Pensions tax reform – is it time to Tee off?

I’m getting to that stage in my life when I’m starting to think about retirement and life after pensions. I might open a small cafe called “Tees and Eets” which might be more appealing in the context of a brew and a bun than when looking at the possible taxation of pensions.

As a reminder the discussion centres on TEE or Taxed, Exempt, Exempt (so contributions are from taxed income but investments and the eventual fund can be paid tax free, so like an ISA) against EET or Exempt, Exempt, Taxed (so there is tax relief on contributions and investments but the eventual benefits are taxed, so like pensions).

Government consultation looked at this entitled ‘strengthening the incentive to save’. However, in the opening paragraph there is reference to the ‘UK’s future financial security’ and [to] ‘put the public finances back on track’ … so the title might be a little disingenuous as it seems pretty clear to me what the Government’s focus is. That said, we are a nation that is in debt to the tune of £1.6 trillion. Despite positive noises about UK growth the picture for the world economy is less bright … when China sneezes the rest of the world goes to bed with a severe case of man flu it seems … it is therefore inevitable that pensions, a tax relieved bastion, will (and arguably should) be targeted.

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There is a comment to the effect that maintaining the current system may be the most cost effective method [of achieving the aims] i.e. balancing the books and getting people to save more. The ‘do nothing’ approach is interesting when you start to look at the implications of changing that tax structure, but more on this later. As I said, it’s not all about (the public’s) money … the strap line is ‘Strengthening the incentive to save’. So how can this be achieved?

(Quasi) compulsion through Auto-enrolment (AE) is a good start. Reversing the trend in occupational scheme membership is positive and a 10% opt out rate is surprisingly encouraging, although this will inevitably increase as the smaller employers reach their staging dates. Currently, the amounts are not adequate but this is in hand. Tick in the box.

The pension (freedom) reforms are absolutely critical, notwithstanding their somewhat bungled implementation. People are living longer and are going to be ‘retired’ for longer but how is retirement defined? The ‘stop work; draw pension’ model has been discredited for a while. People want flexibility in retirement, work less hours, do different things … but still work in some capacity. People have other savings; property, inherited wealth. Income needs are likely to be more U shaped, higher earlier in retirement when people are still active and want to enjoy the free time afforded by ‘retirement’, less so ‘mid retirement’ but increasing again in later life due to care requirements.

It is right that people should be able to plan accordingly and, similarly, product providers need to step up to the plate. Those living in DB land also need to think how to adapt to embrace ‘pension freedoms’, sooner rather than later. So freedoms are another tick in the box.

Given that’s two ticks, do we even need to worry about tax relief? In fact, as the Government’s consultation alludes to, there is evidence that tax relief is not a strong determinant in people’s decision to save. In a recent PWC survey only 14% of those questioned said that they thought the current tax exemptions incentivised them to save towards a pension.

However, if you leave aside the fact that people are not that bothered about tax anyway, PWC’s survey also found that only 27% thought the current tax scenario was the most appealing and 40% would prefer to move to a similar tax treatment as ISAs. So the nation prefers Tee it seems.

This is interesting, as for most people, the tax relief enjoyed on contributions paid in will far outweigh the tax paid on benefits coming out the other end (assuming consistent tax rates) but, nevertheless, people would appear to find the whole tax thing complicated and would prefer to know exactly where they stand.

Broadly, the proposed principles for any pensions tax reform are simplicity and transparency, personal responsibility and sustainability. The first two principles are actually pretty closely aligned – if you simplify pensions so people understand them, they will engage. If they engage they will recognise the importance of long term saving. So let’s get on and simplify …

The suggestion in the consultation (and borne out in the PwC survey) is that to simplify means to create a type of super ISA so people know how much they have without worrying about complicated tax stuff. Hence make your contributions from taxed income and your pot is what you own. Simple. But would a shift to Tee actually be that simple?

Firstly, whilst any move to a Tee scenario would undoubtedly give rise to a short term tax hike, what do you do with all the many years funds built up, tax relieved to date? You couldn’t just take those benefits tax free (or, at least, if you could, that would seem a bit counter productive) so you would need a two tier system (for a long time possibly) and/or some one off adjustment (tax) on funds built up to date.

Also, what is not clear in a possible Tee scenario is what happens with regard to employer tax relief. Will members face a P11d tax charge on any contributions made on their behalf by the employer? Not simple. Also, how would members of DB schemes be taxed in a Tee scenario? It would surely be unfair (or, at least, unreasonable) for them to be taxed on any employer deficit repair contributions.

However, if you attempt to retain some element of tax relief on employer contributions and/or employer contributions are not taxed in the hands of the member, surely all schemes would become non contributory very quickly? (… and you would end up with an Eee – which might be OK for the good folk of Yorkshire and, indeed, the rest of the country but maybe not great for the Government’s coffers).

It’s beginning to look a bit messy.

Given this maybe the answer is to leave things alone, after all it’s worked pretty well for the best part of a century. In fact, is better education the key? That’s a rhetorical question by the way, financial education in this country is scandalous although it is now, finally, included in the National Curriculum (from 2014).

Is it, arguably, a bit perverse to try and ‘simplify’ something rather than just explain properly how it works in the first place?

If you can get people talking about pensions, especially the younger generation, they will become relevant. Pensions might become the must have product, people will tweet about their investment profile; they will put pictures of their statements on Facebook … maybe if Apple were to launch an iPension? Maybe stop calling them pensions. You get the idea.

One thing I might suggest to foster engagement, even if you leave the tax position alone, is to facilitate some form of controlled early access. Whilst, clearly, the idea is to build up funds to provide for financial well being in later life, stuff will happen between then and now (given, for someone in their 20s currently, that could be 50 years or more) and, if you knew that that you could access some of your pension cash if necessary, people would be more inclined to put money aside.

So, if we decide that, in fact, Auto Enrolment and pension freedoms have kick started pensions saving, throw in some education, a bit of positive PR and introduce controlled early access, then we don’t need to worry about messing with the tax. But what about the other principle, i.e. a sustainable tax take?

Pension freedoms may have helped short term but, arguably, at the expense of long term tax receipts. There has been the inevitable tinkering with the Annual Input and Lifetime allowances and, quite reasonably, restrictions on the tax relief afforded to the most wealthy.

What has not been mooted in the whole TEE and EET debate is the third option which is ETE. Not as snappy an acronym, I grant you, but, given there are some £1.6 trillion of funds under management in occupational schemes (interestingly, the same size as the national debt) and a further £500 billion tied up in personal arrangements, a fairly modest tax charge on investment returns would generate sizeable revenue to help offset the £50 billion cost of pensions tax relief currently (a 10% tax levied on a 5% return would be £10 billion by my calculations).

It seems to me that, ever since Brown’s ‘raid on pension funds’ in 1997, assets under management seem to have had a protected status usually only afforded to endangered furry animals but maybe it’s time to move on. I can also hear DB sponsors across the land, already struggling with pension fund deficits, crying foul but, nevertheless, I think it is an option worth considering.

At least we will soon be put out of our misery. In the Chancellors Autumn Statement and Spending Review he announced that his announcement (not quite the same as a double negative) on Tax will be made in the 16th March 2016 budget. There are even rumours of a new T+ET (Taxed, Topped Up, Exempt, Taxed) model finding favour. As the old TV programme Soap used to say – “These questions—and many others—will be answered in the next episode of…”

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