OpinionNov 24 2015

Is the chancellor coming to TEE?

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Is the chancellor coming to TEE?
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Is more radical change indicated by the postponement of the announcement?

That is unclear, but the fact the government is taking the time to give the issue detailed consideration is to be welcomed (albeit with some caution).

The consultation, which closed on 30 September, raised several wide-ranging questions, and the implications of some potential material changes are examined below.

Does the current system’s complexity undermine the incentive for individuals to make pension savings?

The government’s view is that pension saving should be simple and transparent and that one of the problems with the existing structure is its complexity.

While simplicity is a laudable aim, the current complexity has in large part been created by successive governments making almost annual changes over the past two decades, the last Budget in which some aspect of pensions tax relief was not changed being in 2007.

It is unlikely that pensions can be simplified while successive governments are unable to resist implementing multiple changes to erode tax relief.

This underlying problem is illustrated by the almost annual changes to which the “A-Day pensions simplifications” of 2006 have been subjected.

The impact of further reductions in 2016 to the annual and lifetime allowances emphasises the government’s inability to avoid seeing pension tax relief as a readily available source of income to the Treasury.

The majority of pension savers understand that contributions are made tax free and that pensions income is taxable at their marginal rate in retirement.

This is beneficial to all savers as, under the exempt-exempt-taxed (EET) regime, the investment of the additional untaxed portion of the contribution enjoys compound growth over the saver’s working life.

Repeated interference with pension tax relief by successive administrations undermines savers’ confidence in the stability of the system and should be resisted.

What about moving to a TEE structure?

Moving to a taxed-exempt-exempt (TEE) system would be a leap into the unknown and the figures used in the consultation are acknowledged to contain a significant margin of error.

There is also no regard paid to the impact on tax collection for future governments.

Adopting TEE would add complexity and cost in segregating existing pension savings made under the EET regime from future savings out of taxed income.

It is likely that individuals would be confused by their savings being taxed under the “old” and “new” regimes, and how best to access their savings in the most tax efficient way.

Such a fundamental change could create huge difficulties for employers in terms of changes to both payroll and pension administration systems. Member communications would also be challenging.

No changes should be made which would result in employers losing faith and reducing contributions made for their employees. It is unclear how a move to TEE might impact on the tax deductibility of employer contributions, and whether these could then be taxable as a benefit in kind.

The changes could impact adversely on members in other ways, either by subjecting them to a higher tax bracket, or affecting entitlements to tax credits or other state benefits.

If the government’s suggestion that pensions might be taxed on the same (TEE) basis as Isas is implemented, savers would simply to use Isas, from which savings are readily accessible irrespective of age.

Additional incentives would be required to save for retirement if upfront tax advantages were removed.

However, HM Revenue and Customs reported in August that the number of Isas taken out in 2014-2015 was the lowest since 2004-2005, which casts some doubt on the Isas’ supposed popularity as a savings vehicle.

A further danger is one of potential mistrust, as it is unlikely savers would believe that future governments could resist taxing pension withdrawals from TEE pots.

Generational issues could be caused, as the employed generation might not understand why pensioners receive tax free income in a future where there are likely to be increasing burdens on the health and welfare system.

Further change would only add to the confusion of those who have struggled to understand the implications of the Budget 2015 flexibilities.

Would an alternative system encourage greater individual responsibility for making adequate retirement saving?

The consultation suggests encouraging greater personal responsibility for pension saving when, conversely, the whole auto-enrolment regime is founded on members’ apathy to opt-out once enrolled by their employer.

The effort made by employers in communicating and implementing auto-enrolment for different worker categories should not be underestimated and the level of take-up among first-time pension savers is encouraging.

Any change to the basis on which contributions are made could have a detrimental effect on employees’ current, positive perception of auto-enrolment as a whole.

The resultant reduction in workers’ take-home pay (from a TEE system) would probably result in reduced levels of contributions, with related reduction in retirement income.

There is enormous potential for confusion and disengagement, among both employers and employees, if the tax basis for contributions is changed.

A move to TEE could have a major, negative impact on pension saving at a time when auto-enrolment is still in its infancy.

What, if any differential treatment for DB and DC pensions should the government consider?

The rise in state pension age and longevity prospects will necessitate longer working lives to generate sufficient retirement income.

Abolishing the lifetime allowance (LTA) seems increasingly a logical step to incentivise retirement saving, irrespective of level of earnings and whether members are DB or DC.

If the government’s aim is to encourage saving whilst reducing the tax relief granted on contributions, then retaining control over the annual allowance (AA) but abolishing the LTA would achieve that aim.

The multiple reductions in the LTA over recent years mean that the planned further cut in 2016 to £1m is likely to hit a section of the electorate which was never intended to be caught when the LTA was first introduced in 2006.

The AA has fallen from its original level of £255,000 to £40,000 for the current tax year. In addition, the new tapering AA will allow the highest earners (those earning above £210,000) to save only £10,000 tax free a year from April 2016. Such frequent changes have increased the burden on administrators, adding layer upon layer of complex protections for savings made when higher allowances applied.

DB and DC pensions are currently treated differently in the way that the LTA applies to the valuation of savings. With an LTA of £1m, a DB member would be able to accrue an annual pension of £50,000 before reaching the limit.

By contrast, a DC member could receive as little as half that amount in pension if he purchased an annuity with similar levels of inflation protection, payment guarantee period and spousal benefits.

Such an imbalance is counter-productive at a time when the government hopes to encourage mass take-up of savings in a DC environment by way of auto-enrolment.

Clearly, this discrepancy in valuation for LTA purposes currently favours those in DB schemes.

However, the problem is not solved simply by changing the DB valuation factor and some of those to whom it would apply would not necessarily be classed as “wealthy”.

If the DB valuation factor applied at a rate of 25:1 (for example), any person with a DB pension of more than £40,000 would be affected by a penalty tax charge once the LTA is reduced to £1m.

This further supports the argument that the LTA should be abolished completely and tax free pension saving should be controlled through the AA alone.

This would allow individuals to increase the length of their working life without suffering penalty through lower tax relief on pension savings at a time when the government needs to encourage later retirements.

How can the government make sure that any reform of pension tax relief is sustainable for the future?

The government must have regard to the call for stability. It is impossible to encourage pension savings when the goal posts are changed annually.

Pensions tax relief should not be used by the government as a readily-accessible fund to be plundered whenever a fiscal hole needs plugging.

Savers need to be confident that the pension promises made during their working lives will hold good until after they start drawing their pension.

It is easy to see the attraction in the short term to the Treasury of reducing pension tax relief for high earners.

However, the government should be wary of rendering pension saving meaningless to those high-earning employers that it hopes will continue to provide worthwhile pension schemes to their staff.

It is essential to retain employers’ engagement with pension provision on a personal level for there to be a possibility of future workers enjoying pension contributions above the statutory minimum under the auto-enrolment regime.

The government should tread with caution.

Eradicating the highest earners’ personal interest in pension saving by removing their contribution tax relief could simply accelerate the closure of the more generous occupational schemes, as employers leave their employees to save at the basic level required for auto-enrolment compliance.

Pension savers could be forgiven for succumbing to “reform fatigue” and losing interest completely, as the rules change with such regularity. The complexity of the transitional arrangements for the 2015 to 2016 tax year alone are enough to baffle all but the most intrepid.

It appears that employers, advisers and pension savers are to have their endurance tested to the limit as successive governments display their inability to legislate for pension tax relief in a way which is fair and comprehensible and fiscally responsible, and which is sufficiently logical to withstand the test of time.

Lesley Harrold is a senior knowledge lawyer at Norton Rose Fulbright