Budget pension tax relief shake-up looks unlikely

HM Treasury stated: "While the government keeps all taxes under review, no consensus for either incremental or more radical reform of pensions tax relief has emerged since the consultation in 2015."

Is there really no consensus? After all, report after report suggests flat rate relief would be fairer. 

Let's explore the suggestion a bit and walk up and poke the obstacles to see if they are real or not. In order to do that we need to list the ways in which relief is given:

Tax-free lump sums

The gross cost of pension tax relief to the government is £38.6bn. But £13.5bn is received in tax receipts on pension payments taking the net cost down to £25.2bn.

The tax paid of £13.5bn is net of 25 per cent paid tax free (roughly) or another £4.33bn. This routinely gets forgotten about in the perennial cry that it is not tax relief but tax deferral.

It is not – if you save in a pension the most you will pay is tax on three quarters of what you saved, based on current law and not extracting it all at once if you were a basic rate taxpayer in employment.

There is another not so easily quantified amount that is also implicit.

There is already a large tax incentive to join a pension. Increasing tax relief for basic rate taxpayers via a flat rate is unlikely to increase savings.

People are relieved at marginal rate and are taxed at average rate. The average rate is determined by how much is covered by personal allowance, and the basic and higher rate bands. 

So even a basic rate taxpayer who will have received 20 per cent relief on all pension contributions may have at least some of their pension covered by their personal allowance.

In practice the average tax rate for a person fully utilising the basic rate band is currently 15 per cent. If that’s all pension income then that’s another 5 per cent relief.

This is obstacle one – there is already a large tax incentive to join a pension. Increasing tax relief for basic rate taxpayers via a flat rate is unlikely to increase savings – if you can't afford to save, you can't afford to save regardless of the carrot being offered.

Employer relief

If an employer makes a contribution to a pension scheme they claim a deduction in their accounts and, if it is an occupational scheme, that is it.

No tax, no National Insurance on the recipient of such largesse and because of that employer NI saving this has become part of the flexible benefit/salary sacrifice industry.

If higher rate relief on employee contributions was removed to pay or part-fund flat-rate relief then there would either be an explosion in salary sacrifice or there would need to be changes that brought these contributions into the new rules.

Obstacle two – this couldn't be done overnight and therefore flat-rate would take a while to introduce and would be administratively burdensome. 

DB accrual

If the scheme is a defined benefit (DB) scheme – the employer has promised to pay benefits and money is fungible.

Therefore is the contribution they are putting in paying for: my benefit, my colleagues' benefit or paying someone's pension?

Therefore, you need to value the DB accrual in order to tax it. There is the added complication that a lot of the DB accrual is in public sector schemes.

Obstacle three – this will either result in an effective pay cut for higher earning public servants, or recycling of some of the saving into higher pay to compensate for the higher tax. 

Net pay arrangements

For all occupational schemes except Nest, employee pension contributions are included in the National Insurance calculation but are then deducted in determining taxable pay.

This delivers marginal rate relief. It’s brilliantly simple and has been around since the 1940s.

Obstacle four – changing this would increase administration and would require some people to have to reclaim. 

Obstacle five – if you remove marginal rate relief on employer and employee contributions and don’t change the net pay arrangements, there will be some people who have received the wrong relief and once their final marginal rate is determined there will need to be a reconciliation. 

So there is the rub. There is no consensus because it is complicated to apply consistently, difficult to implement quickly and there is no evidence that it would increase pension savings. 

Politically, that is not very attractive.

The government needs cash now to pay for spending pledges and that is why the direction of travel appears to be to choke off the pension contributions of high earners.

Let's see what today's (29 October) Budget brings.

Peter Hopkins is technical director at AJ Bell 

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