ELECTION promises, they are so hard to keep, aren’t they? On April 11th, Britain’s Conservative party said in a pre-election briefing that
we believe that the pensions-tax-relief system will be fair and affordable and we will not propose any further changes to the system during the next
But times change. The election came and went and three whole months elapsed before the Budget on July 8th, when George Osborne consulted on a massive change to the pensions-tax system. Given that the consultation document must have taken a month to prepare, George’s conversion was positively Damascene. The proposed change would be to remove upfront tax relief for pensions contributions. That kind of change will doubtless come under fierce attack from, er, the Conservative party which said in February that
the principle that the vast majority of pensions contributions should be free of tax is fundamental to our whole pensions-and-savings system and changing that would do huge damage to our savings culture and our economy
To call recent British pensions policy a dog’s breakfast would be an insult to canine palates. Governments have struggled to reconcile a desire to encourage saving for retirement, particularly among poorer workers, with a desire to control the cost. In 2006, pensions simplification was introduced. The new system was indeed simple but was largely taken advantage of by high-rate taxpayers. Since the financial crisis began, governments of both colours have been nibbling away at the tax reliefs.
The new change, if it comes about, would be to move from an “EET” system, in which contributions and investment returns are tax-exempt while retirement income is taxed, to a “TEE” system under which contributions are taxed, but returns and retirement income are tax-free. In theory, both are valid approaches. The problem is that switching from one to the other is a little like decreeing that British cars should shift to driving on the right, with the move phased in gradually.
Your blogger spent 90 minutes this morning at a briefing on the issue organised by David Robbins and Dave Roberts, two consultants at Towers Watson, the actuaries. The complications involved in such a shift are mind-boggling. By itself, that casts doubts on Mr Osborne’s aim for reform, mentioned in the budget that
if people are to take responsibility for their retirement, it is important that the support on offer from the government is simple and transparent, and that complexity does not undermine the incentive for individuals to save. It is also vital that the system is sustainable.
The first problem is what to tax. Contributions into schemes are made both by employees and employers. The latter are usually much larger than the former. At the moment, most employees may know they exist but not be aware of their scale. But under TEE, those contributions would have to be taxed. How? Would both income tax and national insurance apply? If only the former, what happens if the two systems are merged, as some suggest? And how is the tax deducted? Taxing the employee would lead to a big fall in take-home pay; for defined benefit (DB) plans linked to a final salary, employers may be contributing 25% of payroll; taxing that at 20% means a 5% pay cut. That sounds a non-starter politically.
Instead, the tax could be taken from the employer’s contributions. But DB employers have made a pension promise, so they would have to top up their contributions to compensate for the tax. Indeed, lots of employers are in deficit and are making additional contributions to bring the scheme back into balance; would those top-up payments be taxed? On the other hand, under TEE, pensions would be tax-free. Perhaps workers would accept a lower pension if the sum were not taxed. But presumably TEE would only apply to future contributions; otherwise, people would switch from the old schemes, from which they already received tax relief in work, to the new ones, on which they paid no tax as retirees. So workers would have two pensions, one under EET and the other under TEE. Sound simple to you?
A further complication is that many workers in DB schemes are in the public sector. As part of a reform package in the last Parliament, such workers were promised no more fiddling with pension promises. The government would be breaking a promise to workers who are already disgruntled by years of pay restrictions. Strikes would ensue.
The second issue is whether this would really encourage pension savings. Workers would have to pay tax now and trust governments to keep their promise not to change the treatment of pensions later; history is full of tinkering with the tax system. Many people suggest the motivation of a switch to TEE would be to increase government revenue at a time of big deficits.
In the long term, this might leave the government’s tax position unchanged; revenues will simply have been brought forward. However, the government could gain from the new system. Under the current EET system, retirees can take 25% of their pension pot tax-free; a big incentive for some. But under TEE, all the final pot would be tax-free but all the contributions would be taxed upfront; the 25% disappears. In net terms, that is a government gain. To offset this gain, the government might offer a top-up to workers; for example, matching every £1 they contribute to a pension, up to a limit. This could be designed to favour low-income workers.
Another complication. The government just introduced pensions “freedom” – abolishing the need to turn a pension pot into an annuity. As we have pointed out, this freedom is a revenue raiser for the government since people pay tax if they turn their pot into cash. This tax charge is actually quite useful in that it stops people blowing their pension pot in a spending spree at 65. But under EET, there would be no tax to pay; the number of pensioners who ran through their pots would likely grow exponentially. That doesn’t seem like a good policy outcome.
I have only scratched the surface of the complications but you get the drift. Alternative plans, such as a flat rate of tax relief are a bit simpler, but still run into difficulties such as how to treat employer contributions. Give it a rest, George, and let one set of reforms bed in before you try another. Just remember your pre-election pledge.