Private pension reforms that could improve pension outcomes especially for women, low earners, NHS senior staff and younger savers.
As we wait to see who forms the next Government, here are some recommendations for pension reforms they need to urgently consider:
- Net Pay tax relief reform
- Reform Tapered Annual Allowance
- Abolish Lifetime Allowance:
- Default Financial Guidance
- Abolish Lifetime ISA
- Net Pay tax relief reform
The lowest earners needs the most help to build up good pensions. Most women earn less and work fewer years than men, leaving them with lower private pensions over their working life. However, there is a problem in the auto-enrolment pension system which results in at least one million lower-paid women being penalised and effectively forced to pay 25% extra for the same pension as someone earning more than them. This is the result of the way their employer’s chosen pension scheme administers the tax relief. In a ‘Net Pay’ scheme, those earning less than £12,500 a year, will pay 25% more for their pension than if their employer had chosen to put them into a ‘Relief at Source’ pension scheme. Nearly all new MasterTrusts use a Net Pay system, so the low earners who are auto-enrolled are unknowingly being charged a penalty for being in that scheme. The Government, the Pensions Regulator, pension providers and the industry know about this problem, but have refused to address it. It is one of the biggest pension injustices, with low-paid workers innocently paying more than they need to for their pensions. There is currently no way of them receiving this money, it is a function of the way their pension scheme and the tax system operates. These low earners were promised basic rate tax relief, yet they are not receiving it. I urge all the political parties to commit to reforming this system, so that low earners enrolled into a workplace pension do all receive tax relief, regardless of what type of scheme they are in. Alternatively, the Regulator should ensure that these low paid staff are either put into a Relief at Source scheme (such as NEST), or reimbursed by the scheme or their employer.
- Reform Tapered Annual Allowance (TAA) – urgently needed for NHS pensions:
The tax rules controlling pension accruals are causing enormous problems for some pension scheme members, especially in the NHS. It is of course reasonable for the Government to look to control the costs of tax incentives, but it has to be achieved fairly, transparently and in ways that enable people to plan properly. The TAA is designed to reduce the amount of tax relieved annual pension contributions that higher earners can contribute. It was originally supposed to reduce the £40,000 annual contribution allowance for people earning over £150,000 down to £10,000 for those earning over £210,000. That sounded reasonable, but the rules are impenetrably complex, unfair and impossible for almost anyone to work out, with workers earning well below £150,000 being affected. In Defined Benefit final salary-type (DB) schemes, HMRC does not just look at the amount earned and the amount each person actually pays into their pension. Instead, numerous adjustment are made to earnings, while contributions are based on a notional accrual of pension each year, rather than money actually paid in. On top of this, there is a stark cliff-edge based on a £110,000 earnings threshold. This complexity is all compounded by the fact that each year’s annual allowance depends on adjusted earnings in that year, which many people won’t know until after the tax year has ended, by which time it is too late to adjust pension contributions to keep within the reduced annual allowance limits. The result of all this is that people earning well below £150,000 a year are being charged tens of thousands of pounds on notional contributions from themselves and their employer, which nobody warned them about and they were given no chance to mitigate. This is an unintended consequence of the measures, and it must be addressed quickly. It is a false economy. While the NHS wants to increase productivity, the pension system is perversely driving many experienced staff to do less work. Senior staff are having to turn down extra shifts, because they have no idea whether working a little more could tip them over the tax threshold and result in them paying the Government for doing that work. There are examples of consultants who receive a promotion that they are told give them a pay rise, only to find they end up paying tens of thousands of pounds to the Government instead. The pension scheme is meant to be a cornerstone of the staff reward package, but is turning into a mechanism that actually leads to sharp pay cuts, without warning, sometimes as a result of promotion or volunteering for extra work. The system must be reformed.
Here are some suggestions for urgent change to address NHS pension problems:
- Annual Allowance taper should apply to past year’s earnings, not current year: This would help people to plan for the current year’s reduced allowance, as they should know what last year’s earnings were.
- Change the complicated earnings calculations: The calculation of the tapered annual allowance is unnecessarily complicated and difficult to predict. Threshold earnings, adjusted earnings and the cliff-edge are not transparent. Basing calculations on total declared earnings would be more readily understood and planned around.
- Change the way DB accruals are assessed for annual allowance tax purposes: The amount of annual contribution could be simplified, so that members can see what they are considered to be paying in. In a Defined Contribution scheme, contributions are clear, but not for Defined Benefit schemes in which accrual is an actuarial calculation. In the NHS, the calculations are different for each pension scheme and the factor used to work out accruals could be adjusted to address the high pension accruals. Using the actual amounts contributed would be much easier to predict.
- Provide staff with individual financial advice. Any reforms will require substantial preparation in terms of changes to legislation, payroll and pension administration systems, together with communication of the new flexible accrual facility to members and employers. The time and cost of this exercise may be wasted and may not even solve the problems. In the meantime, more staff will leave and the NHS crisis will worsen. Therefore, each individual who is potentially affected needs to have access to bespoke financial advice, ideally from an NHS-commissioned financial advice firm, with advisers who understand all the rules. This can help staff understand whether they are going to be potentially affected, which is important because currently many NHS staff are frightened to take on additional shifts, or leaving the NHS completely, but might be worrying unnecessarily. Surely, we want these valuable people to be experts in the vital medical care they are responsible for, rather than trying to work out the baffling, impenetrable, overly complex pension tax rules.
- Adjust the interest rate on scheme pays: It is possible for staff to have their tax bills paid by the NHS pension scheme, however this is effectively a loan from the scheme which is then charged in retirement. The interest rate on the loan is currently 5.8% and, when compounded over many years, results in a huge additional cost that reduces the employee’s pension. This interest rate is punitive and undermines the value of the ‘deferred pay’ package which NHS staff were promised.
- Lifetime Allowance should be scrapped
On top of this problem, the rules relating to Lifetime Allowance (LTA) are further damaging the NHS. The methodology for calculating whether someone has exceeded their LTA makes the tax allowance greater by retiring earlier. So GPs who see a financial adviser find out that taking early retirement leaves them better off by keeping under the LTA. Pension tax rules which drive some of our most valuable NHS staff to stop working and give up on pensions are clearly counter-productive. These rules are seriously impacting availability of GPs across the country. The Government should abolish the LTA and rely only on limiting annual contributions. If the amount of annual contributions is restricted, it seems illogical, in the context of long-term investment planning, to also impose a limit on the success of their investment policy. Pension withdrawals are taxable, so tax can be recovered later, but penalising those whose funds grow ‘too much’ runs counter to the aims of pension investing.
- Default Financial Guidance
The pension freedoms have been a very popular reform, which allow pension savers much more flexibility and choice over how and when to take money out of their pensions. Of course, the best thing is to leave money in the pension as long as possible, but many people do not realise this. They are not always aware of the tax charges they will face on withdrawals, or the dangers of withdrawing pension money and losing all the tax advantages of the pension wrapper. Too many people are stopping their contributions before they need to, take out their tax-free cash and are encouraged to buy a drawdown policy from their pension provider, without knowing the important questions to consider before they do this.
The original idea of the pension freedom reforms was that everyone would have free, impartial guidance before making decisions about pension withdrawals. The Government set up the PensionWise service to provide the free guidance, either on the phone or face to face, but take-up has been far too low. Only around 10% of those eligible actually have an advice session. This leaves them at greater risk of buying inappropriate products, paying too much tax, taking money out too early or falling for a scam as a result of cold-calls or fraudulent advertisements. Pension providers should be required to ensure all their customers are sent for a guidance session before they decide what to do with their pensions. This would improve the way pensions work for people and ensure people have a better chance of making sensible pension decisions that are in their best interest.
- Abolish Lifetime ISA
One more reform that would help improve pension outcomes would be for the Government to rethink the Lifetime ISA. This product is a hybrid that is designed to be used for a deposit on a first home, or for retirement. Confusing these two is not sensible policy. Saving for a house deposit is usually in cash, but this is not appropriate for retirement saving, as returns on cash are generally far lower than on longer-term investments. The Government adds a 25% bonus to money paid into the Lifetime ISA, which is the equivalent of basic rate tax relief, but the accounts are only available to people under age 40 and have complex rules which people might not understand. LISA funds cannot be used to buy all properties, there are restrictions, and any money that is withdrawn before age 60 and not used for a qualifying property purchase suffers a severe penalty. Not only does the 25% bonus have to be repaid, but there is a further 6% or more charge on the redemption. Very few companies have chosen to issue a LISA, partly because there are significant dangers of mis-selling or mis-buying. Indeed, the products should only ideally be bought by those who receive financial advice first, to make sure they are suitable.
There is a serious risk that Lifetime ISAs will damage pension saving for younger people. If people opt out of auto-enrolment to save in a LISA instead, they will be potentially losing their employer’s contribution, might also be giving up higher rate tax relief, may face higher charges, withdrawal penalties and end up with much less in retirement. Of course, withdrawals are supposed to eventually be tax-free, but that is a further drawback of using this product instead of pensions. At age 60, the behavioural incentive will be to take all the money out tax-free, rather than keeping it for much later in life. Many will worry that a future Government might decide to tax it, so all those decades of setting money aside and taxpayer funded bonuses, could still leave many people without extra retirement income. This Lifetime ISA seems unlikely to last a lifetime. On the other hand, pensions have the best behavioural characteristics for a lifelong income. The slower people withdraw their money, the less tax they pay, incentivising people to keep money as long as possible. It would be best to abolish this Lifetime ISA and just have one product to help people save for their first home, while leaving retirement provision to pensions.