Pensions tax relief is so often seen as an easy way for the government to save money and in the last year with spending so high, the issue has been raised multiple times. The most recent report in early March by the Treasury Committee again called for not just a review but an urgent reform.
It stated the following: “Given the regressive nature of the benefits accruing to individuals from the current arrangements on pension tax relief, especially those in the top earnings decile, the Chancellor should urgently reform the entire approach to pension tax relief.”
The government has pushed back on this, dismissing the need for a full-scale review, just as they did when the Public Accounts Committee referred to pensions tax relief in their report in mid-2020. The government also commented that the lifetime allowance has been frozen which effectively caps not only tax-relieved savings but also the amount of tax-free cash available to savers. It also pointed out other measures and previous reviews, including the substantial review in 2015.
On the surface, flat-rate tax relief is very appealing and would definitely benefit a lot of lower earners, which would be positive. However, I think it is fair to say that although pensions tax relief looks pretty simple from the outside and just cutting the rates an individual could reclaim might appear to be a quick win, there are multiple other knock-on effects to consider.
Salary sacrifice would not work should flat-rate relief be introduced, or higher-rate relief abolished because a higher rate taxpayer would still be getting full tax relief when sacrificing their salary for employer pension contributions.
The taxable amount of salary would be reduced so they wouldn’t be paying their highest marginal rate on that amount any longer. The only way around this would be to tax the member on the contribution, possible by way of the benefit in kind regime, where a P11d is issued at the end of the tax year. This takes account all of the benefits that the employee has received and should be taxed on their value.
Other options would be available and are offered by employers now, such as including the contribution, or benefit in kind as a notional payment on a payslip so the correct tax is paid at the time, but this is subject to the employer being able to offer this. This essentially negates the benefit of salary sacrifice in the first place, at least in respect of the tax relief.
So, although salary sacrifice for pensions has always been protected when changes have been made, this could force the government’s hand to ban it for pensions too.
Salary sacrifice has also been used significantly by employers who have set up new pension schemes in order to meet their automatic enrolment obligations. It would be costly for the employer to stop offering the sacrifice arrangement and also reduce the employee’s benefits, which really isn’t what the government is trying to do here – at least not for basic rate taxpayers. The knock-on effect for the government is the additional benefit of increased National Insurance payments received.
The same argument applies for employer contributions, should flat-rate or removal of a higher-rate be considered. Employer pension contributions really are just another payment to the employee even though it goes straight into their pension. The employee is receiving full marginal rate tax relief on this payment because it isn’t a taxed benefit. Employers could change contracts for employees to pay them a higher pension contribution and a lower salary. This isn’t salary sacrifice because the employee would never have been entitled to the payment as salary, but the outcome is the same. Higher-rate taxpayers would still be benefitting from higher rate relief even if the rules only offered personal contributions at a lower flat rate.
This again would mean that employer contributions would need to be monitored and the employee taxed accordingly to ensure no one is getting a different rate of tax relief into their pension.
Final Salary Schemes
Final salary schemes face their own challenges, many are underfunded, and this may see fewer funds going into the scheme from members, depending on the spread of taxpayers that are members. This will mean that the employer may need to make up the difference to keep the scheme solvent.
Employer contributions are not calculated based on the needs of the scheme which means that contributions are not attributable to individual members in the same way money purchase pension scheme contributions are. This would mean that trying to ensure higher rate taxpayers aren’t getting more than their fair share is impossible. Final salary schemes would, therefore, need to be excluded from these rules or another test applied. We already have significant differences in the way money purchase and final salary schemes are treated and this would just increase that.
The review of tax relief and who is benefiting from it is an important subject, but not the quick fix that many see it as.
I have always said that any change in this area would need significant consultation and deep consideration to get the right outcome. We want to ensure the tax relief is driving the right behaviours which will definitely take some brainpower to get right.
Claire Trott is head of pensions strategy at St. James’s Place Group