In this article, our Pensions Director, Steven Cameron, explores potential Government pension tax reforms ahead of the Autumn Budget on 30 October 2024 as they look to plug the ‘black hole’ in the nation’s finances.
All views expressed in this article are based on our understanding of current taxation law and HMRC practice, which may change.
Following Chancellor Rachel Reeves’ speech regarding the £22bn ‘black hole’ in the nation’s finances, there’s been intense speculation of future reforms to how pensions are treated for tax purposes. Changes designed to increase the tax take could be included in the Autumn Budget, either as a ‘done deal’ or by launching a consultation.
There are several pensions related reforms which could raise tax receipts. One possibility is bringing pensions within the scope of inheritance tax or reviewing the treatment of death benefits in drawdown. Fingers crossed there are no plans to reintroduce the Lifetime Allowance, but there could be tighter controls on various limits including tax-free cash which of course is subject to a new cap in absolute terms, so due to fall in real terms anyway.
Here, I will delve deeper into the possible client considerations and implications of moving from marginal to flat rate tax relief, somewhere between the UK basic and higher rates, looking at:
- A recap of the current approach
- Flat rate relief on personal contributions
- Flat rate relief – treatment of employer contributions
- Defined benefits – special considerations
- Winners and losers
- Next steps and client considerations
1. A recap of the current approach
At present, individuals receive tax relief at their highest marginal rate on personal contributions. This can be direct through ‘net pay’ or using ‘relief at source’ with tax relief above the basic rate reclaimed through tax returns. Pension funds grow virtually tax-free but unlike ISAs, the proceeds are taxed at the individual’s highest marginal income tax rate at that time, after allowing for pension commencement lump sum(s), typically 25% for most individuals, now capped at £268,275 in absolute terms.
By contrast, employer pension contributions are generally treated as a business expense, so reduce the employer’s corporation tax bill (or income tax bill for partnerships and sole traders who don’t pay corporation tax).
Employee National Insurance (NI) is paid on total salary before pension contributions, while employer pension contributions are exempt from NI. Partly because of the difference in NI treatment, some schemes and employers allow employees to exchange part of their salary for an employer pension contribution with corresponding tax treatment, saving NI in the process.
This approach to pension tax relief, the tax on pensions in payment and NI applies across the UK. However, in Scotland, there are additional income tax bands with their own thresholds and different income tax rates. For simplicity, I refer in this article to the UK rather than Scottish situation, but the same principles apply. Scottish individuals on the starter (currently 19%), Scottish basic (20%) or intermediate (21%) rates will be affected similarly to UK basic rate (20%) taxpayers. Scottish higher (42%), advanced (45%) and top rate (48%) are affected similarly to UK higher (40%) and additional rate (45%) taxpayers.
2. Flat rate relief on personal contributions
The rate of tax relief under a flat rate system would be for the Government to set and could change over time. Here, I’ve made an assumption of 30% to help illustrate the impact. It could be lower, and possibly higher – I will explore the consequences later.
Moving to a flat rate of 30% would be good news for basic rate and non-taxpayers who would get an extra Government top-up every time they contributed to their pension.
But this would be at the expense of higher and additional rate taxpayers who would get a less generous top-up than at present.
In terms of consumer understanding and engagement, there are merits in a flat rate of 33%. This could be presented as ‘buy two get one free’. However, depending on the overall profile of individual and employer pension contributions, this could end up granting higher total tax relief than the current system, which would not deliver on the purpose of reducing the ‘black hole’.
It’s difficult to see how moving to a flat rate could work under a net pay arrangement – the simplest approach might be to move unilaterally to Relief at Source with no extra to claim back.
3. Flat rate relief - treatment of employer contributions
It’s highly likely that a move to flat rate relief on personal contributions would be accompanied by changes to the tax treatment of employer contributions. Without this, higher and additional rate taxpayers could retain their existing tax relief by opting for salary sacrifice.
To level the employer / employee playing field, higher and additional rate taxpayers might be charged a ‘benefit in kind’ style tax on employer contributions. Contributions paid by an employer rather than the employee (including through salary sacrifice) would save a higher rate taxpayer 40% tax on the salary given up and paid into their pension – effectively 40% tax relief. If the flat rate relief were 30%, then the benefit in kind tax charge would be the difference of 10%.
This means higher and additional rate taxpayers would face a ‘double whammy’ – less relief on personal contributions and a new charge on employer contributions.
In some schemes, including many public sector Defined Benefit (DB) schemes, employers pay very substantial contributions. It’s not unheard of for employer contributions to be worth 20% or more of pay. Here, an individual earning £80,000 might be benefitting from an employer contribution worth £16,000 a year and could be landed with a tax bill of £1,600 in respect of benefits not accessible until (currently) age 55. This could further raise opt out rates in ‘generous’ public sector schemes and could also further discouraging higher paid professionals, such as in the NHS, from remaining in work.
Employer NI
Employer pension contributions are also exempt from both employer and employee NI. While making employer contributions subject to employer NI would generate significant revenue for the Exchequer, it would place an additional burden on business and act as a disincentive for employers to go beyond the auto-enrolment minimum. With such employer support for pensions so important, I hope this isn’t under consideration.
4. Defined benefits – special considerations
One of the most complex areas to resolve is how DB schemes would be affected by flat rate relief. While very few remain ‘open’ in the private sector, they remain common in the public sector and attract a high proportion of overall pension tax relief. To me, this makes it essential that any move to flat rate relief applies equally to both DB and DC – anything else would be hugely divisive.
Failure to do so would mean higher rate tax paying employees in a public sector DB schemes would get preferential treatment over a similar individual contributing to a private sector DC scheme. But basic rate taxpayers wouldn’t get such generous treatment. It would also create even more complexity for members, some of whom will be members of both types in future.
As with DC schemes, moving to a flat rate of tax relief would involve consideration of the treatment of both personal and employer contributions. The treatment of personal contributions translates well to DB. But while employee DB contributions are fixed, contributions from employers change over time to deliver promised benefits and aren’t ‘earmarked’ for individuals. Back in 2015, at the time of the Osborne review, we proposed a solution for employer contributions. You can read a summary of our proposal in Defined benefits – deemed employer contributions.
Looking at the overall funding of such schemes, if tax relief across total employee contributions fell, the employer would be left having to pay more to compensate. Government might wish to investigate the likely range of impacts for both private and public sector (including local government) schemes.
5. Winners and losers – the critical ‘rate’
Clearly, basic rate and non-taxpayers would be the ‘winners’ from a move to flat rate relief above 20%. Higher and additional rate taxpayers would be less well treated, but it’s critical that pensions still remain tax efficient for them too – otherwise, we could see widespread opting out of auto-enrolment.
I’ve assumed a flat rate of 30% throughout. Many have argued that this is the minimum required to avoid double taxation for those who pay 40% tax in retirement. The argument is that 25% of proceeds can be taken tax free with higher rate payers paying 40% on the rest, equating to an average tax in payment of 30%.
However, if you delve into the detailed calculations, this is an oversimplification. Individuals only pay higher rate tax on total income (including private and state pensions) above the higher rate tax threshold, currently £50,270 (The higher rate threshold in Scotland is £43,662).
To keep things simple, I’ll use the English rates and assume tax thresholds and the state pension remain at today’s levels. Someone with the full state pension of £11,542, with a personal allowance of £12,570 and no earned income, can take the first £1,028 of private pension tax free. The next £37,700 is subject to 20% tax. If their income in retirement was not much over £50,270 they would be paying 40% on only that small excess, meaning their ‘average’ rate was closer to 20%. The ability to take a tax-free lump sum also reduces the pension income which is taxed. For someone paying higher rate tax on the top ‘band’ of their retirement income, the amount commuted into tax-free cash reduces that top band.
An alternative way of looking at this would be that individuals would need to think carefully about building up a pension fund which once added to their state pension and after taking the maximum tax-free cash, would produce an income taking them above the higher rate threshold. The role employer contributions play here would be relevant. This would certainly need detailed advice!
Despite the above analysis, I’m strongly in favour of any flat rate being set at no less than 30%. Few individuals will appreciate these detailed calculations and anything below 30% would be damaging to how pension tax incentives are perceived.
Individual behavioural response
One of the big unknowns is how individuals will react to such a change. It’s hoped that basic rate taxpayers would continue to contribute at no less than current levels. If their net contribution remains unchanged, the gross will increase, improving the adequacy of outcomes – something much needed as the auto-enrolment minimum contributions are inadequate for most.
But there’s a good chance that some higher and additional rate taxpayers might see pensions as less attractive. Some faced with paying tax on employer contributions could even leave their schemes entirely, storing up real challenges for the future. Also, middle earners - an increasing number of whom are being brought into higher rate tax - are a group at significant risk of not saving adequately to maintain their working age living standards into retirement.
We recommend the Government tests any new approach with savers to understand how it might change retirement savings behaviours. This might be split by earnings band, age, employment status and whether currently accruing in a DB or DC scheme.
I very much hope the Government would not want to see mass opt outs. Pensions are good not just for individuals, but they reduce future reliance on the state and are increasingly recognised as a source of UK economic growth.
A potential behavioural loophole
One consequence of moving to a flat rate of relief above basic rate is that basic rate taxpayers get more relief than they’ll pay in tax on the proceeds. Those approaching the age they plan to draw an income could ‘game’ the system by receiving say 30% in tax relief and immediately drawing income on which they’d pay an average effective rate of 15% or less.
6. Next steps and client considerations
The next steps here are very much down to the Government. While current national finances are stretched, I strongly believe pensions must be seen as far longer in duration than the timetable for addressing the UK’s financial ‘black hole’, or any Government’s five-year term. Any system of pensions tax relief needs to incentivise an appropriate degree of savings for retirement, irrespective of earnings. Failure to achieve this will fundamentally undermine auto-enrolment.
It should also support overall Government pension policy. This is why I believe the Pensions Review should be undertaken first, with any reform of pensions tax following this to support it.
Advisers may well wish to discuss the possibility of changes such as those outlined here with their higher and additional rate clients. For some, the ‘no regrets’ action might be to pay additional sums into their pension ahead of the Autumn Budget taking place on 30 October 2024.
In terms of the treatment of personal contributions, there are no specific or ‘different’ issues for DB schemes. However, it’s more common for these to be operated on a net pay basis, so a unilateral move to relief at source would have more widespread ramifications.
For employer contributions, in line with DC, we believe it would be necessary to apply a benefit in kind style tax charge in respect of employer contributions. But here, as employer contributions are calculated at scheme level and not allocated to individuals based on individual benefit accrual, this would need to be based on ‘deemed employer contributions’ for higher and additional rate taxpayers.
The ‘deemed employer contribution rate’ should be based on a prescribed assessment of the additional benefits accrued by members. We don’t believe it would be feasible to carry out this assessment based on the actual additional benefits accrued at individual level, year on year. Instead, we propose a general means of arriving at the deemed employer contribution at scheme level. This would be based on accrual rates, retirement age, pension in payment increases and spouses’ retirement benefits.
This could be determined as a flat percentage across all ages, but there’s a strong argument to vary by age band. A year’s DB accrual is worth much more at older than younger ages so this would improve accuracy of the ‘value’ and fairness, albeit at the expense of increased complexity.
We believe that purely for this purpose (not for scheme funding) the Government Actuary’s Department should set the prescribed actuarial basis for assessing benefits. This would need to be subject to periodic review, perhaps every three or five years to reflect anticipated future economic and other demographic conditions.
Importantly, the deemed employer contribution should relate to the cost of future accrual. Any employer contribution increase to fund a deficit or reduction in respect of a surplus should not be included as these relate to past experience.
The total contribution assessed as equivalent to the accrual, less the rate being paid by the employee, would be the deemed employer contribution rate and could then be taxed as a benefit in kind with higher and additional rate taxpayers taxed on the difference between the flat rate and their marginal rate.
For example, a scheme offering 1/60ths of final salary from age 65, with 50% spouse’s pension, both escalating at 3% might be assessed as requiring a total contribution rate of 25%. (This is purely for illustration and isn’t based on any underlying calculations). If employees contribute 10%, then the deemed employer contribution would be 15%, which would be taxed in the style of a benefit in kind. If the flat rate of relief were 30%, a 40% higher rate taxpayer would be subject to a tax charge of 10% on that 15%, or 1.5% of pensionable earnings.
There are both advantages and disadvantages of using a ‘deemed’ approach rather than attempting a more personalised approach. The deemed route is far simpler and gives the employee certainty in advance of how much their tax charge will be.
Under an individual assessment, those in final salary schemes would for example face a significant tax charge on a promotion as the increased salary would apply to all past accrual too. However, for some individuals, for example those in final salary schemes whose salary does not increase in line with the assumed salary escalation within the deemed funding rate calculation, they may be taxed on a deemed employer contribution which exceeds the value to them personally.
For this reason, the Government Actuary’s Department might choose to base the deemed contribution rate on relatively optimistic assumptions such as a relatively high real investment return.