'We must not forget pension tax change prompts behavioural response'

And in an era where we are living longer, their importance as a means of funding our later years is growing.

The state simply can’t afford to provide everyone with a comfortable retirement, so it’s important individuals, along with their employers’ support, save for themselves. This is why the government introduced auto-enrolment, to get millions more saving into workplace pensions.

But for most people, minimum AE contributions won’t provide the income they’ll aspire to, so incentives to top these up voluntarily, or even not to opt out, remain hugely important. 

For many decades, pension contributions have attracted tax relief on the way in, funds grow free of tax and after a tax-free portion, proceeds are taxed as income when taken. There are also special tax treatments of death benefits that were changed more recently when pension freedoms were widened. 

However beneficial private pension savings are to individuals, and also to the state, the tax incentives to encourage those savings come at a cost to the exchequer – for 2020-21 this was £48.2bn.

There are also questions around the fairness of how tax reliefs are spread, with 52 per cent going to higher rate taxpayers and 6 per cent to those paying additional rate. 

People who have been ‘doing the right thing’ shouldn’t suddenly find the rules have changed before they benefit from the proceeds.

Lifetime and annual allowances were introduced to avoid any individual receiving ‘too much’ tax relief, but they create their own challenges, including discouraging higher paid individuals over the age of 55 from remaining in the workforce.

The money purchase annual allowance, limiting contributions to £4,000 once a defined contribution pension has been accessed flexibly, is even less defensible. 

The chancellor recently set out his four E’s of economic growth. Within this, under employment, it’s been reported that he may be considering relaxing at least some of these ‘allowances’ as part of his drive to get early retirees over 55 ‘off the golf course’ and back into work.

Fingers crossed the March 15 Budget will announce an end to the current freezes and hopefully some step increases.

It would mean collecting a little less in income tax by granting a little more pensions tax relief, and less collected in tax penalties for those who breach the limits. But the upside in terms of keeping people economically active for longer could far outweigh this.

More fundamental reforms, whether to save the chancellor money or to spread reliefs more fairly, are often centred around moving away from offering tax relief at the individual’s highest marginal income tax rate and instead offering a flat rate of tax relief for all, irrespective of earnings.

Radical changes ahead?

Recently, the Institute for Fiscal Studies set out even more radical proposals in a 109-page paper.

These certainly added new ideas to the debate, including a complete overhaul of the interaction with national insurance contributions, controversial proposals to limit the much-loved tax-free cash entitlement and less generous tax treatment of employer contributions.

But major reforms of the pension tax system are fraught with challenges.

We’re (thankfully) not starting with a blank sheet of paper; millions of individuals across the UK have already built up private or workplace pension provision, defined benefit and DC, and in some cases very substantial sums are involved. 

To me, one of the sacrosanct principles behind any radical reform would be to avoid retrospective adverse change. People who have been ‘doing the right thing’ shouldn’t suddenly find the rules have changed before they benefit from the proceeds.

One IFS proposal is to grant national insurance relief on personal contributions with national insurance then deducted from the proceeds. But surely, those who have not benefitted from national insurance relief on 40 years of contributions couldn’t be asked to pay this on future proceeds?

At the very least, we’d need a very lengthy transition, which creates layers of complexity.

Pensions tax relief, while costly, is hugely beneficial.

There have been previous proposals to tax pensions like Isas. Rather than the ‘exempt, exempt, taxed’ (EET) approach, why not like Isas allow all proceeds tax free, but cancel tax relief upfront?

I see major downsides here because people value reliefs up front. Furthermore, the core aim of pensions is to provide an income throughout later life, but moving from EET and allowing all proceeds to be taken tax free immediately would not encourage the right behaviours.

An Isa style approach also couldn’t be incorporated into existing pensions – you’d need to ringfence every existing pension and set up a new one for every individual. The consequences for DB are horrific.

Even moving to a flat rate of tax relief creates major challenges. These are particularly high for DB schemes where a means would have to be found to convert additional entitlements into a contribution rate, then split employer/employee.

Salary sacrifice arrangements create further complexities and there could be a need to tax higher earners on employer contributions using some form of ‘benefit in kind’ approach.

Some would argue that the tax treatment of pensions on death is too generous, particularly in drawdown. But before rushing to impose inheritance tax on unused funds, the behavioural response this would prompt needs to be thought through.

Do we really want people to deplete their funds too soon, potentially falling back on the state? 

And it’s on that behavioural note that I’ll finish. Pensions tax relief, while costly, is hugely beneficial. If there is an appetite for radical reform, the technical details need to be thought through very, very carefully.

But on top of that, we mustn’t forget that change will prompt a behavioural response from individuals and employers and that needs to be fully tested.

We need to make sure everyone continues to agree that pensions are good for you.

Steven Cameron is public affairs director at Aegon