Strengthening the incentive to save: a consultation on pensions tax relief Response by the Chartered Institute of Taxation

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1 Strengthening the incentive to save: a consultation on pensions tax relief Response by the Chartered Institute of Taxation 1 Introduction 1.1 The Chartered Institute of Taxation (CIOT) sets out its comments below on HM Treasury s consultation on the future of pensions tax relief. 1.2 Chapter 1 of the consultation document examines the context for proposing reform and paragraph 1.4 notes that increasing longevity and changes in pension provision therefore provide the context for considering whether there is a case for reforming pensions tax relief. Paragraph 1.4 of the consultation document adds a further context for proposing reform: the deficit and the continuing pressure on the public finances. 1.3 The CIOT s response is predicated on the need for long term and sustainable stability in regard to pension arrangements from the time an individual first starts contributing towards their retirement until death (potentially and hopefully 70+ years later). 1.4 In this context the CIOT welcomes a number of the comments included in the foreword to the consultation document, ie: 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 government s interest is in a lasting system that stands the test of time. The government is clear that there is a need to proceed gradually. 2 Executive summary 2.1 The radical reforms introduced by Finance Act 2004 were the result of many years of painstaking work and consultation. We consider that a similar comprehensive study should

2 form a key part of any future reforms. What is required to incentivise saving is a stable, trusted and sustainable system of pensions taxation. 2.2 The ideal would be that the underlying approach is conceptually straightforward for people to grasp, that pensions saving remains attractive, that the underlying legislation is clear and certain and that HMRC guidance and examples can be relayed so that people do not have to become deep subject matter experts to understand what is involved. 2.3 The extent to which upfront tax relief is a factor in saving towards retirement should be researched. For example, to what extent has Auto-Enrolment changed the landscape? And have increases in personal allowances reduced the benefit of tax reliefs to those on lower incomes? 2.4 If individuals are to be encouraged to save into pension schemes then part of any reforms to the system of pensions tax relief must be a confidence that government will not subsequently substantially change the rules to the detriment of the individual. 2.5 Equally, it should be recognised that a large proportion of pension contributions are made by employers. Considerable weight should therefore be given to employers views before any decision to reform pensions tax relief is made. 2.6 Should the government decide not to undertake a wholesale reform of pensions tax relief then the current system of pensions taxation should be subject to a thorough review with the aim of restoring the simplicity intended through the Finance Act 2004 reforms. This is a point that we have made previously and we underscore it again now. 2.7 While the complexity of the current system may not undermine the incentive to save for the majority of individuals it certainly does not help. A contributing factor does seem to be the year-on-year changes to the current system which undermines confidence in the longevity of the pensions taxation system. 2.8 So whether or not the government decides on a fundamental change in approach, eg from EET to TEE, we do believe that the rules should be simplified so that people do not get bogged down trying to unravel the complexities that have arisen from the multitude of changes made over the last decade. 2.9 If the Government decides that an alternative system of pensions taxation is required we agree that the Government s suggestion of an ISA like system warrants further investigation. ISAs are genuinely simple, as illustrated by their increased popularity. The question must be though how would a Pensions ISA distinguish itself from an ordinary ISA? We consider this point further below The aim of any alternative system should be to encourage people to set aside funds to provide an income in retirement. Some individuals, especially those with tough financial commitments, will undoubtedly require some incentive to put funds aside now for the future. Also, we do think that some restriction on withdrawing funds should be considered to ensure there is an adequate amount for [the whole of] retirement, especially as many underestimate the funds required to meet their retirement expectations A key aspect to any alternative system must be trust and confidence. Unless individuals are confident that today s saving vehicle will be subject to today s rules tomorrow a difficult concept to achieve given a future government cannot be prevented from adopting a P/tech/subsfinal/ET/2015 2

3 different view they may not have the confidence required to use that vehicle to plan for their retirement. Simple to say but of course difficult to deliver, as the changes to tax relief made over the last ten years amply demonstrate There will undoubtedly be many obstacles to cross if an alternative system of pensions taxation is adopted. Time must therefore be devoted to fully exploring how to navigate through these issues, eg would existing schemes be grand-fathered or subject to a one-off charge, would defined benefits schemes be treated differently (possibly yes) but if subject to a TEE regime how will employer contributions be taxed, etc Rather than rushing through legislation we would recommend the creation of a working group to explore how these obstacles can be navigated and a smooth transition made to any alternative system of pensions taxation If a new sustainable system of pensions taxation is to be achieved it will require a clear (and cross-party) consensus around what it is that the government is trying to achieve so that for the foreseeable future there is a confidence that the new system will remain largely unchanged. That said, we welcome the government initiating the discussion with the issue of this consultation document. 3 Pensions Simplification 3.1 The foreword to the consultation document notes that it has been [a little] over a decade since the government last reviewed the support on offer through the tax system for those savings into a pension. In the context of the usual lifetime for an individual s pension savings this is of course a relatively short time lapse, although a lot has happened in that time (most notably the economic downturn). 3.2 The underlying and laudable aim of the previous review was to introduce a single tax regime that attempted to simplify most aspects of the current pension tax system. HMRC s Pensions Tax Simplification Newsletter No 1 (June 2005) summed up the new regime as intended to improve choice and flexibility for pension providers, employers and individual pension savers, further encourage individuals to save for retirement, and reduce administration and compliance costs for the pensions industry and pension scheme sponsors. 3.3 In essence, similar points were being made then as are being made now for a sustainable system of pensions taxation that encourages individuals to save towards retirement. 3.4 Unfortunately, in no more than what is really a blink of an eye in pensions timeline terms we appear to be back to where we started: huge complexity, grand-fathering between one set of rules and another (albeit an essential element of change to ensure fairness and trust), and so much legislation that it is probably once again almost impossible for any one person to appreciate the full picture. 3.5 A similar end point to that which Finance Act 2004 attempted to achieve should be the goal of any future reforms. But rushing to change the system because something has to be done and this is something would be a mistake. P/tech/subsfinal/ET/2015 3

4 4 Pensions tax relief 4.1 As noted in paragraph 2.1 of the consultation document the current structure of the [pensions] system can be characterised as Exempt-Exempt-Taxed (EET). One way of looking at this is that taxes on employment income are deferred through redirecting that income into a pension scheme, allowing the funds to grow tax-free, then taxed when the income is withdrawn from the scheme (subject to the tax free lump sum and withdrawals being exempt from NIC). So we think the question to be answered is essentially does the EET approach to pensions taxation need changing or should it be retained and the current rules reformed? 4.2 The total cost of pensions tax and NICs relief for 2013/14 is estimated at 50 billion per year, although one could deduct from this the tax revenue received from deferred employment income, ie pensions, each year. Paragraph 2.5 notes that a substantial proportion of this cost to the Exchequer results from the need for employers to finance deficits in (largely closed) defined benefits (DB) schemes. With open private sector DB schemes rapidly in decline, deficit costs in these closed schemes, coupled with the cost of ongoing public sector DB schemes, will likely remain a significant factor in the cost of pensions tax relief for many years to come, especially as any change to pension scheme rules will require grand-fathering provisions for existing EET arrangements. 4.3 The cost of pensions tax relief in defined contribution (DC) schemes in comparison has been somewhat curtailed in recent years with significant reductions in the Lifetime (LTA) and Annual Allowances (AA), such that from 2015/16 additional rate taxpayers will get very little effective tax relief with the AA tapering down to 10,000 and the LTA reducing for all to 1 million. The consultation document estimates the projected saving at around 6 billion per year (paragraph 2.8) against a net cost to the Exchequer from pensions of 21.2 billion in (paragraph 2.4). 4.4 With the introduction of auto-enrolment (AE) many more individuals, especially those on lower incomes, are contributing towards their retirement than before. AE could be said to have replaced an incentive to save with a compulsion to save, especially as it appears that relatively few are opting out. This could suggest that tax relief has become less important as an incentive to save. And with increases in personal allowance those at the lower end are proportionately getting less from pensions tax relief, so if this group of people do need tax reliefs to support their saving towards retirement, it may be that the targeting of the relief has gone awry. We think this point needs further research. 4.5 However, although more individuals are personally contributing towards their retirement, it must be recognised that about three-quarters of pension contributions are made by employers, rather than by individuals. Therefore, any review of pensions tax relief must take account of, and give considerable weight to, employers views. There is a need to ensure that any changes do not reduce the contributions that employers make to pensions. 4.6 Furthermore, although under the current rules the approach has been to treat DB and DC schemes broadly the same, the rules do discriminate in favour of DB schemes. Any reform should therefore aim for a level playing field. 4.7 These factors suggest that it is right to be looking at the tax and NIC breaks required for people to be persuaded to save for their retirement. But any proposals for reducing the cost of pensions tax relief must be qualified by the ongoing need to finance DB deficits, P/tech/subsfinal/ET/2015 4

5 reductions in tax reliefs for those on higher earnings already in the pipeline and the reduced benefit of tax relief for those on lower incomes. 5 Principles for reform 5.1 Paragraph 3.4 of the consultation document sets out four principles any reform should meet. As noted above these are not so different from the aims of the previous review, albeit after a decade of constant change we have fallen well short of these aims. 5.2 Consequently, we think that added to the principles for reform should be trust : The individual should have confidence that the tax rules will remain the same over the lifetime of the individual s participation in the scheme. 6 Consultation questions 6.1 Our responses to the questions asked in the consultation document are set out below To what extent does the complexity of the current system undermine the incentive for individuals to save into a pension? 6.3 This is a very difficult question to answer because the population is far from homogenous. There will be many who argue that the system is relatively straightforward for the vast majority of pension savers, as they never come close to reaching any of the relevant allowances. There might even be an argument that for those individuals, there is more confusion around the withdrawal stage, rather than the input stage. At the same time there are a sizeable and increasing number of people who are impacted by the AA and LTA limits, the various forms of protection etc. for whom life is undoubtedly complicated. 6.4 There does seem to be survey data that shows that many people do not understand the value of their pensions, albeit that this is of course a rather different point. Many current savers have seen previous generations retiring with retirement income of two-thirds or one-half final salary and have similar expectations for their Defined Contribution (DC) schemes without really understanding what their pension funds will buy them in retirement. 6.5 Turning to those with higher earnings and/or pension accrual, it is certainly the case that people are being discouraged from saving by the complexity of the current system. However, this is a multi-faceted problem. Some elements of the pensions tax system are inherently complex (such as DB pension input amount calculations) or the rules for non-uk plans. Others are in our view simply puzzling, such as the apparently random difference in tax treatment of dependants pensions depending on whether they are from DB or DC savings. 6.6 There is the point that the legislation has become complex because government has felt compelled to make changes, driven by the economic circumstances. So, for example, in relation to reducing the amount of tax relief available by curtailing the AA and the LTA but at the same time providing (understandably) for transitional protection, scheme pays for P/tech/subsfinal/ET/2015 5

6 DB schemes etc. And we think that it is inevitable that as something gets more complicated people become less comfortable having to deal with it. And the problem then is that this can have a trickledown effect in that even where employees may not be directly affected by, say the AA and LTA changes, if others within the organisation are and they are the ones in charge of setting policy on pension provision then the emphasis and energy in explaining and encouraging other employees to save is very likely to be diminished. On this basis there is therefore a principled case to be made for reviewing the current system, even if no fundamental reforms are made, to try to remove this complexity and so adhere to the original aims of the last review (see 3.2 above) Do respondents believe that a simpler system is likely to result in greater engagement with pension savings? If so, how could the system be simplified to strengthen the incentive for individuals to save into a pension? 6.8 We think that Individual engagement is likely to depend on how much an individual trusts an alternative, simpler system to remain simple. 6.9 We do, however, think that the Government may be on to something in suggesting a Taxed-Exempt-Exempt (TEE) approach similar to ISAs. Many individuals across the entire earnings spectrum are very fond of ISAs, even where there are marginal (or no) tax advantages for them. This is possibly because ISAs are genuinely simple you pay money in, up to a maximum amount each year, and you take it out when you like. And the legislation has not really changed since they were first introduced The Centre for Policy Studies has campaigned for an ISA model 1. The current pensions system has become a complicated and costly method of saving, and we think that a 60% rise in stocks and shares ISA usage in the last five years illustrates the popularity of the simplicity, transparency and legislative stability of ISAs We think that a simpler system would definitely help to increase people s focus on saving for retirement, but they will still need to be able to access quality financial and investment advice at a reasonable cost if they are to understand the opportunities open to them It should also be possible to align the objectives of auto-enrolment, ie ensuring that those who need to save most do so, with a restructuring of pensions tax relief, based on the popularity of ISAs. In particular, and as noted in the consultation document at paragraph 3.12, people s contributions (out of net pay) could be topped up by the government, with a decision to be made as to whether this should be done on a generic basis or whether more top-up should be available for the most needy. This being funded out of the savings that would be made by (i) the upfront relief for tax and, importantly, NIC that would no longer apply, (ii) there no longer being a tax free lump sum (ie an amount taxed neither on the way in or the way out, and (iii) the marginal rates applying for those in employment generally being materially higher than those applying in retirement Another point to consider is the question of access to funds were the government to pursue thinking on a Pensions ISA (as we believe it should). One approach would be to say that funds cannot be withdrawn until age 55, with the quid pro quo being the government top up that would be available to Pension ISAs that would not apply to ordinary ISAs. We also think the government should reflect on whether it is right that people should be able 1 See for example SomeSuggestionsfortheNewPensionsMinister.pdf or P/tech/subsfinal/ET/2015 6

7 to withdraw all their Pension ISA funds in one go, given that they need to last over the course of what will (hopefully) be a long period of retirement. We appreciate that the government have introduced the ability to do so under the current pensions regime but we do suggest that this should nevertheless form part of the thinking in relation to any new TEE approach Would an alternative system allow individuals to take greater personal responsibility for saving an adequate amount for retirement, particularly in the context of the shift to defined contribution pensions? 6.15 This depends on what an adequate amount for retirement is and how individuals would know what that was. Since last year, there is no need to provide any income in retirement from DC funds the retirement pot is the individual s own money to do with as he or she sees fit Whilst very few are going down the route of using their pension funds to buy a Lamborghini, it is puzzling that at a time when people are living longer the Government took the decision to allow people to take all their pension savings in one go when surely the idea should be to ensure they have more available for later on in their lives, particularly given the high cost of care for the elderly. We have referred to this issue at paragraph 6.13 above In many cases individuals underestimate the amount they need to save to provide for their retirement indeed in a lot of cases the size of the fund is simply too great for the individual to retire at the age that they might otherwise have in mind In the past governments emphasised the point that the quid pro quo for tax relief on pensions was that the funds set aside would enable people to provide an income through their retirement 2. In our view this is equally valid now and we believe it should be incorporated as one of the aims on any new system that the government may choose to introduce That said, it might be the case that tax relief is not an explicit driver of pension savings, especially amongst those on lower incomes. And if there is automatic enrolment, where individuals have to make an active decision to stop saving, do you need to provide any incentive to save? 6.20 In addition, whatever system is in place should also encourage individuals to begin making contributions early in their working lives so that (in a defined contribution context) their contributions plus investment return should be suffice to meet their needs during their retirement. In this respect, and in the context of any TEE approach, the government might want to consider framing any top-up so that it particularly encourages saving from an early age There is also the point made above at 4.5 that whatever system we have it should not reduce employers contributions to pensions Would an alternative system allow individuals to plan better for how they use their savings in retirement? 2 See for example SI 2012/522 ( P/tech/subsfinal/ET/2015 7

8 6.23 This depends on the resolve of the government to ensure that any alternative system would operate over the long term. And history would suggest that it might be difficult to convince people that the rules would not change again in the near future. In particular, when a future government sees tax from post-retirement income reducing could it be trusted not to turn TEE pension arrangements into a TTE or a TET system in order to tax investment growth? Without that trust and confidence an alternative TEE system might discourage rather than encourage plans for retirement savings An important further consideration is that if a substantive change is made, there will be significant legacy issues. It will always be challenging (and potentially expensive) to run two parallel systems and, as time passes, there will be fewer and fewer skilled administrators remaining in the workforce who are able to operate the current system properly. Given the very large numbers of individuals who already have savings in the current system, the implications of this should not be overlooked or underestimated Should the government consider differential treatment for defined benefit and defined contribution pensions? If so, how should each be treated? 6.26 Ideally, it might be argued that DB and DC pension plans should be treated in the same way in order to keep things simple. However, equally we have to realise that they operate differently in terms of what they offer as pension in retirement, with DB plans being particularly valuable in terms of the employer promise. Under the existing EET system the approach to DB and DC has been broadly the same, albeit using factors to approximate annual saving and lifetime limits for AA and LTA purposes. That said, it would be fair to acknowledge that the current rules discriminate quite unfairly in favour of DB schemes If we moved to a TEE system then valuation issues for DB schemes would become much more pronounced, albeit we think the problems should not be not insuperable (eg it may be that the upfront tax charges are dealt with on a scheme pays basis). At the same time it is undoubtedly the case that a Pension ISA approach, ie essentially TEE evolving from a DC model, is easier to deal with under DC because tax would be deducted from cash that would otherwise flow to the individual That said, there is a wider point on DB. That is that for existing arrangements it would seem complicated to change horses mid-way through someone s active membership of the plan, particularly in trying to determine what element of retirement benefits would be taxable and what exempt. So it may be that we have to accept that DB arrangements do need to be ring-fenced from DC, certainly for existing arrangements, although any reform should aim for a level playing field between DB and DC schemes What administrative barriers exist to reforming the system of pension tax, particularly in the context of automatic enrolment? How could these best be overcome? 6.30 All large and medium sized companies will already be operating automatic enrolment. They will have invested considerable amounts of money in appropriate systems used for calculating who is eligible and the amounts that must be contributed. Any changes to the pensions tax system will necessitate changes to these systems with associated costs. The smallest companies are now reaching their staging dates and so clearly any change would complicate things for them. P/tech/subsfinal/ET/2015 8

9 6.31 Given the difficulties that already exist in operating automatic enrolment (the rules regarding who is caught and when are complex), it could well be that employers would prefer that no further changes are made. For the smallest employers, much of the work would be done by payroll providers. Changes to the system of tax reliefs would have a significant impact on those organisations How might any change be implemented? Would it be gradual (increasing complexity through incremental change) or would the approach change on A-Day 2.0, with separate systems being required to apply EET to pre-implementation savings and TEE postimplementation? These points need to be carefully considered, albeit our thinking is that A-Day 2.0 would probably be the better option, but only where there is sufficient lead time for everyone to be properly prepared Would people be required to pay some form of tax-equalising amount and rollover their EET savings into a TEE system? Or, perhaps better, would the old savings cease and be grandfathered and the new rules apply to savings arrangements entered into after A-Day 2.0? 6.34 These and other consequences would need to be thoroughly thought through and consulted on, and time given for system changes to be made, before any major reforms are introduced How should employer pension contributions be treated under any reform of pensions tax relief? 6.36 For DC arrangements then under a TEE system employer contributions effectively become additional cash payments, subject to PAYE/NIC at source, which are then contributed (net) to the plan, eg to the Pensions ISA We have touched on the issues for DB plans at 6.26 above. Our sense is that with the issues of valuation, ongoing participation in existing plans and dry tax charges it may be that dealing with employer contributions, or rather automatic annual incremental benefit, proves too difficult to allow for a move from, say, EET to TEE. We think this would require further more detailed evaluation How can the government make sure that any reform of pensions tax relief is sustainable for the future? 6.39 Unfortunately history tells us that this is unlikely to be possible, not least because the current government cannot bind its successors. In any event each government tends to have its own views and priorities as to how taxpayers money is spent and to the extent that Exchequer subsidy remains a large figure this is likely to continue. Having said that, we should not completely lose hope. If one takes the view that going forward we will increasingly be living in a DC world and that the reality is that the amount of government subsidy for pension saving needs to be reduced and better targeted then the key will be gaining cross-party consensus that whatever approach is decided upon is accepted across the board. Whether this approach is to tweak the EET status quo or to move to a TEE system or something else. The problem in recent times is that governments of all colours have made regular changes to the pension tax rules. Each time a change is made, there is some argument put forward about controlling costs, or seeking to achieve greater fairness, or something similar. It is clear that economic and demographic changes have been P/tech/subsfinal/ET/2015 9

10 underestimated or not anticipated. In addition, in recent years governments have tried to micro-manage the effects of pensions tax, with changes made almost annually A point to bear in mind though on any move to a TEE system is that from a demographic perspective, as the population ages, income tax receipts are likely to decline in later years; the impact of bringing forward the tax take by up to a generation could be felt more severely by future governments and could encourage a future government into changing a TEE system into a TET system. So the numbers will have to be crunched very carefully. 7 The Chartered Institute of Taxation 7.1 The Chartered Institute of Taxation (CIOT) is the leading professional body in the United Kingdom concerned solely with taxation. The CIOT is an educational charity, promoting education and study of the administration and practice of taxation. One of our key aims is to work for a better, more efficient, tax system for all affected by it taxpayers, their advisers and the authorities. The CIOT s work covers all aspects of taxation, including direct and indirect taxes and duties. Through our Low Incomes Tax Reform Group (LITRG), the CIOT has a particular focus on improving the tax system, including tax credits and benefits, for the unrepresented taxpayer. The CIOT draws on our members experience in private practice, commerce and industry, government and academia to improve tax administration and propose and explain how tax policy objectives can most effectively be achieved. We also link to, and draw on, similar leading professional tax bodies in other countries. The CIOT s comments and recommendations on tax issues are made in line with our charitable objectives: we are politically neutral in our work. The CIOT s 17,000 members have the practising title of Chartered Tax Adviser and the designatory letters CTA, to represent the leading tax qualification. The Chartered Institute of Taxation 6 October 2015 P/tech/subsfinal/ET/