Most people do not understand how pension tax relief works, and there are 10 million people saving as the result of automatic enrolment anyway.
I am, however, fairly sure of two things:
- People do understand the concept of ‘free money’ and the idea of it being a reward for ‘good’ behaviour
- People may not understand exactly what they are getting but they will care if it is taken away from them
The government is perfectly right to consider the sustainability of the current system, and whether it has the effect intended. However, they should think carefully about some key questions before making fundamental changes.
Do we need tax relief at all?
Automatic enrolment has made a great start by encouraging more people to save for their retirement but, for most, the amounts being saved are wholly inadequate. Unless the government is willing to bring in compulsion to save, it relies on incentives to encourage employees to increase their contributions to the levels required to maintain a reasonable standard of living in retirement.
It is likely, in fact, that minimum contributions will have to be raised at some point and it would be unfair on both workers and employers if the government was not seen to be playing its part.
The Treasury must therefore balance the cost of the increasing numbers claiming tax relief with the cost of supporting the same people in later life if they don’t save enough, or at all.
Are we rewarding the right behaviour?
If the intention is to encourage a pattern of long term saving the exempt, exempt, taxed (EET) structure of the existing system is absolutely the right one. Paying tax relief up front is the most efficient way of helping people to build up the maximum possible pension fund, as it means that more is invested early on and will benefit from many years of compound investment growth.
As longevity increases and the amount of savings required to provide a lifetime income rises, savers will need all the help they can get to accumulate adequate funds.
Are we rewarding the right people?
Much has been made of the fact that over 70% of pension tax relief is claimed by higher and additional rate taxpayers. Restricting tax relief to the basic rate would be popular with people on average earnings who might never benefit from higher rate relief anyway.
On the other hand, it would mean that any individual who became a higher rate taxpayer at any point in their lives would not only receive less in their pension, they could face the prospect of being taxed twice on some of their money. Marginal rate tax relief was designed specifically to avoid this issue – up front tax relief offsets the tax paid on income at retirement.
Are we rewarding the right amount?
When a flat rate of tax relief was first suggested, 20% was very much at the lower end of the proposed scale. Reducing the amounts going into pension savings in general, at a time when we already know savings are inadequate, will certainly result in a shortfall that will have to be made up from somewhere else.
On the face of it, basic rate taxpayers may not feel they will be any worse off but with the higher rate tax threshold currently set at £50,001 (including the personal allowance) in England and Wales, younger workers would do well to realise this could mean their ability to accumulate the sort of pension savings held by todays pensioners looks extremely remote.
Is there a workable solution?
Any solution needs to be practical. Flat rate tax relief would be relatively easy to apply to relief at source pension arrangements, however it would cause potential issues for net pay schemes. Final salary schemes in particular would find it hard to identify the correct amount of tax relief applicable to pooled employer contributions. Funding levels, which for some schemes have taken around a decade to return to anything approaching solvency, would also be significantly impacted.
All in all, I think there is no doubt tax relief is needed, there is no doubt the Treasury needs to control costs and there is no doubt that any cuts will result in lower pensions for many people. Hard choices lie ahead.
Fiona Tait is technical director at Intelligent Pensions