- Could Government commitment to sort out NHS pensions herald radical pension reform?
- NHS problems are canary in the coalmine showing need to urgently change pensions tax rules.
- Tapered Annual Allowance and Lifetime Allowance should be changed or abolished.
- Reforming the £50billion annual cost of pensions tax reliefs (which gives top earners most help) could raise much-needed revenue AND improve pension outcomes.
Reforms that could introduce new one-nation pension incentives and also save money include:
- Give everyone the same top-up to their pension rather than complicated tax relief
- Limit the tax free lump sum, reform Annual Allowance and abolish Lifetime Allowance
- Most radical idea: Make minimum auto-enrolment contributions compulsory and focus Government incentives only on contributions above minimum
- Worst idea: Turn tax relief on its head ISA-style – this will increase pensioner poverty
The Tory landslide election victory offers the new Government opportunities for radical reform.
Manifesto commitment to NHS pension reform may pave the way for radical overhaul: The Conservative Manifesto promised measures within 30 days to address the problems created for the NHS by the pernicious effects of the complex, impenetrable, illogical pension tax rules facing long-serving and senior staff. The Tapered Annual Allowance (TAA) has driven senior NHS medical experts to pull out of pensions and reduce work, which is fuelling the NHS crisis and damaging performance. The Lifetime Allowance (LTA) has caused driven GPs and other medics to retire early, aggravating staff shortages. Once the pension system starts undermining both pension provision and work incentives, it is clear the situation is unsustainable.
The NHS is perhaps the canary in the coalmine alerting Government to rising pension dangers: By signalling the damaging effect of attempts to clamp down on pension tax relief for higher earners under the current system, the Government may decide that pension incentives and tax rules need a broader review. Rather than trying to reform the TAA and LTA just for medical staff, Ministers may be tempted to revive reforms of pension incentives considered in 2015/16.
Triple tax lock may force Government to find new sources of revenue for infrastructure spending: The promised ‘one nation’ agenda will cost billions of pounds, requiring revenue-raising measures to fund proposed major spending programmes on ‘left-behind’ areas, NHS, social care and education. Given the ‘triple tax lock’ commitment – no increases in income tax, National Insurance (NI) or VAT – plus a promised rise in the 2020 NI lower threshold to £9,500 next year and then to £12,500 , where can such huge sums come from?
Pensions tax relief may be a tempting target: The current cost of pension tax incentives is around £50billion a year – so the size of the prize is substantial. Around half is spent on the top 10% of earners – with significant sums going to generous workplace Defined Benefit (DB) schemes. The success of auto-enrolment has also seen higher than expected spending on Defined Contribution (DC) incentives, which has increased tax relief costs. Treasury attempts to try to control the costs of incentives for top earners with the Lifetime and Annual limits have been counter-productive.
NHS shows Tapered Annual Allowance should be radically rethought and perhaps abolished: The rules for calculating this TAA are ludicrously complicated and often impossible to adequately predict or plan for in advance. The aim was to reduce annual contributions and their associated tax relief benefits, for people earning over £150,000 a year. But the way ‘earnings’ and ‘contributions’ are calculated means those who are not pension experts have scant chance of understanding how to assess their position. The ‘notional’ contributions in DB schemes depend on complex calculations and inflation adjustment, not the actual amount each worker or employer pays in. The earnings ‘threshold’ is not simply the amount the person earns in their current employment. The rules clearly should have been simpler, but the situation is now so damaging to work and pension saving, that I believe they should be abandoned.
Lifetime Allowance seems illogical if there is also an Annual Allowance limit: It has always seemed illogical to limit both the annual contributions and the amount built up over time. I favour an annual limit only, with people feeling free to invest for strong returns over time, rather than punitive taxation if investments perform ‘too well’. Such a regime would be relatively simple for DC schemes. For DB schemes, I suggest annual contribution levels could be assessed using the accrual for the current year, in the current scheme, only. This should replace the complex estimated long-term career returns and inflation uplifts of the present system.
Even more radical reform options, to improve pension incentives or reduce the £50billion cost, could include the following:
Changing tax relief to flat-rate one-nation incentives: One tax relief reform option often favoured is the abolition of higher rate tax relief and National Insurance relief, which currently do not seem well understood and, therefore, are inefficient incentives. With a cost to taxpayers of over £50billion a year, most of which is spent on the highest earners, this may be an attractive option. Moving to a more transparent system with a uniform amount that the Government adds to each person’s pension contributions – maybe 30p added for every £1 contribution – would be more generous than basic rate tax relief, less than higher rate relief and much easier to understand. This would, therefore, give better pension incentives to the majority of the workforce, while still offering good additional money for higher earners’ pensions too.
Limiting the tax free lump sum: Another proposed reform is limiting the amount of tax-free cash. Current rules permit most schemes to pay 25% of the pension fund to each person tax-free. In the past, the tax-free cash withdrawals were considered sacrosanct by Treasury officials, and any change was emphatically ruled out in 2015/16. Abolition of the Lifetime Allowance could be accompanied by a simple monetary limit on the tax-free lump sum instead, such as £100,000 per person.
Making auto-enrolment minimum contributions compulsory, without tax relief: An even more radical alternative may be making the legal minimum auto-enrolment contributions compulsory and removing tax relief from this sum. Compulsion obviates the need for taxpayer incentives. The legal minimum contributions are 8% of ‘band earnings’ for each worker. This 8% is made up of 3% from the employer, 4% from the worker and 1% from tax relief (although the lowest-paid workers are often forced to pay 5% rather than 4% because their employer scheme does not allow them to have the tax relief. If their employer pension scheme uses a Net Pay administration arrangement for tax relief, the lowest earners actually pay an extra 25% for their pension without knowing it. In any event, the extra money put into workers’ pensions from the 3% employer contribution is much more than the 1% from tax relief. As the ‘free money’ added by employers dwarfs the impact of tax relief, the billions of pounds spent on auto-enrolment by taxpayers seems poorly targeted. Auto-enrolment has been a success, bringing ten million workers newly into pensions. While opt-out rates are low, this may be an opportune time to consider compulsion. Compulsory employer and employee contributions would eliminate the need for taxpayer incentives and could be a timely revenue-raising reform. Government incentives would then only be added to contributions beyond the minimum, and could be more generous for average earners than the current system, in order to encourage more people to build above the minimum and drive better overall retirement provision.
The worst idea: Turning pension incentives into ISA-style saving would be hugely damaging: Importantly, it would be damaging to replace the current tax relief incentives structure with an ISA-style regime. Radical reform to pension incentives must consider long-term consequences and costs. Maintaining a tax ‘brake’ to discourage large early withdrawals, as the current pensions rules provide, incentivises keeping money in pensions for much later life. The 2015 freedom and choice reforms offer excellent behavioural nudges that mean more people having money in pensions in their 80s or beyond. Of course, people need help to recognise the risks of taking money out too soon, and the benefits of leaving pensions to grow over time. The 2015 reforms were rightly accompanied by the Government establishing ‘PensionWise’ – a national free service to help people understand the new pension rules. Unfortunately, however, take-up of this free services has been far too low. Nevertheless, the thrust of the current incentives and tax treatment is behaviourally sound. It is known as ‘EET’ – with contributions exempt from tax, investment growth exempt from tax, but pension income being taxed. People receive initial incentives to contribute to pensions, encouraging or helping them to put more money in. The investment returns roll-up over time tax-free. Then money withdrawn from the pension in later life (aside from the tax-free lump sum) is taxed as income, . This is designed to ensure people do not take out too much at once. In addition, money passed on after death is free of inheritance tax, so people need not be frightened of having some money left in their fund. People are incentivised to keep money in their pensions as long as possible, into their 80s and 90s. By contrast, an ISA-style system would be ‘TEE’ – with contributions made out of taxable income (but the Government could add an initial bonus), then investment returns would be exempt from tax and all withdrawals would also be tax-free. This poses an existential threat to pensions. Taxpayer upfront incentives, paid for by today’s taxpayers, are supposedly designed to ensure future pensioners have more money to live on in retirement than just the low state pension. However, allowing future sixty-somethings to withdraw the entire fund tax-free, would encourage them to empty their fund in their 60s, leaving nothing for later life. Future Governments would have to deal with increasing numbers of poor pensioners, lower spending power and less tax revenue, because people spent their pension funds as soon as they could. Just as today’s retirees almost always take their tax-free cash straight away, future pensions may fear the ISA-pension would not remain tax-free once future Governments needed to raise more revenue.
Radical simplification of pension incentives has many benefits for ‘one-nation’ Britain: Pension tax relief reform could provide much-needed revenue for the Chancellor, while also improving incentives for the majority of people. The 85% of taxpayers who pay basic rate tax and low earners who do not earn enough to pay tax, would receive more money for their pensions. A flat-rate bonus would also solve the injustice of the lowest-paid workers paying the 25% surcharge to fund their own tax relief in Net Pay pension schemes. However, it is vital that any radical overhaul avoids the pitfalls of short-term thinking and maintains the current behavioural incentives to keep money in pensions for much later ages. Sensible reforms could improve pensions for millions of citizens, save money to taxpayers and help fund growth-boosting infrastructure projects in a new one-nation Britain. Let’s see what happens.