PENSIONSANDSAVINGS.COM

• Removing higher rate tax relief from pensions is a lose-lose proposition which helps nobody and hurts millions. 
• Reforming pension incentives is enormously complicated and Treasury should beware of unintended consequences.
  
• Recent changes to Pension Allowances designed to reduce pension tax relief for higher earners  fuelled an NHS crisis, showing the dangers of chasing political headlines and short-term cost saving.
  
• Government should not be undermining saving incentives when debt is already at record levels. 
• Any reform of tax relief should improve pension outcomes for the majority and help them understand the incentives provided. 

New Chancellor would be wise not to follow in Gordon Brown’s footsteps: There is much speculation suggesting the Treasury is considering removing higher rate pensions tax relief. Such a move would be extremely unwise and I would caution the new Chancellor against any temptation to do this. The last Chancellor in a Government with a huge majority, who used his first budget to raid pension tax relief, was Gordon Brown in 1997. His infamous removal of dividend tax credits from pension schemes has gone down in the annals of history as one of the major contributors to the demise of Britain’s gold-plated Defined Benefit schemes. Although there were many other factors affecting pensions around that time, there is no doubt that the removal of large sums of money from pensions, which aroused little attention at the time (apart from among pension experts) turned out to be very damaging in the years that followed.

Removing higher rate relief is a lose-lose proposal, helping nobody, hurting millions: Taking away higher rate relief would be a blow to pensions that is likely to result in much poorer pensions for millions of people. Nobody will be better off as a result of the change and huge costs will be imposed on pension schemes to adjust their administration systems. This would be a draconian assault on pensions, offering nobody the prospect of better pensions and potentially imposing costs that will reduce pension outcomes across the board. In 2015-16, the Treasury considered reform but was looking to improve outcomes for some, not just make pensions worse overall.

Complexity of pensions and tax relief means knee-jerk changes are fraught with danger:  I must admit I don’t believe the Government is seriously considering the proposals that have been mooted, I certainly hope not. Reforming pensions tax relief cannot be done in a knee-jerk manner, it is enormously complex and requires careful consideration of the consequences. It is certainly easier to do this for Defined Contribution (DC) pension schemes than for Defined Benefit (DB) schemes. The implications for employers using salary sacrifice schemes and the unintended consequences for auto-enrolment of reducing saving incentives should not be overlooked.

Unintended consequences of restricting tax relief for higher earners should hopefully stop Treasury making the same mistake again on an even larger scale: The changes to Annual and Lifetime Allowances in the past few years, supposedly designed to reduce the cost of pensions tax relief for higher earners, have been damaging. These changes sounded reasonable in theory, and the Conservatives could claim to be hitting the better-off, but in practice they have had disastrous consequences. In particular, the Tapered Annual Allowance and reduced Lifetime Allowance changes have forced NHS managers to try to replace senior clinicians and GPs, who have left the NHS or stopped taking on extra shift due to pension tax penalties. This may end up costing more than the tax generated by the pension restrictions – plus the cost to the public of longer hospital waiting times, cancelled operations and lack of GP availability. This should be a warning signal that the Treasury should not rush into draconian reform of tax relief without much greater consideration.

Cutting everyone to basic rate relief would be another blow to the savings culture: A new raid on pensions, especially when the UK is already struggling with rising debt levels, would be another blow to long-term savers. Interest rates for savers have remained at ultra-low levels for many years, credit card rates have reached record highs and the savings ethic in the economy has dwindled as people are encouraged to spend rather than save. Many savers, desperate for higher returns, have felt forced to take on extra risks, which they may not be in a position to bear. For example, those who used the Woodford Funds as an alternative to cash savings suffered big losses. As Bank of England Quantitative Easing policy has flooded markets with liquidity, banks do not need savers’ money as much as they used to. So people turned to National Savings and Investments (NS&I) to try to find safe returns, but Treasury limits have led to a large reduction in NS&I interest paid to savers. Even before the latest cuts, the returns to savers did not protect against inflation. They face the dispiriting choice between losing the value of their savings in real terms each month, or trying to find better returns, but with the chance of losing their capital.

Mature economies can’t thrive with falling savings and growing debts: Removing higher rate tax relief from pension savers, without offering any better incentives to those earning less than £50,000 a year, would damage the economy at a time when the aging population needs more retirement resources, not less. No mature economy can thrive in the long-run with ballooning debts and falling domestic savings. As auto-enrolment has brought millions more people into pensions, it would be highly irresponsible to damage incentives in this way.

£50billion cost of tax relief is a tempting target to raid:  Including the cost of National Insurance relief, pension tax relief is estimated to cost the Treasury around £50billion a year, with the majority going to higher earners. Of course, using a progressive tax system as an incentive mechanism will inevitably act in a regressive manner when used in this way. The current rules do ensure that higher earners benefit significantly from pensions tax relief and have much greater incentives than those on basic rate tax.

Tax relief is meant to be a saving incentive, but few people understand how generous it is: The problem, however, is that it is complicated and most people have no idea how much the Government adds to their pension. They may also not realise how much more generous it is to higher earners. But the fact that the majority of people do not understand how tax relief works, suggests it cannot be a well-designed incentive.

Pensions tax relief is not just tax ‘deferred’ – it is much more generous than that: Some have argued that pensions tax relief is not really an ‘incentive’ to save, it merely ensures the money is only taxed once and it amounts to tax deferred, not tax ‘relief’. However, this is not how the system works and it actually offers a generous level of incentive. Higher earners are treated particularly favourably in pensions. They pay no tax on their contributions, no tax on the investment returns earned then, in retirement, they can plan withdrawals so they are either not taxed at all, or only taxed at basic rate. One quarter of the fund can be taken tax-free, no National Insurance is paid on pensions and the pension fund can pass on to the next generation free of inheritance tax. So, most pensioners who received higher rate tax relief on their contributions, pay lower rate or no tax at all on their pension in retirement. This tax arbitrage benefits higher earners, and there is clearly room to redistribute some of the money spent on higher earners’ pensions, to improve pensions for the majority of people instead. Basic 20% rate tax relief is far less generous than 40% or 45% relief.

Basic rate tax relief amounts to a 25 per cent ‘bonus’ added to the person’s pension contributions: Many people do not realise how tax relief works. 20% tax relief is not the same as adding 20% to each person’s pension contribution. Because of the way the system ‘grosses up’ the relief, every £1 in the pension represents 80p paid in by the individual and 20p added by tax relief.  In other words, 20% tax relief amounts to a 25 per cent bonus on people’s pension contributions. So, if you pay £1 into your pension, basic rate relief adds an extra 25p. And for every £3 you pay into a pension, tax relief adds an extra 75p.

40% tax relief is 66.6% bonus and 45% tax relief is an 81.8% bonus: The impact of tax relief for higher earners is far more generous than basic rate. 40% taxpayers do not just receive double the ‘incentive’ that is paid to basic rate taxpayers. It is not just 40% added to their pension. The ‘grossing-up’ means that each £1 in their pension comprises 60p paid by them and 40p added by the Government, which is a 66% bonus, as opposed to just 25% for lower earners. And, for every £3 they have paid into a pension, they receive an extra £2 from the Treasury to represent tax relief (compared with just 75p for basic rate taxpayers). Those on top rate tax do not just receive a 45% addition to their pension. The ’grossing-up’ means they receive an 81.8% bonus, so for each £3 they pay into a pension, tax relief adds an extra £2.45.

Higher earners paying the same contributions as lower earners can build much bigger pensions. The Table below summarises the position.

 

	Tax rate	% ‘bonus’ that tax relief adds to each £1 of pension contribution	Extra money granted for each £3 the person pays into pension	Initial size of pension fund if they contribute £300
Basic rate taxpayer	20%	25 per cent bonus	75p	£375
Higher rate taxpayer	40%	66 per cent bonus	£2	£500
Top rate taxpayer	45%	82 per cent bonus	£2.45	£545

But taking away higher rate relief will create millions of losers:  Around 4 million people pay higher rates of tax, and not all of them will benefit from lower tax rates in retirement. Some of these people will receive 20% tax relief on their contributions but may then pay 45% tax on their pensions. This is obviously not the majority of those 4 million people, but the problem is that they will not know what tax they will pay in retirement. Therefore, just taking away higher rate relief will disincentivise many more people from building up a pension. These are the kind of unintended consequences that suggest this reform should not be contemplated.

Redistribution of tax relief could help improve majority of people’s pensions – but that requires considered thought, not just hitting high earners without benefitting anyone else: The idea of reforming pension incentives by changing the way tax relief works has often been suggested. Making the incentive of a Government contribution to people’s pensions more explicit could encourage better pensions. Many have suggested turning tax relief into a ‘bonus’ payment added to each person’s pension which would be more generous than the 25% added by basic rate relief. Perhaps an extra £1 added for each £3 contributed, which would be a 33% bonus. This could help the majority of people to build better pensions, as well as understanding the incentive more clearly.

I hope the new Chancellor will resist the temptation to grandstand against tax relief for higher earners’ pensions: In conclusion, I hope the Treasury will analyse carefully how changing tax relief will impact both DB and DC pensions, what to do about auto-enrolment and National Insurance relief and co-ordinate with the Office for Tax Simplification about wider reforms. The Government needs to take time to consider carefully how best to revive a savings culture and help more people build better retirement resources for the future.. That certainly would not be achieved by just removing higher rate relief.