Strengthening the incentive to save: a consultation on pensions tax relief – Sackers’ response to consultation

Background

On 8 July 2015, HM Treasury published a consultation to examine whether there is a case for reforming pensions tax relief.

The Government has asked for views on the potential for reform. While the consultation itself does not put forward different options in any detail, it suggests that they could range from a fundamental change to the system (for example moving to a “taxed – exempt – exempt” (TEE) system, like ISAs, and providing a Government top-up on pension contributions) to less radical changes (such as retaining the current system and further altering the lifetime and annual allowances), as well as options in between.

It is intended that any reforms would build on recent changes to pensions tax relief and the pension flexibilities introduced from 6 April 2015.

In this response

• General comments
• Complexity in the current system
• Increasing engagement and incentivising pension saving
• Personal responsibility
• Retirement planning
• Treatment of DB and DC pensions
• Administrative barriers
• Treatment of employer contributions
• Sustainability of the system

General comments

We welcome the opportunity to comment on HM Treasury’s consultation. We do not seek to comment on general policy issues, but to share our experience in the light of the questions raised.

We make the following general points:

• Confidence in the system: Significant tinkering with different elements of the pensions system since 6 April 206 (A-Day) has not, overall, boosted confidence in the system. Whilst we recognise that certain changes are necessary in order to keep pace with changes in working life and financial sector regulation, among other things, as a long-term savings product, pensions need to fit within a constant regime that is protected from changes by successive Governments. A consistent approach and greater stability in the pensions tax system would help to aid understanding of the incentives on offer, underpin the importance of saving for later life, and, ultimately improve confidence in pension saving.
• Automatic enrolment: We believe that automatic enrolment has shown itself to be a success so far in bringing new members into pension saving. We therefore hope that it will continue to be protected and promoted. There is a risk that changes to the existing system may cause low contribution rates to be maintained and/or opt-out rates to increase. Instead, the Government should be seeking to encourage pension saving in excess of current automatic enrolment minimum rates, with a view to promoting greater levels of self-sufficiency in retirement.
• Intergenerational fairness: there is currently at least a perception of unfairness between generations – particularly as a result of the split between defined benefit (DB) and defined contribution (DC) pension scheme membership. There is a risk that further radical change to the system of pensions taxation in the UK could perpetuate or increase existing disparities, leading to further loss of confidence in the system.
• Education: we believe that financial education is key to people understanding the pensions system and therefore wanting to take responsibility for their retirement savings. This should be available from an early age and continue into the workplace.

Our specific comments in relation to the various consultation questions are set out below. We have based these on our experience of the current system, focusing on the areas most relevant to our practice.

Complexity in the current system

In our view, there are various factors which act as a disincentive to pension saving. The current system of pensions tax relief is inherently complex and persistent tinkering with the rules since “simplification” of the system at A-Day has only increased the level of complexity for individuals, employers, providers and administrators. Added to this, increased regulatory oversight has led to many employers closing and/or changing their workplace pension schemes.

There are currently different methods for accessing tax relief on pension contributions, under the existing net pay and relief at source arrangements. As a result, some confusion can arise, for example, when individuals change jobs and are exposed to a different system. This may also be a reason why pensions tax relief is not always fully understood – because it may not be immediately obvious to pension savers. A consistent method of achieving tax relief (or Government top-up, if that option is pursued) would help here.

That said, the success of automatic enrolment since its introduction in October 2012 suggests that the complexity of the system is not the main obstacle to pension saving. As HM Treasury notes in the consultation, “The introduction of automatic enrolment now means that more than five million people are newly saving into a private pension through their workplace. By 2020, the Government expects to see 8 to 9 million people newly saving or saving more, generating £11 billion a year more in workplace pension saving.”

The way in which automatic enrolment has been communicated by the Government, the DWP and the Pensions Regulator to explain the advantages and existing incentives, such as tax relief, has played a key role in getting across the benefits of pension saving. Combined with the automated process which makes pension scheme membership very straightforward for individuals, these elements have together contributed to the low opt-out rates seen to date.

Increasing engagement and incentivising retirement saving

Successive Governments have sought to understand the rationale for low take-up of pension saving and to look for ways of incentivising both new savers and higher rates of saving. This was the main focus of the Turner Commission in the early 2000s.

We agree that the simpler the system, the greater the likelihood of engagement. This is the case for employers, providers who can benefit from a system that is straightforward to administer, and for individuals in terms of being able to understand their pension product and the importance of saving for later life. However, it should also be acknowledged that some people do not, and in many cases, cannot, prioritise pension saving.

Real change in engagement levels seems most likely to come from greater understanding of existing incentives, including tax relief and employer contributions, as a result of a renewed focus on education and communication of their benefits. We consider that a move towards taxing contributions upfront, leading to lower take home pay in the short-term, risks adding a disincentive, with the potential that more people will choose to opt out of the schemes into which they have been automatically enrolled.

Under an EET system, individual pension savers can count on their incentive (in this case, the tax relief on contributions) being “banked” from the outset. Whilst we recognise that a Government top-up in a TEE system could also act as an incentive, individuals may not trust that the benefit of the exemption will still be available to them at retirement, based on the track record of changes in the pension system to date.

Whilst ISAs are popular and generally easily understood, part of their attraction appears to be the ease of access to funds at little or no notice, without penalty. Cash ISAs, in particular, are a popular product as these are easy to understand. As such, they may already be used as an alternative to pension saving. If pension products were to be treated more like ISAs, there is a real risk that ISAs would be favoured ahead of pensions as savings vehicles, with more savings directed towards cash as opposed to revenue generating investments. This could lead to insufficient retirement savings for individuals and, with investment diverted away from business and infrastructure, have potentially wider ramifications for overall growth in the UK.

In recent years, there have been significant improvements in standards of governance and fiduciary oversight over private pensions, which have not been replicated to the same extent for other savings products, such as ISAs. An important factor to be taken into account will be the extent to which individuals will be protected if there is a move away from existing pension vehicles to ISA style products.

In 2010, HM Treasury issued a call for evidence on “Early access to pension savings”, then seen as an option that may incentivise pension saving. At that time, the coalition Government concluded that “early access to pension savings should not be considered at the present time”, but promised to review the situation once automatic enrolment has been fully phased in. We would support further work in this area, as experience in other jurisdictions, such as with the New Zealand Kiwisaver model, demonstrates that being able to access or borrow from pension funds in certain circumstances can be an important incentive to pension saving.

It is worth noting that the success to date of automatic enrolment has relied, in part, on apathy inducing a reluctance to opt out. It is generally agreed that the minimum contribution rates for automatic enrolment (even after these have increased by the end of the transitional period in 2018), are likely to produce insufficient income in retirement. Therefore, with a view to encouraging greater self-sufficiency, the Government could consider raising the minimum automatic enrolment contribution rates.

Personal responsibility

We agree that the shift over recent years to DC pensions has increased the need to ensure that individuals contribute enough to their pensions. We also agree that various reductions in the Lifetime and Annual Allowances (LTA and AA) are already affecting, and will do so increasingly, the ability of individuals in terms of planning their retirement savings and, ultimately, of achieving their desired level of income in retirement.

An important factor in promoting personal responsibility, whether in the current or an alternative system, will be the clarity and accessibility of the incentive provided. We believe that making the incentive (whether tax relief or top-up) clearer in Government and Regulator communications (as for automatic enrolment), as well as at scheme level for member communications and pension savings statements, could also help promote personal responsibility towards saving for retirement.

We recognise that there has been much interest in the pension freedoms that were introduced in April 2015. However, it is too early to know what impact they will have on promoting personal responsibility for pension saving in the longer term.

As noted above, part of the success of automatic enrolment is due to the fact that individuals are not required to make decisions in order to access pension saving. The nature of ISAs is that they rely entirely on member choice in terms of both product selection and investments. We therefore question the extent to which automatic enrolment could be achieved with an ISA style retirement product.

Retirement planning

As noted above, we believe that greater financial education is an essential factor in terms of individuals engaging with pension savings and their ability to take greater personal responsibility in terms of the level of contributions payable, product selection and investment choices (where appropriate) and the way in which benefits are taken in retirement.

It is the continual changes to the pension system year on year which make retirement planning difficult. The stability of any pension system will be key to allowing individuals to plan appropriately.

Treatment of DB and DC pensions

We believe that treatment of DB and DC pensions must be fairly handled. The current system of EET, albeit complicated in recent years by successive changes to the AA and LTA, works for both DB and DC pensions.

In practice, should the Government pursue a move to TEE, this would be more straightforward for DC schemes. Applying TEE to DB schemes would be significantly more complex.

For DB schemes there are a number of issues that would require careful consideration if a TEE system were to be applied. These include:

• Valuing DB accrual
  
  The consultation does not address how DB accrual would be treated under TEE – we envisage that it would need to be valued annually in order to assess the tax due.There would be a number of difficulties in carrying out such an assessment, given the disconnection between contributions paid and the rate of accrual for each individual member. The ultimate value of accrual in a particular year is only ascertainable when the individual leaves the scheme and their actual final salary is known.The current multiplier of 16 for AA purposes provides a rough measure for calculating an individual’s pension input amount on an annual basis. However, it cannot take account of early or late retirements. It also ignores non-statutory increases and other augmentations, contingent death benefits and other elements such as bridging pensions.A more sophisticated approach would therefore be needed to ensure that tax charges arising on the pension input amount are applied fairly. However, this would increase complexity for schemes.
  
• DB accrual as a taxable benefit
  
  Having valued an individual’s DB accrual in a particular year, HMRC would need a mechanism for collecting the tax due. To assist individuals who may not be able to meet the tax liability directly, the scheme pays facility could be adapted for use in these circumstances. However, this is complicated for schemes to operate and, at present, is only used for a minority of DB scheme members. Requiring the system to operate for all DB members would increase the already complex process considerably.It also needs to be borne in mind that a common result of the general shift in recent years from DB to DC pension provision, is that many members have both DB and DC benefits. This may be within the same scheme (for example, hybrid or arrangements or DC AVCs in a DB arrangement) or in separate schemes. Explaining any differences in the regime would be a particular challenge in connection with such arrangements and not conducive to promoting engagement.

If the Government were to maintain EET for DB, while applying TEE to DC schemes, thought would need to be given to the tax treatment of DB to DC transfers.

If a switch is made, transition from one regime to another is likely to be complicated. In addition, given that many DB schemes are in run-off, the impact in relation to DB schemes of switching from EET to TEE, in terms of revenues collected by the Government, is likely to be limited, particularly as contributions and deficit reduction contributions will diminish over time.

Administrative barriers

Any change to the tax system for pensions would require changes to trustees, employer, administrator and provider systems and processes, with any transitional period adding a further layer of complexity. At a time when there have already been significant changes to pension systems, the additional costs that would be associated with yet further change could well act as a barrier to achieving the Government’s objective of strengthening the incentive to save.

As noted above, whilst in our view, pension savers should be able to expect parity between the DB and DC systems, if the Government is minded to introduce any form of TEE, we envisage that the practical difficulties in applying TEE to DB arrangements could lead it to consider a different approach for DB and DC. However, dealing with separate regimes for DB and DC would also add to the complexity, not only for trustees, employers, providers and individuals, but also for HMRC.

Treatment of employer contributions

We are of the view that employer pension contributions should remain a deductible expense. However, as we explain above, there would be practical difficulties in valuing the employer contribution as part of an individual’s DB accrual.

Sustainability of the system

Sustainability of the pensions system has been the mantra of successive Governments and was a key focus of the Pensions Commission. It is little more than a decade since incentives to pension saving were considered as part of the Commission’s “new pension settlement for the twenty-first century”, and changes since then, including the introduction of automatic enrolment, the charge cap for DC default funds and the abolition of DB contracting-out, have had a positive impact on pension saving. Whilst we support measures that will help individuals benefit from a more secure retirement, we are surprised that a radical overhaul of the system may now be on the cards now.

We recognise that there can be a tension between managing public finances and achieving the stated objective of strengthening the incentive to save. However, care should be taken to avoid a situation where existing incentives are reduced, with the result that lower levels of pension saving actually ensue.

To us, sustainability means individuals being able to understand what individuals can (and should) pay and when, and what they will receive (at least in approximate terms) in the future.

For a system to be sustainable, it also needs to be left alone. Although the introduction of automatic enrolment is achieving its aim of increasing the take-up of workplace pension saving, other changes, such as the reduction of both the LTA and AA, can be seen to be having the opposite effect. Constant change can be detrimental, leading to increasing distrust of the pensions system. Further changes will only exacerbate this problem.

Schemes are still assimilating the changes to private pensions that have been introduced in the past few years. In the event that further changes are introduced, these must be fully considered, with employers, trustees, providers and others being given sufficient time and support in relation to implementation.