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23 Jul 2020
by Maggie Williams

The £38bn pensions tax problem that can no longer be kicked down the road

There are 1,100 of them, and they cost the government £159bn a year. The top 10 alone cost £117bn; the biggest is £38bn.

And no-one knows if they are working.

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This week the Parliamentary Accounts Committee (PAC) made a first tentative step towards unravelling the mystery of the thousand-plus UK tax reliefs, including a review of the pensions system. Because pensions is the £38bn heavyweight accounting for almost a quarter of the government’s £159bn annual tax relief bill.

Worryingly the PAC concluded that no-one knows whether pensions tax relief actually achieves anything. Its report made the damning conclusion that there has been “no assessment of whether that huge cost actually encourages saving for retirement…or whether it just enables those already saving comfortably to save more.”

Speculation on changes to pensions tax relief has been a pre-Budget staple in recent years – but the Chancellor’s red box has remained firmly shut on the topic – until now.

With the government expected to borrow £370bn this year as a result of the Covid-19 crisis, there is no more road left to kick the pensions tax can along. Change is more likely than ever to happen, and that will have implications for employees’ wider financial wellbeing, one of the key topics at REBA’s virtual Employee Wellbeing Congress 2020.

Unpicking and reconstructing pensions tax relief is not for the faint-hearted. The Annual Allowance (AA) taper alone has proved so complex that it caused a crisis for NHS consultants that had to be resolved with new legislation.

Reductions to the Lifetime Allowance (LTA) could result in more high and middle earners becoming excluded from pension savings, with the unintended consequence that they lose interest in providing good quality pension schemes for their wider workforces.

But you could argue that senior consultants and the higher echelons of management are not the biggest priority for the pensions tax relief regime. Younger workers likely to suffer long-term pay scarring because of the economic after-effects of the pandemic, and other low-earners who struggle to save for retirement could be higher priority for the cash-strapped public purse.

The PAC’s review may have some good news for them. Part of its recommendation is to address the anomaly of net pay and relief-at-source pension schemes. It estimates that around 1.75m workers are not receiving any tax relief on their pension because they earn less than the personal earnings threshold and contribute to ‘net pay’ schemes.

Net pay schemes collect pension contributions before income tax is deducted, so anyone who is not paying income tax receives no relief. In contrast, relief-at-source schemes take 80% of tax from an employee’s post-tax pay, and claim the remaining 20% back from HMRC on the employees’ behalf, so offer a better arrangement for the lowest earners.

What could a broader pensions tax relief review look like? It could take one of (at least) three directions:

  • It could simply result in some tinkering with the LTA and AA. That would mean employees have to get to grips with new ways of saving tax-efficiently, including exploring alternatives to traditional pensions for more senior earners.
  • But we could see a far more radical reform. It might even change the entire nature of pensions relief, putting it more on a par with ISAs from a tax perspective and/or making a better tax environment for ‘sidecar savings’. That would require radical change to savings models, require financial education for all staff – not to mention a significant amount of shake-up in the pension provider community.
  • A third way might be a flat rate of tax relief. That would create a more straightforward, fairer approach than the current regime, and mean business as usual for providers. Inevitably there would be winners and losers relative to the current arrangements, and could drive a more joined-up approach to long-term savings that could also include Lifetime ISAs and other savings models.

In more so-called normal times, we might expect a review of pensions tax relief to proceed at glacial pace, as the implications for the Treasury, pensions community and savers are all worked out and aligned.

But these are anything but normal times. After years of gentle speculation about change, it could now be swift and radical – driven by urgent necessity. And employers will need to respond in kind to help staff navigate new ways of saving for retirement.

The author is Maggie Williams content director at REBA.

You can explore joined-up approaches to financial wellbeing at REBA’s Employee Wellbeing Congress on 9 September, where our speakers include Paul Johnson, director of the Institute of Fiscal Studies. Paul will be exploring what equality, fairness and responsibility mean for employees’ financial wellbeing.

Register to attend the Employee Wellbeing Congress.

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