Pensions tax relief costs the government £34 billion a year. It has been under constant fire for many years now, with commentators suggesting it favours higher-rate taxpayers while not adequately incentivising those on the basic rate.
This is fair comment only if you consider it as a giveaway from the government to the taxpayer. In reality, though, it is just a deferral of tax received by the government. Higher-rate taxpayers, by definition, are earning enough to pay tax at the higher rates, so therefore they are contributing more.
One of the possibilities that has been mooted to reallocate relief in a supposedly fairer way is flat-rate tax relief. Another, as has recently been used in the Lifetime Isa, is a bonus payment, which takes the form of a percentage of the amount paid in.
Both these options ultimately amount to the same thing. But the implications of going down this route would be so significant that they would pretty much see the pensions industry, as we know it, destroyed and reinvented overnight.
Salary sacrifice risks
We saw changes announced with regards to salary sacrifice earlier this year, but at the same time we were promised that pensions would be left alone. I am sure that this was welcomed across the board, but should a significant change along the lines of flat-rate relief be announced then salary sacrifice’s days will be numbered.
Salary sacrifice reduces pay in exchange for an alternative benefit, which is usually an increased employer pension contribution. By doing this the member will not be paying tax or national insurance contributions on the sacrificed amount.
This means they are technically getting full tax relief on the contribution as well as the benefit of lower national insurance contributions. This isn’t currently a problem because the member would be entitled to that tax relief anyway – even if they had to reclaim the higher-rate proportion through their self-assessment.
In some cases the employer will also pass on some of their national insurance contribution savings to the member.
However, this process would not work if flat-rate relief is introduced because a higher-rate taxpayer would still be getting full tax relief when sacrificing their salary for employer pension contributions. The taxable amount of salary would be reduced, so they wouldn’t be paying their highest marginal rate on that amount any longer. The only way around this would be to tax the member on the contribution, possibly by way of the benefit in kind regime, where a P11D form is issued at the end of the tax year.
This takes account of all benefits the employee has received and should be taxed on their value. It will then usually result in an adjustment to their tax code in the following year to recoup the underpaid tax or, in this case, claim back additional tax relief from which they would have benefited.
Further complications
Other options would be available, and are currently offered by employers, such as including the tax contribution or benefit in kind as a notional payment on a payslip so the correct tax is paid at the time. But this is subject to the employer being able to offer the option, and it furthermore basically negates the benefit of salary sacrifice in the first place – at least in respect of the tax relief.
It would therefore be simpler to just abolish salary sacrifice for pensions. This would be an issue for a good number of employers and pension schemes that operate the whole of their pension scheme on a salary sacrifice basis to benefit their employees.
Indeed, salary sacrifice has been used significantly by employers who have set up new pension schemes to meet their auto-enrolment obligations. It would be costly for the employer to stop offering the sacrifice arrangement and also reduce the employee’s benefits, which really isn’t what the government is trying to do. Not for basic-rate taxpayers, at least. The knock-on effect for the government would be the additional benefit of increased national insurance payments received.
Employer contributions
The same argument applies for employer contributions, were a flat rate to be introduced. Employer pension contributions really are just another payment to the employee, even though they go straight into their pension. The employee is receiving full marginal rate tax relief on this payment because it isn’t a taxed benefit.
Therefore employers could change contracts for employees to pay them a higher pension contribution and a lower salary. This isn’t salary sacrifice because the employee would never have been entitled to the payment as salary, but the outcome is the same. Higher-rate taxpayers would still be benefiting from higher-rate relief even if the rules only offered personal contributions a lower flat rate.
This, again, would mean that employer contributions would need to be monitored and the employee is taxed accordingly to ensure no one is getting a different rate of tax relief into their pension.
Final salary schemes
Final salary schemes face their own challenges. Many are underfunded and a change to tax relief may see less funds going into the scheme from members depending on the spread of taxpayers involved. This will mean employers may need to make up the difference to keep the scheme solvent.
Employer contributions are not calculated based on the needs of the scheme. This means contributions are not attributable to individual members in the same way money purchase pension scheme contributions are, which would mean that trying to ensure higher-rate taxpayers aren’t getting more than their fair share is impossible.
Final salary schemes would therefore need to be excluded from these rules or have another test applied. We already have significant differences in the way money purchase and final salary schemes are treated, and this would just increase that disparity.
Other options
All these complexities are reasons why we have the system that we do. It isn’t perfect, but it does still limit the amount of tax relief any individual can receive by curtailing their total tax-relieved input into pensions by way of the annual allowance.
This was as high as £255,000 per annum. Now we are restricted to a more realistic figure of £40,000 for most, but as low as £10,000 for the highest earners and those taking benefits.
It is possible to pay in more than this, but any tax relief received will be negated by an annual allowance charge. The annual allowance has worked, to a fashion, and is understood by most. It is relatively simple in its basic form, but over recent years has been made more complicated in an attempt to limit tax relief for high earners. We need to get back to this simplicity, scrapping all of the variants and restrictions on the annual allowance to stop the confusion, encourage saving and rebuild trust in the system.
A problematic solution
The issues with tax relief going predominantly to higher-rate taxpayers have been around for many years, but without a complete overhaul of the pensions regimes then there is unlikely to be a way to sort it out without causing further pain and cost to everyone involved.
Flat-rate relief may sound great to lower earners, but whatever amount of tax relief they receive they still need the cash in their pocket to make the contribution in the first place. No amount of incentives will encourage someone to contribute if they need the money to live on today.
Claire Trott is head of pensions strategy at Technical Connection
