Deja vu: Will flat-rate tax relief make pensions even more complex?

As the Budget fast approaches, there has been much speculation as to the outcome of the Green Paper – Strengthening the incentive to save: A consultation on pension tax relief.

The aim of the consultation is to consider how to incentivise more people to save for retirement with any government support to be simple and transparent.

I am sure we would all accept that these are good intentions but there is great emphasis placed on the long-term sustainability of any changes and can the government seriously achieve simplicity?

If the speculation is to be believed it appears the government is opting for a flat-rate of tax relief of between 25% to 33%.

On the basis that two-thirds of tax relief goes to higher and additional rate taxpayers a flat-rate, providing they can afford to do so, may incentivise the lower paid to save more into their pension.

Auto-enrolment has been a great success with HM Treasury estimating that by 2020 8 to 9 million more people will be saving towards retirement, and offering the lower paid an upfront additional payment to their contributions will only add to its success.

However, is such a change sustainable and can it be simple?

Big numbers

The estimated cost to the Treasury of tax and National Insurance relief to registered pension schemes for 2013/14 is in the region of £45bn.

If the government went for relief of 33%, the Centre for Policy Studies estimates it would cost an additional £2.5bn. If they opted for 25%, the think tank estimates the government would save £6bn.

There is also the potential risk that the government may reduce further the lifetime and annual allowances. That may appear a somewhat gloomy prospect but what about the final aim of keeping retirement savings simple and transparent?

If a flat-rate of 25% relief was presented to Joe Public – that for every £3 he saved a year the government would give him an additional £1 up to a certain level – then it would appear job done.

However, how will this be administered? For defined contribution schemes it will be difficult, but for defined benefit schemes (DB) it will be a potential nightmare.

In all likelihood, all employer contributions which are currently paid gross under net pay arrangements will move to the relief at source model.

So based on a flat-rate of 25% relief instead of making a gross contribution of £4 the employer will make a net contribution of £3 with the pension fund claiming back the £1.

The employer will then put the gross £4 contribution through their payroll system ensuring the grossed up contribution is taxed at the employee’s correct tax rate.

Any adjustments to higher and additional rate taxpayers’ personal contributions will continue to be dealt with via their tax returns and notice of coding where taxed via PAYE.

If you thought that was complex what about DB schemes?

The employer contribution is likely to be based not on the actual amount paid in but on the value of benefit accrual.

One would assume that this will be calculated along the lines we currently do for annual allowance with an adjustment made to take account of any member contributions.

This would need to be done for every active member and at the very least at the end of each tax year. This could prove very cumbersome and may take some time to implement.

Finally, there is also the potential political backlash, mainly from those in the public sector as the value of their benefit accrual becomes evident through the tax they will have to pay on it.

Thinking differently

So is there another possible solution?

Pre-A-Day tax reliefs for pension funding through a money purchase arrangement were controlled through the amount that could be contributed. For DB arrangements, tax reliefs were restricted by capping the benefits that could be taken.

Post-A-Day pension tax reliefs are controlled by the annual and lifetime allowances so unlike the pre-A-Day position DB and money purchase arrangements are treated in the same way.

Some have suggested moving to the following set up:

If such a set up were introduced then it is likely that the annual allowance would be reduced from its current level of £40,000.

For DB arrangements, the lifetime allowance test would work as it does currently with scheme pension being valued using a conversion factor and any lifetime allowance excess being subject to a lifetime allowance charge.

One will have to await the outcome on 16 March but it is extremely unlikely that the government will be able to keep matters simple. I do have a feeling of déjà vu.

Neil MacGillivray is head of technical support at James Hay Partnership

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