TAX STRATEGY GROUP PENSION TAXATION ISSUES

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1 TSG 13/07 TAX STRATEGY GROUP PENSION TAXATION ISSUES Introduction 1. Last year s TSG paper on pension taxation issues (reference TSG 12/21) set out the various changes made in the incentive regime for pension saving over recent years. That paper also included details of the broad feedback received by the Department of Finance and the Revenue Commissioners to the informal consultations undertaken at that time on potential future changes to the incentive regime for pension saving and the broad options for such change, including changes to marginal rate tax relief on pension contributions. The contents of the 2012 paper may be a useful background reference for the contents of this paper. 2. In his Budget 2013 speech, the Minister for Finance clarified the Government s position on a number of issues in the pension savings area and stated that: Tax relief on pension contributions will only serve to subsidise pension schemes that deliver income of up to 60,000 per annum. This will take effect from 1 st January 2014 Tax relief on pension contributions will continue at the marginal rate of tax. The Pension Levy announced as part of the Jobs Initiative will not be renewed after The Budget speech went on to say that: The current arrangements governing the maximum allowable pension fund at retirement for tax purposes of 2.3 million still allow for very generous pensions for higher earners through tax-subsidised sources, particularly by way of Defined Benefit schemes in both the public and private sectors.the necessary arrangements to give effect to the Programme for Government commitment to effectively cap taxpayers subsidies for pension schemes that deliver income of more than 60,000 per annum will be put in place in Earlier this year the Department of Finance established a Working Group and Steering Group to consider the technical aspects of delivering on the Minister s Budget undertaking, including consideration of possible alternatives to the Standard Fund Threshold (SFT) regime with a view to presenting the Minister with proposals for change for Budget The remainder of this paper deals with the various options examined by the Working and Steering Groups that could be considered to deliver on the commitment in relation to capping taxpayer subsidies as outlined above. None of these options are without complication and all would present challenges of one kind or another in seeking to deliver on the commitment. 1

2 Possible approaches for delivering on the Budget 2013 commitment to cap taxpayers subsidies to pension schemes delivering income over 60,000 per annum. 5. A number of potential approaches present themselves for delivering on the Budget commitment. These include: Retaining the existing Standard Fund Threshold (SFT) regime (the maximum allowable pension fund at retirement for tax purposes) while reducing the threshold significantly. Retaining the SFT regime but changing the standard capitalisation factor (20) which converts Defined Benefit (DB) pension entitlements into a capital value for measurement against the SFT to a higher factor thus improving the relative equity between DB and Defined Contribution (DC) pension arrangements and between private sector and public service schemes for SFT purposes. Retaining the SFT regime but change the current standard capitalisation factor to a variable capitalisation factor which would depend on age of retirement thus increasing equity further as between those who retire early and those who retire late. Replace the SFT regime with a super tax on high value pensions. Change from a Standard Fund Threshold (SFT) to Standard Pension Limit. Introduce a more restrictive annual pension contributions regime. Each of these options is briefly examined below. Retain the existing SFT structure 6. One possible method of delivering the Programme for Government commitment to cap taxpayers subsidies for pension schemes that deliver pension income of more than 60,000 per annum would be to retain the SFT regime in its current form and achieve the commitment within the parameters of the current arrangements. This would involve a significant reduction in the current value of the SFT of 2.3 million to about 1.38 million. Where the SFT is exceeded as retirement benefits are taken, an immediate tax charge of 41% is applied to the excess over the threshold, with the balance of the excess taxed at the individual s marginal tax rate. This would result in an overall effective tax rate of 65% on any excess over the SFT (excluding USC etc). 7. Basically, a 60,000 pension entitlement arising from a public sector final salary DB scheme, using the existing 20:1 conversion factor, would translate into a capital fund at retirement of 1.38 million when the retirement lump sum of 180,000 is included ( 60,000 x ,000). However, in the case of private sector DC schemes, a fund of 1.38 million, after taking the retirement lump sum, would only purchase a pension, with equivalent benefits to a public service pension, of just 26,158 in the open annuity market. In reality, therefore, such an approach is unlikely to be acceptable as it would clearly exacerbate and amplify the existing inequities as between DC and DB occupational pension schemes and as between public sector and private sector arrangements. 2

3 Retain the existing SFT structure and change the standard DB capitalisation factor to a single higher factor 8. During 2011 and 2012, consultations took place between the Department of Finance, Revenue and the Taxation Policy (Pensions) Group (TPPG), an umbrella group representing the Irish Association of Pension funds (IAPF), the Irish Insurance Federation (IIF) and the Society of Actuaries of Ireland (SAI), on the potential for alternatives to standard rating tax relief to achieve significant budget savings. 9. The TPPG engaged Milliman Consultants to research the alternatives. Milliman produced a number of reports, one of which put forward proposals for amending the SFT regime in a way that, according to Milliman, would place a cap of 60,000 on pension benefits delivered by supplementary pension arrangements and thus be consistent with the commitment on capping tax-subsidies for pension schemes in the Programme for Government, while being more equitable than the current regime as between DC and DB schemes in terms of the conversion factor used. 10. The main changes being recommended by the TPPG and Milliman involve: A smaller reduction in the value of the SFT from 2.3 million to 2 million ( 60,000 x ,000 (lump sum)). A change in the standard conversion factor (from 20:1 to 30:1 1 ) for converting DB pension benefits to a capital sum for benchmarking against the SFT (see above). Account to be taken of the State Pension for the purposes of the SFT 2. Annual indexation of the SFT in line with the CPI. Periodic (5 yearly) review of the capitalisation factor to take account of intervening movements in interest rates and longevity assumptions, and Reduced rate of chargeable excess tax where benefits at retirement are marginally above the limit due, for example, to high investment returns close to the point of retirement. 11. The main benefits put forward by the TPPG and Milliman in favour of their proposals include: Claimed savings 3 to the Exchequer of close to 400 million in a full year which would not, in their view, be significantly different from the saving to the Exchequer from standard rating tax relief. The changes to the SFT regime are anticipated to impact on less than 27,000 4 individuals as compared to an estimated 500,000 who would be impacted if standard rating tax relief on pension contributions was to proceed 5. 1 The 30:1 factor is justified by the TPPG on the basis that it reflects roughly the current cost of purchasing a pension similar to the State Pension ( 29 for each 1 pension) and is broadly in the range of open market costs of purchasing (a) a level pension for a male age 65 with no spouses pension and (b) a pension increasing with price inflation, for a female age 60 with a reversionary spouse pension of 2/3rds of the primary pension. 2 Pre-1995 public servants are not entitled to the State Pension (Contributory) as a result of which their current effective SFT limit is 240,000 lower than post-1995 public servants who do qualify for the State Pension. 3 According to the TPPG the savings arise mainly from the reduction in the cost of tax relief on pension contributions or accruals that would cease in respect of those affected plus the tax take on compensatory remuneration payments made by employers to employees affected by the lower SFT limit. 3

4 It arguably strikes a more reasonable balance between the competing demands of DB and DC pensions. 12. There are issues around the scale and timing of the Exchequer savings estimated by the TPPG/Milliman. In addition, the use of an increased standard capitalisation factor of 30 to convert DB pension entitlements for SFT purposes, while improving the relative equity of DC compared to DB, would be particularly onerous on individuals with DB pension benefits who retire late in their career. 13. Changes to both the absolute value of the SFT and to the capitalisation factor used to value DB pension benefits for SFT purposes also complicate the pension fund protection arrangements required in respect of those with pension funds valued between the current SFT and any new SFT at the point of change. Such protections (by way of Personal Fund Threshold certificates - PFTs) were provided on the previous occasions when the SFT was first introduced (in 2005) and subsequently reduced (2010). 14. A reduction in the value of the SFT and an increase in the DB capitalisation factor is also likely to lead to higher tax liabilities at the point of retirement for certain affected public servants where the SFT or PFT is exceeded, given that public servants cannot opt-out of their pension scheme (except on retirement) or to receive alternative compensatory remuneration in lieu of pension accrual as may occur in the private sector. The likely extent and scale of such alternative compensatory remuneration in the private sector is unknown but where it did occur it would result in additional tax yield. The existing tax recovery arrangements may have to be examined in the context of the higher tax liabilities arising at retirement for those who cannot opt out of pension schemes (mainly individuals in the public service) 6. Retain the existing SFT structure and change the standard DB capitalisation factor to a variable age-related factor. 15. This approach would represent a variation on the single higher factor approach discussed above. It would involve the application of higher capitalisation factors to DB pension entitlements for those retiring at earlier ages (e.g. under 60) and lower capitalisation factors for those retiring later in their career (e.g. at 70 plus). This would further improve the equity between DB and DC pension arrangements ( a DC pension pot of any value will provide less retirement income if taken at an early retirement age than at a later age) and generally as between individuals who retire at a later age as compared to a younger age. 16. On the other hand, this approach would further complicate the SFT regime 4 This comprises 11,400 who would stop pension contribution/accrual immediately plus an estimated 15,500 whose pension contribution /accrual would reduce over time as the capital value of their fund approaches the SFT limit. 5 As already mentioned, the Minister effectively ruled out a move to standard rating of pension relief in his 2013 Budget Statement. 6 In cases where the SFT (or PFT as appropriate) is exceeded by the capital value of retirement benefits taken, most likely in a public service context for the reason stated, the immediate chargeable excess tax of 41% is paid upfront by the pension administrator and recovered from the pensioner through the retirement lump sum, gross pension, from the individual directly or a combination of these arrangements. 4

5 Replacement of the SFT Regime with a super tax on higher levels of supplementary retirement income 17. This approach would abolish the SFT regime altogether and replace it with a super tax on the excess of all forms of supplementary retirement income in payment over 60,000 per annum, which would apply equally to all regardless of when they started to receive such income The super tax approach can be justified on a number of grounds: as an inter-generational transfer from those who have done very well out of the supplementary pensions system in the past to the current generation, most of whom in the private sector have no private pension provision at all. (Only an estimated 40% of private sector employees have any form of private pension cover). The burden of fiscal adjustment measures on supplementary pensions has been focused almost exclusively on those who have yet to retire; whereas this proposed measure would apply some of the fiscal adjustment burden to those already retired on large pensions. It is a better and more equitable way to achieve the policy objective of limiting tax subsidised pensions than using the current cumbersome SFT/chargeable excess tax approach with a reduced 1.38m threshold. It would produce a long-term predictable flow of tax revenues, unlike the current arrangements. 19. While superficially attractive, however, it is not clear how a super tax approach would cope with the fact that virtually all significant DC pension pots are not, in fact, used to purchase a pension annuity in retirement but rather end up being invested in an approved retirement fund (ARF). An individual could tailor the amount of annual draw-down from the ARF to keep below any super tax threshold. 20. Abolition of the SFT regime in favour of a super tax approach would possibly also allow for the build-up of excessive pension pots as happened in the past. This would also open up the prospect of individuals in receipt of significant DB pensions becoming nonresident to avoid the super tax (in circumstances where Ireland under its DTAs generally cedes its taxing rights on pensions to the country of residence). 7 Note the current SFT regime only takes into account pension benefits that commenced after 7 December 2005 (the date of introduction of SFT) pensions in payment before that date are not impacted or taken into account. 5

6 21. There are also issues around the level of any super tax that would be required on pension income over 60,000 to deliver any meaningful tax yield as well as the risk of legal challenge to any measure in this area. For example, a super tax could possibly be regarded as discriminatory if it isolates a particular type of income for harsher tax treatment without, arguably, a sufficiently strong rationale to support the differential treatment e.g. why tax pension income over 60,000 more harshly than employment income over 60,000 Change the system from a Standard Fund Threshold to a Standard Pension Limit 22. This approach advocates changing from a notional pension fund limit to a standard pension limit with a view to ensuring that retirees with DC benefits can aspire to obtaining broadly the same value of retirement benefits as those in private and public sector DB arrangements, without fear of exceeding any new limit. 23. The Standard Pension Limit (SPL) approach specifies a limit in terms of the amount of pension that can be taken, irrespective of the type of pension arrangement an individual has. The pension limit would include the pension equivalent of retirement lump sums and DC funds. Basically, the capital value of retirement lump sums and DC funds would be converted to a notional pension amount by using a factor specified annually by the Minister for Finance for those retiring in that year. The factor could be based, for example, on the current open market value of a public service pension of 1 per annum. 24. Clearly, the open market cost of 1 of public pension will vary depending on the age at which the individual retires as well as on other features of the pension and the conversion factor could, therefore, vary significantly depending on when an individual retires. If a Standard Pension Limit were to be implemented, therefore, it is likely that a broad brush approach would have to be taken in determining an appropriate average conversion factor. 25. Chargeable excess tax would only apply under this system when excess pension is taken above the new limit. Basically, excess pension would be converted to an equivalent capital amount by using the chosen conversion factor and applying a tax charge of 41% to the result. For example if the average conversion factor was 38 the tax due would be times the excess pension (38 X 41% = 15.58) which could be rounded down to 15 times the excess pension. 26. The impact of this approach is best illustrated by an example: If the SPL was set at a pension equivalent of 60,000 per annum, then to stay within the limit a public service retiree would be able to receive a maximum pension of 55,610 per annum and a lump sum of 3 times the pension i.e. 166,830 ( 55,610 x 3), the lump sum being converted to pension equivalent by using a conversion factor of 38:1 ( 166,830/38 = 4,390; 55,610 pension + 4,390 lump sum pension equivalent = 60,000 pension limit). The private sector retiree, on the other hand, taking the same level of retirement lump sum of 166,380 (pension equivalent of 4,390) would be allowed a residual defined contribution fund of million which would have a pension equivalent value 6

7 of 55,610 ( million /38). This would give the same pension equivalent benefits as those for a public service individual. 27. Changing the current system of specifying a maximum fund into specifying a maximum pension and permitting the conversion of retirement lump sums and DC funds into notional pension at a factor more closely reflecting open market rates, could be viewed as providing equal and fair treatment to all retirees whether they are in a DB or DC pension arrangement or whether they are in the public or private sectors. 28. While this approach appears workable and seems to deal equitably between individuals with different types of pension benefits, this approach does not differentiate between individuals who can retire early and those who retire later. An individual could retire at age 59 with a pension of 59,000 per annum and pay no additional tax while another might retire at 69 with a pension of 61,000 and pay tax on the excess over 60k, notwithstanding that the pension benefit of the late retiree is less valuable over the period of retirement. There is also the question of whether this approach has such significant additional advantage as to warrant the replacement of a current workable solution (the SFT regime) with a completely new regime Introduce a more restrictive annual pension contributions regime 29. The SFT regime seeks to address the issue of restricting the funding of retirement benefits above a certain value by dealing with it at the point of benefit drawdown at retirement rather than by restricting tax relieved pension savings on the way in. As the wording of the Programme for Government commitment speaks in terms of capping taxpayers subsidies for pensions that deliver income in retirement of more than 60,000, it could be interpreted to mean limiting the use of subsidies during the pension build-up stage. 30. The main subsidies available to on-going pension funding are: Marginal rate tax relief on pension contributions Gross roll-up in the pension fund, and No employee benefit-in-kind (BIK charge) in respect of employer contributions. 31. As regards marginal rate tax relief on contributions, the Minister for Finance ruled out any change in this area in his 2013 Budget Statement. In the context of the benefits imparted by the gross roll-up regime, it would appear difficult to impose any on-going tax or duty charge on the growth in pension fund assets in the context of the existing temporary pension levy which is funding the Jobs Initiative and the assurance given in the 2013 Budget Statement that the levy would end in

8 32. The absence, however, of a BIK charge 8 on employees in respect of employer contributions to occupational pension schemes on their behalf represents a significant tax relief in its own right. This, when coupled with the fact that employer contributions to such schemes are not included in the age-related percentage limits that apply to tax relieved employee pension contributions 9, represents a significant employee benefit. This is particularly the case for employees who can influence their remuneration packages in a way that allows them to maximise their pension savings through employer based pension contributions. In effect, the age-related percentage limits on employee contributions can be by-passed by such employees. The introduction of a BIK charge would act to restrict the attractiveness of employer based contributions but the level at which it would apply 10 would need careful consideration. 33. By comparison, the annual tax-relieved contribution limits operate effectively to control the contributions to pension savings of the self-employed and of individuals in nonpensionable employment (almost exclusively in the private sector) where the limits apply to both employee/individual contributions and to employer contributions (if any) made to their pension saving arrangements. Where, for example, the combined employer/employee contributions to a Personal Retirement Savings Account (PRSA) of an employee in non-pensionable employment exceed the annual tax-relieved limits, a benefit-in-kind (BIK) charge applies to the excess in the hands of the employee. It is reasonable to assume that employers and employees would seek to ensure that the relevant annual limit is not exceeded. 34. The reasons for the concessionary treatment of employer contributions to occupational pension schemes are that the controls over occupational schemes have historically been benefit-based as opposed to contribution-based (occupational schemes are not permitted to fund a pension benefit for an individual of more than two-thirds of his/her final salary, whereas in the case of personal pension plans such as PRSAs and RACs such a benefit limit would not be practical) and the over-arching control of the maximum allowable pension fund at retirement for tax purposes (the SFT) applies to occupational schemes and other pension arrangements. 8 Section 118(5) of the Taxes Consolidation Act 1997 specifically exempts employer contributions from BIK in the hands of the employee. 9 Apart from the overarching SFT limit, the annual amount of tax relieved pension savings that an individual can contribute to their pension arrangements is restricted to an age-related percentage limit of earnings as follows: Up to age 30 15% of remuneration 30 to 39 20% 40 to 49 25% 50 to 54 30% 55 to 59 35% 60 and over 40% This is subject to an overall earnings cap (currently 115,000). At present, therefore, the maximum annual tax relieved contribution that an individual can make to a pension savings arrangement is 46,000 (i.e. at age 60 or over). 10 In the case of employment based PRSAs, a BIK charge applies where the combined employer and employee contribution exceeds the employee age related percentage limit of earnings. 8

9 35. In addition, the rules governing occupational pension schemes allow for the accelerated funding of pension benefits for employees who cannot, by reason of their date of entry into a scheme, complete 40 years' service before normal retirement age. A pension of 2/3rds final salary can, therefore, be provided for service of not less than 10 years to normal retirement age. The application of annual limits to employer contributions would undermine this facility and would have particular implications for proprietary directors who often do not fund for their retirement until late in their career, opting instead to invest in their companies in the early stages. 36. Any consideration of changes to the annual pension contribution limits regime to capture employer contributions to pension saving would have to have regard, among other things, to the impact on the different forms of pension arrangements. Any changes would have to ensure comparable treatment between DC pension arrangements (where separate employer and employee contributions are transparent) and DB pension arrangements (where employer contributions are not employee-specific in funded schemes or are not actually made as in unfunded public service schemes). 37. By way of comparison, the UK operates a single annual limit regardless of age (the Annual Allowance or AA) on the amount of contributions made to an individual s pension savings (including employer contributions) that can be tax relieved. The AA is 50,000 for the tax year 2012/13 and is being reduced to 40,000 per annum for tax year 2014/15. While there is no limit per se on the amount of pension contributions that can be made to a pension arrangement and which can be tax-relieved, any such relief afforded on contributions above the AA limit is neutralised by taxing such contributions at the individual s marginal tax rate. 38. To treat registered DC and DB pension schemes (including unfunded public service DB schemes) in a comparable way under the AA regime, each annual increase in accrued pension benefit in a DB scheme is converted into a deemed or notional contribution for measurement against the AA. A flat rate factor of 16 is used to convert each annual accrued DB benefit into deemed or notional pension contributions for the purpose of the AA. 39. All registered pension schemes and pension saving arrangements in the UK, including public service pension schemes, are obliged to have arrangements in place to track annual contributions (actual and deemed) for the purpose of the AA and to notify scheme members (and the UK tax authorities) of contributions to their schemes or plans for the purpose of the AA. Where the AA is exceeded, a tax charge arises on the excess at the individual s marginal tax rate (the AA charge). The AA charge, where it is arises, is paid by the individual out of current income and involves the individual making a tax return to the UK authorities under its self-assessment requirements. Alternatively, where the charge exceeds 2,000, arrangements can be made to have the charge paid up-front by the pension fund administrator and recovered out of the individual s pension benefits at retirement. 40. The introduction here of an annual pension contributions regime along similar lines to the UK regime would require significant legislative and administrative change to the existing arrangements. To do this in a proper way would require discussion and consultation with all the various interests in the pensions sector on the necessary changes. In that context, for example, while the UK already had the basis of its AA regime in place 9

10 when it introduced significant reforms in 2011, the authorities there began consultation with the pensions sector on these changes a year previously due to the scale and complexity of the changes being introduced. 41. It might also be considered that input controls such as stricter annual pension contribution limits cannot on their own determine the level of pension income an individual might eventually receive at retirement. Other factors such as age, years service, years to retirement, current level of pension savings/entitlements, investment growth and the cost of pension annuities are also significant determinants. Output controls such as the maximum allowable pension fund at retirement for tax purposes (the SFT) may not deliver in a perfect way on the Budget commitment either but, arguably, is likely to be more effective in doing so than input controls. 42. The TSG may wish to discuss the issues raised in this paper. Fiscal Division September

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Pension Taxation Issues. 2. This paper deals with a number of topical issues in the general area of pension taxation.

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