Don’t bite the hand that feeds us

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The Government has been consulting on changing the current pensions tax relief regime to cut the amount it ‘gives away’ each year. HM Treasury published its consultation paper entitled Strengthening the incentive to save: a consultation on pensions tax relief on the same day as last summer’s Budget.

If you read between the lines of the 23-page document there is no doubt that the Treasury is worried about the rising cost of its annual pensions tax relief giveaway that is increasing exponentially with auto-enrolment bringing so many more employees into pensions savings. Since 2009/10 the Government has seen a jump in the tax relief it has paid out from about £30bn to nearer £35bn last year. However, if you include relief on both Income Tax and National Insurance Contributions (NICs), the Government relinquished nearly £50bn in the 2013/14 tax year.

You could also argue that the current pensions tax regime is inequitable as higher rate taxpayers get much more benefit from tax exemptions than lower income basic rate taxpayers as contributions go into their pensions. And yet, when they come to withdraw these savings, they are generally taxed at the basic rate of 20 per cent once their incomes have fallen steeply in retirement.

This inequity, as detailed in The Institute of Fiscal Studies’ (IFS) savings tax reform study, and also reinforced by thinking from the Centre of Policy Studies (CPS), is clear. To fix this, Michael Johnson at the CPS has long-campaigned for the pension tax regime to be switched from the current exempt-exempt-taxed system (or EET) to the taxed-exempt-exempt (TEE) system of tax payment mirroring the system used for ISAs.

But after a great deal of deliberation, the IFS concluded that the current EET system should be retained but that this should be accompanied by “the removal of the excessively generous and distorting treatment of employer contributions (that is, allowance of NIC relief in addition to income tax relief on pensions contributions). The IFS report added: “The tax-free lump sum is an odd method of providing an additional incentive for saving in a pension.” The IFS favours replacing the tax-free cash (TFC) with a reduction in tax rate paid on pension withdrawals. The ABI favours moving to a simpler but perhaps less generous flat tax relief regime or ‘saver’s bonus’ based on 25 to 33 per cent of contributions. Tisa has even gone as far as to cost a saver’s bonus at 33 per cent and has found it to be eminently affordable.

So now that all the options are on the table, what will the Chancellor decide to do? We all expected an announcement from him on this in his Autumn Statement last month, but it did not come. Still, there is no doubt George Osborne has been looking at pensions tax relief changes over the next month as he will need to determine how much new money is likely to be coming into the Treasury before he finalises his spending plans in time for the spring Budget on 16 March.

If he succumbs to the ‘dash for pensions cash’ by reaching for the nuclear option of TEE, I believe the changes may look good for the Treasury in the short term, but longer-term it will spell disaster for future governments, UK plc as well as the next generation of pensioners. Worse, it opens the door for future governments (in yet another fiscal tightening cycle) deciding to go to a so-called ‘TET’ regime – taxing pensions savings on the way in and out – thereby killing them off for good.

I say this because pensions tax relief is the key incentive for saving sensibly for retirement, just as Income Tax and NIC relief is one of the major incentives for employers to pay generously into workplace schemes. Pensions Tax Relief is what stimulates employees and employers alike to pay in and keep paying in throughout their working lives.

The current EET regime, which promises to tax savings as they are taken out, also serves to encourage savers to keep their money in for longer and not denude their pension pots too early. This brake on consumption in retirement has, of course, become a much more socially important issue since the new pension freedoms regime offered over-55s the option of cashing out early without purchasing an annuity.

The result of keeping pots invested in pension funds is that these funds are effectively recycled into UK plc to enable businesses to invest for long-term growth. Healthy businesses, of course, provide greater security for their employees who can then keep paying into their pensions. Healthy corporate balance sheets also result in healthy corporation tax, income tax and NIC receipts. It is a virtuous circle which works for the wider health of the whole economy.

However, more importantly, it puts fewer future pensioners in the unenviable position of relying on the new Universal State Pension for their core income in retirement. Now we know that the new flat rate State Pension will deliver £155.65 per week or about £22 per day when it starts next year, it ought to be the Government’s aim to ensure the smallest possible proportion of us are depending on that income alone in retirement. The more people who are depending on the State Pension alone, the more significant the problem of poverty in retirement becomes and the higher the knock-on costs on the state become.

Right now, the UK is recovering well. In addition, stronger investment in pension funds (partly stimulated by new auto-enrolment receipts) is now also benefitting UK-based businesses more than usual for several macroeconomic reasons, including recent doubts over China’s future growth prospects, and the poor economic outlook in some South American countries (most notably Brazil and Venezuela right now).

But we should not risk a reverse in fortunes by biting the hand that feeds the wider economy. We mess with the current UK pensions tax relief regime at our peril.

Adrian Boulding is director of retirement strategy at Dunstan Thomas

Key points

The government is in the midst of consultation on changing the current pensions tax relief regime.

Pensions tax relief is the key incentive for saving sensibly for retirement.

The result of keeping pots invested in pension funds is that these funds are effectively recycled into UK.