The Treasury has asked eight great questions which go to the heart of how we incentivise pension saving. Here are our responses.
We haven't formally sent these responses to the Treasury yet, so if you have any comments, please send them to [email protected] or simply post them in "comments", wherever you find this!
You'll notice that this has already started happening and the submission is filling up with comments we've received over the past few days.
In our response we use some jargon (EET and TEE), this refers to when you get your tax exemptions. For those who don't know about UK pension tax law, approved pensions allow people to get tax-relief on contributions (E), tax free growth on investments (E) but they must pay tax on their savings when they draw them (EET). The Treasury proposals are to reverse the reliefs (to TEE) so you pay tax on the contributions
We also refer to "net-pay" and pension "relief at source". Net pay is where pension contributions are paid out of gross salary so you get relief at your marginal (highest) rate, pension relief at source gives everyone the same tax relief, higher rate tax-payers can claim back their tax separately.
Bog-off means "Buy One Get One Free". In this context the incentive is based on how much you put in which is topped up by Government within certain limits. For instance for every pound you pay in , the Government might top up your contribution by 30p. Typically the top up would apply on a certain amount of savings.
1. To what extent does the complexity of the current system undermine the incentive for individuals to save into a pension?
The current complexity does not discourage saving, it encourages the wrong kind of saving. The tax incentives on offer are attractive to those who have adequate retirement savings and ignored by many who need to save the most.
Take as an example the misunderstandings that surround pension relief at source. A statement on one company's pension website reads
“you cannot get tax relief - if you do not pay tax”.
This is true of one occupational pension savings scheme which encourages members (many of whom earn below the minimum income tax threshold) to save for their future using the net-pay system. Many employees simply miss out on tax-relief that would be available under "pension relief at source"
Large employers operating net-pay taxation systems for low-paid employees, do so unchallenged by employee representatives. Had the occupational scheme in question offered “relief at source” many poorly paid employees would have received 20% enhancements to their pension contributions from HMRC at no expense to employees, the only downside to the employer being that higher rate tax payers would have had to wait for higher rate tax relief.
This state of affairs shows what a shambles pension taxation has become. We are not suggesting that those using net-pay are wilfully ripping off their low-earners, most "pension experts" are simply unaware that this is happening.
Take this comment from payroll expert Kate Upcraft.
"Most employers and particularly the micros have no idea that there are two types of tax relief, in fact quite a lot of accountants/payroll agents don't either so if they are advising the micros on scheme choice or worse only offering a default, people are sleepwalking into this poor choice for the NPA population.
I also think quite a lot of the junior support folk manning provider help desks don't understand either. This has really though only become a problem since April when the tax/AE thresholds diverged, but will get much worse given the increase in the personal allowance over the next two years and just at the wrong time for the employees of micros."
It is not just tax-relief on contributions that is causing confusion
The complexity of the annual allowance, lifetime allowance and pension input periods generates millions for lawyers, tax-advisors and pension consultants. Complexity acts as a disincentive to many people to save adequately- they just don't know where they are, what to do and they have difficulty getting expert help at a reasonable price.
Finally there is an issue with eligibility for tax relief among those at the margins of our taxation system who are nonetheless being auto-enrolled. Again this is from Kate Upcraft
"If you have the right to work here and do pay UK tax but are subject to social security in your home country then you have no NINO in the UK and that denies you tax relief in a RAS scheme but not in NPA - well it does in NEST
I know some of the other providers are asking for dummy NINOs and hoping they might get a real one before HMRC spot it's an invalid claim. Equally a lot of the EU migrants here for the harvest season for example are auto-enrolled for 3 months (6 month contract minus 3 month postponement) but during that 3 months are still waiting on DWP to allocate them a NINO. In NEST as they won't take net contributions without a NINO they have to pay gross contributions.
DWP and HMRC need to work with providers to sort out this un level playing field so all RAS schemes can offer tax relief in year as long as a NINO is present by tax year end".
In summary, millions of pounds of tax relief is wasted by the Treasury helping wealthy people avoid tax. Many people are confused and scared of pensions and would rather miss out than risk getting caught out by an obscure tax rule. The tax reliefs available to the poor are often ignored, under appreciated and seldom encourage positive savings behaviours by those who need to save most.
Incentives are available to those on low earnings who pay no tax , but this message is not getting through, we need a system that resonates with all workers , not just those with the means to take tax advice. The incentive should be linked to the payment of contributions and not be dependent on the tax or NI status of the contributor - if people are in - they get incentivised.
2. Do respondents believe that a simpler system is likely to result in greater engagement with pension saving? If so, how could the system be simplified to strengthen the incentive for individuals to save into a pension?
It’s counter-intuitive but research shows many people invest in ISAs who do not pay tax. They do so because ISAs deliver returns tax free in the future.
It's a feature of saving that you aspire to be richer in the future than you are today. This is why people people find TEE attractive - especially if they are too poor today to be bothered by tax.
Many people expect to pay-tax in years to come, they do not aspire to be poor for ever - TEE suits people working to get out of pension poverty,
Because they are easier to explain, commentators like Martin Lewis promote ISAs, Martin Lewis does not promote pensions. At a recent NAPF conference he condemned the pension system as out of touch with everyday people. Part of the problem is that pensions are too hard for most people to understand
We should look to build on the success of ISAs and encourage pension savings using top-ups.
Proposals for how such incentives might work are well rehearsed. Here are some practical suggestions from payroll expert Kate Upcraft
I'd scrap NPA and RAS at the point that HMRC have got digital tax accounts live and replace it with a real time system that as pension contributions are reported
HMRC show on the taxpayer's account (and with amendment to the Employment Rights Act - on payslips) what amount has been transferred for that tax month as a top up direct to their fund.
For DB single employer trusts the EPS file sent each month could offset 'pension relief' against tax/NICs paid.
This can be badged as 'pension relief' not tax or NI relief so is not aligned to your tax paying status or current rates of either tax or NICs but fixed as a separate rate for the year.
It could be further finessed to incentivise certain groups such as those of a certain age or earnings level - this would be easy for HMRC to do given payroll supply over 120 pieces of info per employee per month.
The self employed would have their relief added annually once their SA return was submitted. If they wanted a more regular feed of relief to their fund, in line with employees, they could opt to real time report their income once a month or quarter.
The paper produced by the current pension minister some 13 years ago targets these incentives at low-earners and tapers reliefs to those contributing from high income. A similar system - with a "Bog-off "strap-line has been put forward by Michael Johnson. We favour this kind of incentive.
We need to be clear that ISAs and what some people are called "pension ISAs" are different things.
The tax advantages of pensions make them a better way to save for retirement but many people keep their money in ISAs as a pension substitute. ISAs do not provide tax free income and they don't provide any insurance against living too long.
ISAs are working as a savings vehicle but they are not solving people's fundamental worries about retirement.
In our answer to question 4, we explain the conditions that should apply to the pension savings vehicle in order for it to qualify for these top-up incentives.
3. Would an alternative system allow individuals to take greater personal responsibility for saving an adequate amount for retirement, particularly in the context of the shift to defined contribution pensions?
People like to see what is going on. The current system of tax relief on contributions, especially net-pay, is almost invisible to non-pension specialists. Tax-relief does not properly show up on payroll statements (payslips) nor can the tax incentive be readily identified on annual statements from providers. Even online scrutiny of your pension account doesn’t really show the impact of the tax relief.
Because it is invisible, the incentives are less valuable, particularly to those on low incomes for whom the statement “if you don’t pay tax, you don’t get tax relief” is hard coded into their financial DNA.
People on low income have less to save, but many do save long-term, as we can see from ISA saving statistics. They are desperately in need of good financial information delivered in the workplace. One educationalist has written to us
We have to improve levels of financial awareness and again digital tax accounts play a role here but allied to this transparency of data.
We need something like a 'financial passport' that employers could deliver if they were given more than the £150 per head/ per year benefit in kind allowance. For those employers who didn't want to provide it, TPAS or MAS or CAB could be funded to do so.
Investors in people should be awarded to companies that offer the passport and it needs to become a 'an employer of choice' PR tool reflected in things such as the Times 100 best companies.
It has to become aspirational for employers to want employees to value what their whole reward package is worth that the employer is paying for and to ensure that investment is wasted on scammers and 'live for today' strategies.
For tax purposes, pension saving should be like a "Super-ISA" with it being made absolutely clear that income-poor people are those who most need to and will most benefit from - pension saving.
4. Would an alternative system allow individuals to plan better for how they use their savings in retirement?
The pension minister has rightly pointed out that an alternative TEE system does not help people create an income for themselves in retirement.
Such a system may mean they have a bigger retirement pot (because people choose to defer consumption and “spend their wages on later life”) but in isolation, TEE is only part of the answer.
What is also needed is a proper system of turning exempt cash into exempt income. We think that the answer to this lies in the Defined Ambition legislation in the Pension Schemes Act 2015.
We are working with Government (through the Friends of CDC) on how it could create a default means of spending tax-exempt savings in a way that did not leave people short of income in extreme old age.
This is not a call for the return to annuities, more a call for the kind of pensions that existed in the early years of the defined benefit era.
We recommend that any incentives granted to savings into a pension should be conditional on the use of those savings in securing a long-term income which provides insurance against living too long and the potential costs of extreme old age.
We do not think this should limit people's freedom of choice at retirement. Examples of how this could be achieved include annuities, collective decumulation (DB and CDC) and planned drawdown. People would only lose their incentives if they chose to spend all their pension savings wilfully (with a view to relying on others later in life).
5. Should the government consider differential treatment for defined benefit and defined contribution pensions? If so, how should each be treated?
The principle of getting people to value the incentives to save for retirement mentioned above are as appropriate for DB as for DC. The huge contributions made by employers to DB schemes and notionally assigned to individuals through pension accrual are often un-noticed and usually undervalued.
This is bad for the labour market as it makes it expensive to employ people in DB schemes and leads to all kinds of rancour in the workplace. We would like people in defined benefit schemes to be aware of the (currently) tax-free benefit they receive from employers both in terms of the benefits in later life and in the cost to the employer at the point of contribution.
Moving to an alternative system which made contributions to DC taxable but excluded contributions to a DB plan would be a mistake. It would extend the pensions apartheid between employees with DB and DC pension plans.
In the long-run, the fairest system is to make pension contributions a benefit in kind, taxable in the hands of employees .
The value of contributions can be determined by GAD and a GAD value to DB accrual could be simply applied (by using formulae such as 16:1 or 20;1 where the smaller number relates to the increase in accrual and the larger the taxable value of the accrual)
It is a radical proposal which is likely to be unwelcome in parts of the labour market where DB is still universally available, but it is important, if public confidence in pensions is to be maintained that there should not be one law for DB and one for DC.
Putting employer contributions into the personal tax net will mean encouraging people to stay in defined benefit pension schemes in different ways. One obvious way would be a program of financial education around the value of benefits that many DB members take for granted.
6. What administrative barriers exist to reforming the system of pensions tax, particularly in the context of automatic enrolment? How could these best be overcome?
Administration should not be underestimated but nor should it become a barrier to getting tax-relief right. Many legacy record keeping systems will not cope with a radical new regime and many schemes will have to invest in new “kit” to deal with an alternative system. This may not be a bad thing , the old kit wasn't working particularly well.
The Pensions Regulator has recently concluded that many occupational DC schemes will never have the quality features that tPR wants. TPR wants such schemes to merge into bigger schemes that have the ambition to do the job properly.
We believe that the introduction of a new tax regime would accelerate this process leading to a call for pension schemes to improve or merge. In doing so , there is an opportunity for them to do a one off data cleanse - which in many cases is long overdue.
As for insurers, the few remaining insurers in the workplace and personal pension market are now of sufficient scale to be able to absorb these costs. Clearly Government should work closely with the ABI to establish what the impact of change would be. The impact should not be passed on to members in higher member-borne charges but should be met by the shareholder or- in the case of the remaining mutuals, across the whole body of membership.
Kate Upcraft adds
the admin burden will fall on employers and the payroll industry too, to minimise this DWP/HMRC must see them as key stakeholders and engage early and insist that the pension industry develop single interface systems akin to RTI.
7. How should employer pension contributions be treated under any reform of pensions tax relief?
One of the easiest means of avoiding the impact of tax relief is to “salary sacrifice” , the practice by which employee contributions are converted into higher employer contributions. If employer contributions were exempt from being considered a benefit in kind, employers would simply go “non-contributory” and members would move en masse to salary sacrifice.
We favour a system where employer contributions are considered a benefit in kind but were exempted up to a certain amount (similar say to the Annual Allowance system- though probably with a lower threshold). Contributions over that amount would be taxable as a benefit in kind. As mentioned above, this is the best way to deal with DB and DC.
This system would simplify the Annual Allowance and would enable the Government to ditch the Lifetime Allowance which is unfair and injurious to prudent pension savings.
It would also protect the national insurance fund which risks being depleted where salary is sacrificed.
An alternative proposal from one payroll source may be appealing to HMRC and DWP
employer contributions may have to be subject to class 1a NICs, perhaps if they are above the combined employer and employee AE minimum or a figure fixed each year like the NEST limit
Which ever route , or combination of routes, HMRC chooses, we cannot allow salary sacrifice to be used to game the system.
8. How can the government make sure that any reform of pensions tax relief is sustainable for the future?
We cannot future-proof pensions and talk of a pension commission to guard against unwelcome future changes in taxation is fanciful.
There have been examples of Government getting tax incentives right, the PEP/ISA taxation rules being a good example. The reason we have such a complicated tax system for pensions is because it was designed for a different world.
The net pay system was never designed for all employees (as auto-enrolment is taking us), more fundamentally the EET system was designed for a world where funded pensions were for those who paid higher-rate tax.
The long-term future for pensions and pension taxation is to create a system that is fair for everyone and encourages those on low incomes to save (as well as traditional savers).
We welcome the proposal to move to an incentivised TEE system and will champion it if adopted.
It is with popular support, that these changes will be lasting.
About Henry Tapper
I'm best known for helping small employers and business advisors with their problems with pensions. These are typically over choosing the right pension for auto-enrolment though through my work with First Actuarial, I get involved with big occupational schemes too.
I'm on this site as I see accountants as the missing link between the pensions industry and the business community - especially small businesses.
I've a Cambridge MA and 30 years in finance behind me, but I'm looking forward to the next ten to twenty years (my flexible "corridor to retirement") to help restore people's confidence in pensions.
Director- First Actuarial
Writer- www.HenryTapper.com and many magazines and papers,
Manager; Pension Play Pen linkedin group, Pension Auto-Enrolment Linked In Group
Choices Champion; Friends of Auto-enrolment