief restrictions from April 2016 to those with earning over £150,000. At earnings over £210,000 full tax relief on just £10,000 of pension contributions will be available. This measure was the quid pro quo for changes to Inheritance Tax, allowing an extension of IHT reliefs to £1m for a couple when including the family home. Do keep up! The restrictions above form the £6Bn of calculated annual savings as of today.

It is therefore obvious that higher earners, within higher rates of tax have seen the lion’s share of tax relief, and consequently current pension rules, despite successive restrictions, remain desirable to the higher rate taxpayer. Again, giving away a little more about my own investment strategy, why do I, as a higher rate taxpayer have any interest in making SIPP related pension contributions? There is a primary answer with a few other peripheral considerations – to save tax and receive a 40% contribution by HM Treasury to my pension fund. Additionally, the swap of higher rate tax relief today, and with other planning, the possibility of paying at just basic rate upon pension income at retirement is also a powerful persuader. The tax cushion is also useful in uncertain markets, with my own “seed money” protected a little by government tax subsidy in market downturns. If employers make pension contributions directly, in agreement for a salary sacrifice, there are the usual tax savings, but also employer and employee National Insurance savings as well due to base salary reductions. This is the complication that I fear will lead to complex drafting of any changes if advanced in the March 2016 budget.

So it is fair to say, for higher rate taxpayers, that the reason for pension contributions has little to do with the goal of saving for the future; other savings and investment strategies will probably see to that based on surplus income beyond expenditure on an annual basis. The main goal is tax relief. For 2013-14, total tax relief on pension contributions is published as a fairly staggering £31.3Bn (so probably nearer £35Bn for 2015/16). The Treasury document considers total reliefs, including national insurance losses to be close to £50Bn per year. Now we’re into the realms of significant inroads into the current budget deficit. I have been unable to find a breakdown of how this tax relief is distributed across basic rate, higher rate or additional rate taxpayers, but I would estimate that the relief is skewed towards the higher and additional rate tax payer.

To my mind, it is the basic rate taxpayer that needs encouragement into pension saving. Whilst the document suggests that lower income groups do not consider the tax saving as a key driver, and that pension saving is simply done as a good in itself, any tax consideration by a basic rate taxpayer would simply conclude that the “good money today, promises tomorrow” nature to pension saving represents a fairly unexciting prospect. On purely fiscal terms there is a deterrence to pension saving by basic rate (or increasingly by non-taxpayers under successive welcome increases to personal tax allowances: to be £11,000 by 2017/18). Whilst non-taxpayers can invest up to £2,880 and currently receive a tax “top-up” of £720 by the government, this is rarely done, not least due to inertia in the provider market. But realistically how much spare savings cash is really available to the non-taxpayer or even the basic rate taxpayer, beyond a windfall or family gift, to enable significantly increased pension saving to be made?

The Treasury document suggests that all options are open to discussion, whether an ISA style “Taxed-Exempt-Exempt” (TEE) system would be preferable. No tax relief on the way in no matter what tax status you are, but accumulation income growing tax free as now, with ultimate returns of income outside of PAYE. Questions arise – would all be able to be taken out as with current ISAs, or could we see an upset to the long-established ISA rules that rolls old ISAs into new rules to encompass new Pension ISAs with capital extraction restrictions? How much confidence would the taxpayer have that a subsequent government might argue for tax on the way out in the future as well “Taxed-Exempt-Taxed” (TET).

What might emerge, more importantly – what should emerge

As ever in tax, what might and what should are two different things. As a Chartered Accountant and Chartered Tax Adviser, the close to 20,000 pages of UK tax code (vs Hong Kong’s 235 pages) is way too complex already. My fear is that change will simply add to an already burdensome regime, particularly if an appealing “flat rate” of relief, as seems to be emerging is advanced. But this is not a reason to do nothing.

I do see appeal in a flat rate, and it is not an alien concept as a tax reducer, rather than a tax relief at source. Similar exists in tax relief under Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCTs) whereby, if a taxpayer has paid sufficient tax during the year, 30% of the EIS investment is returned as a tax refund, not related to the marginal rate of tax that the taxpayer is in. Obviously such schemes are more likely to be used by well advised, and well-heeled sophisticated investor, most likely to be a higher rate taxpayer as well (but the IHT reliefs and CGT hold-over reliefs play a part in considering such investments). The existing concept of small pension contributions by non-tax payers being topped up by HM Treasury explained above, albeit by added contribution to the scheme is not wholly dissimilar either. Rates already suggested are between 25% and 33%. My plea is to at least mimic tax rates deemed appropriate in other parts of the tax system, so please let’s choose 30%.

The main problem arises in salary sacrifice arrangements, and this is where pages of anti-avoidance legislation could slip in to counter an obvious potential abuse. What would be recognised as avoidance – current defined benefit schemes? Employers deciding to reduce an expected salary increase to take account of new employer contribution requirements of Auto-enrolment? New employer contributions at any level? A bad trading year? Would this be dealt with as a tax and NICable benefit-in-kind?

My proposals

It would be easy to advance a complete redesign of the system, however I would prefer to advance merely an evolution that retains as much of the existing and understood parts of the current system unchanged.

  • A flat rate of tax subsidy relief of 30% up to the amount of tax paid by the taxpayer (akin to EIS) whilst retaining existing top-up available to basic-rate and non-taxpayers by the government. Higher rate taxpayers would suffer a reduction in relief, but basic rate taxpayers put at an advantage to encourage saving. For a basic rate taxpayer, using 2017/18 pre-published rates, a taxpayer earning just at the lower rate/higher threshold of £43,300 in 2017/18, personal allowance £11,000. Total basic rate tax paid (£32,300 x 20% = £6,460). Total pension contribution possible to maximise 30% tax reducer - £21,533 {x 30% = £6,460}.
  • Salary sacrifice of up to £10,000 not recognised. Some tax and NIC loss but a significant measure to reduce complexity and would exempt a huge majority of normal behaviours from coming within benefit in kind anti-avoidance legislation.
  • A restriction to “tax free” lump sums to 25% (as is) or £50,000 whichever is the smaller. This would again skew favour towards smaller pension savers and basic rate savers who would be unaffected, limiting attractiveness of pension saving further away from the higher rate taxpayer.
  • First £5,000 of pension income to be tax-free up to the higher rate threshold, thereafter to the higher-rate taxpayer, this portion of retirement pension to be taxed in a way similar to UK-based single premium investment bonds, deemed to have suffered basic rate at source. This would mirror many features of the new dividend tax regime together with the new extension of tax-free interest income. With personal allowances increasing to £11,000 in 2017/18 and the new flat rate State Pension of £155.65 pw, this will extend freedom of tax to most pensioners, many of whom feel aggrieved following years of saving for a degree of self-provision now faced with a requirement to pay tax at moderately low levels of overall income, whilst other measures within the tax system at similar income levels allow tax-free receipts.
  • Other aspects to the new pension freedoms and taxation thereon to remain unchanged.

The savings to the Treasury of these proposals

Large pension contributions by higher rate taxpayers would lessen, with a greater take-up by basic rate taxpayers, this is the behavioural benefit. There would be a small loss of tax on future income arising out of pensions by those on lower incomes. Overall, I estimate an additional annual saving to the public purse in restricted tax reliefs borne particularly by higher rate and additional rate taxpayers to be in the order of £10bn per year.