REFORM OF PENSIONS TAX RELIEF

WHITE PAPER 2015 REFORM OF PENSIONS TAX RELIEF The right changes for the right reasons JLT EMPLOYEE BENEFITS

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JLT EMPLOYEE BENEFITS 1 CONTENTS Foreword 2 Executive summary 4 Introduction 6 A review of the literature 7 4.1 The origins of the current system 7 4.2 Turner, et al - 'The Reviews' 8 4.3 Principles for any review of pension tax relief 11 4.4 Options for an alternative tax regime 13 4.5 Tee 14 4.6 Single Rate 15 4.7 TEE versus Single rate 17 4.8 Tax-free cash 17 4.9 Implementation 19 Modelling 20 5.1 The cost of pension tax reliefs and how they are distributed 20 5.2 The impact of alternative systems and the incentive to save 24 Survey 27 Lessons from abroad 34 Conclusions and recommendations 35

2 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 FOREWORD In our 2014 White Paper - The New Pensions Landscape - we observed that the key components of better retirement outcomes are in place: Foundation: a flat-rate State pension that individuals can build on Participation: getting workers into the savings habit by auto-enrolling them, and asking them to opt-out of rather than opt-in to pensions saving Confidence: restoring people s trust in pensions with new minimum governance standards Flexibility: empowering pension savers by letting them choose how to use their savings, but supporting them with guidance where they want it. We added, however, that there is still more that can be done to ensure that as many people as possible get the best possible outcome from the reforms to the UK pension system. The Government s consultation on the UK pensions tax relief system provides an opportunity to further improve later life outcomes and, in the report that follows, we recommend that the current EET system is maintained but refined. In particular, we believe that more can be done to incentivise the millions of lower and middle income earners who are currently destined to retire on inadequate incomes and who will, therefore, need to rely on the State for survival. Various options are available, and the impact of these is considered in our report. However, our preferred way forward, in terms of ease of communication and targeting the right people, is a single rate of tax relief expressed as a matching contribution. Consistent with this change, we also advocate reform of the anomalous tax-free lump sum on retirement.

JLT EMPLOYEE BENEFITS 3 These evolutionary changes retain the basic EET concept, with a more even distribution of tax relief, and avoid the upheaval of alternative, more revolutionary systems. Inaction is not an option. Doing nothing will result in an unfair burden that will otherwise fall on the shoulders of future tax payers, who will have to support a growing older population at the same time as trying to save for their own future. In short, we believe that replacement of the current EET system with a single rate and reform of the taxfree lump sum are the right changes for the right reasons. This consultation on whether our pensions tax relief system remains appropriate is an opportunity not to be missed and our recommendations are aimed at incentivising, in an affordable way, those who, for all our sakes, need to save more. DUNCAN HOWORTH CEO JLT EMPLOYEE BENEFITS

4 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 EXECUTIVE SUMMARY The origins of the current system for the taxation of pension schemes tell us, inter alia, that A common tax regime for approved/registered pension schemes took over 50 years to achieve Tax-free lump sums on retirement came about more through accident than design. Lessons to be learned from the history of pension tax reliefs are Uniformity of tax treatment for different types of pensions, which took so long to achieve and has now been in place for several decades, should not, without good reason, be disturbed Despite it now being an embedded part of the pensions landscape, an informed debate on the utility of the tax-free lump sum on retirement is long over due. Previous research on the current pension tax relief system contains some common conclusions, including - The current UK pensions tax relief system is not properly understood nor is it incentivising pension saving (especially amongst lower and middle income earners) The single rate and matching ideas are considered attractive in terms of having the potential to address this, with a single rate of pensions tax relief expressed as a matching contribution also being very easy to communicate Arguably, saving for retirement is different from other forms of saving (something that is not always recognised with other, more radical models for reform, especially where they include provision for early access to savings). Therefore, if it is accepted that the key reason for a review of the pension tax relief system is to decrease the number of older people who rely on means-tested benefits, a single rate of relief, set above the level of the basic rate of income tax, could encourage lower and middle income earners to save more. The outcome would be an increase in people able to retire with dignity and a reduction of the burden that would otherwise fall on the shoulders of future tax payers. Such a change, when expressed as a matching contribution, also has the benefit of being easy to understand and represents a more evolutionary reform to the current pension tax relief system relative to more revolutionary suggestions that do not appear to be as well aligned to the above objective.

JLT EMPLOYEE BENEFITS 5 One factor that we do not consider to be relevant to the review of pension tax reliefs is current economic circumstances. This assumes that the objective of reform is a robust and sustainable system which incentivises the right people and helps protects future generations of workers from increased taxes. In other words, reform must be based on sound, lasting principles and not be motivated simply by the prospect of a short-term increase in public revenue. Based on the above, our principal recommendations are that 1. the current pension tax relief system should be replaced by a matching system (set at a minimum level of a 1 government match for every 2 saved but with consideration given to a more generous match, at least at the point of establishment of the new system); and 2. tax-free lump sums should be capped for the future. We believe that these represent the right changes for the right reasons; properly implemented they could also result in a reduction to the cost of pension tax reliefs; and they build on and are consistent with the role of government which is to provide individuals with a foundation (the State pension), nudge them in the right direction (auto-enrolment); and incentivise them to make adequate provision for their later life (tax reliefs). Nevertheless, if it transpires that these reforms are not achieving the objective of adequate retirement incomes for the vast majority of low to middle income earners then the re-introduction of some form of compulsion for saving in respect of later life may be the only way forward to avoid pensioner poverty, higher taxes or both.

6 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 INTRODUCTION Following the Stability Budget on 8 July 2015, the Government launched a consultation on whether the current pensions tax relief system remains appropriate. Currently, as illustrated below, contributions to pensions are exempt from tax when they are made but pension benefits are taxed when they are paid out to the individual. Employer pension contributions are also not subject to employer or employee National Insurance Contributions, and investments grow largely tax-free. The UK pensions tax relief system Contributions Investments Pensions Contributions paid to registered (tax approved) pension schemes receive tax relief at the individual s marginal (highest) rate of income tax Money invested in pension schemes builds up largely free of income and capital gains tax Benefits from pension schemes are taxable at the individual s marginal rate of income tax (but 25% of pension savings can normally be taken as a tax-free lump sum) This pensions tax relief system is commonly referred to as Exempt, Exempt, Taxed, or EET. It is not unique to the UK (see Section 7 of this paper) but, in terms of the right system for this country, that is neither here nor there. It is possible (but far from confirmed) that pensions may become taxed more like Individual Savings Accounts (where contributions are paid from taxed income but savings are subsequently accessible tax-free). A corollary to this may be that members will be able to access pension savings before the normal minimum pension age (currently, age 55). In this paper, we consider the different options and their impacts on employers, employees and government. Our modelling and survey in Sections 5 and 6 of the paper cover both financial impacts and possible behavioural responses arising from changes to the current system for pension tax relief. As will be seen, together, they point towards a single rate of tax relief, expressed as a matching contribution, as the optimum way forward. Alternatively, a completely new tax regime could be developed for pensions and this could even entail different reliefs for defined contribution (DC) arrangements and defined benefit (DB) schemes.

JLT EMPLOYEE BENEFITS 7 A REVIEW OF THE LITERATURE 4.1 THE ORIGINS OF THE CURRENT SYSTEM 1 The foundations of pension fund taxation date back to the period immediately following the First World War, when only about two million employees paid income tax. Subsequent to legislation in 1921, there were two main alternative regimes for pension provision in the UK; one based on the treatment of life assurance policies 2 and the other mirroring that for Friendly Societies 3. In line with the civil service scheme, which provided lump sum benefits on retirement since 1909, provision was introduced to place a limit of one-quarter on benefits in insured funds that could be taken as a lump sum. It is worth highlighting, however, that lump sum benefits on retirement in the civil service scheme came about as a result of an administrative muddle. A report in 1948, by employer, insurance and pension bodies, proposed a system where all reasonable contributions would be tax deductible and investment income would be tax-free, but all retirement benefits (lump sums and pensions) would be taxable. This was not, however, enacted. Legislation in the 1950 s sought to address anomalies and promote uniformity of tax treatment, but resulted in separate provision for pensions and lump sums. It was the advent of New Code Approval under Finance Act 1970, which required conformity for new schemes from 1973 and for existing ones by 1980, that led to a common tax regime for all occupational pension schemes, and the provision of pensions and lump sums from a single source. The principles of this regime, at least in the sense of the EET treatment of tax approved pension arrangements, have largely survived to this day, even taking into account the introduction of a single pensions tax regime for Registered Pension Schemes (occupational and personal) in April 2006. So, the origins of the current system for the taxation of pension schemes tell us, inter alia, that A common tax regime for approved/registered pension schemes took over 50 years to achieve Tax-free lump sums on retirement came about more through accident than design. In turn, the lessons that might be learned from this brief history of pension tax reliefs are Uniformity of tax treatment for different types of pensions, which took so long to achieve and has now been in place for over 45 years, should not, without good reason, be disturbed Despite it now being an embedded part of the pensions landscape, an informed debate on the utility of the tax-free lump sum on retirement is long over due. 1. Taxation of Occupational Pension Schemes in the UK (1985), Centre for Policy Studies. 2. Where employee contributions obtained relief at half the standard rate of income tax; and no tax was imposed on employer contributions. However, fund income was taxable (at a concessionary rate from 1940). Benefits could be paid as tax free lump sums. 3. Contributions employer and employee were tax deductible and fund income was tax exempt. All benefits were required to take the form of taxable pensions, which were subject to a composite rate of tax of 1/3 or 1/4 of the standard rate of income tax.

8 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 4.2 TURNER, ET AL THE REVIEWS The Pensions Commission, chaired by Adair Turner, was set up in 2002 to review the UK private pension system and long-term savings. 4 The Pensions Commission completed its review in 2005 and has been disbanded. However, it concluded in its Second Report that a single rate of relief, recast as a government matching contribution had significant attractions in principle 5 Pension tax relief is costly, poorly focussed and not well understood. Unsurprisingly therefore the Pensions Commission received many submissions suggesting that it should be reformed to make its benefits both better focussed and clearer. A common proposal was that tax relief should be at an equal rate for everyone and therefore higher than at present for basic rate tax payers and lower for higher rate tax payers. Some submissions also suggested it could be recast as a government matching contribution. This would mean that for all pension savers, up to some level of contributions, the tax benefit would have the same percentage effect on the rate of return achieved. If the present 12.3 billion spent on tax relief was recast in this fashion, and at current levels of pension contribution, it would be possible to provide a matching contribution of 43%. This proposal clearly has significant attractions in principle. It would improve rational incentives to save via pensions (individually or via employer contributions) for many lower income people who are currently accruing inadequate pensions. It would also make these incentives much clearer; people would be far more likely to understand the benefit offered. However, it thought this would be difficult to implement for DB schemes and the Pensions Commission did not recommend any major reform in the short-term. 6 The Sandler Review 7, also concluded that there is some evidence that matching schemes are a more effective means of affecting savings behaviour than ordinary tax relief. Sandler recommended that in future, governments should avoid introducing new tax-based savings incentives if their aim is to increase aggregate savings levels. The core objective of policy in this area should be simplification. Citing research from Aegon 8, the Workplace Retirement Income Commission (WRIC) 9, like Turner, found evidence that the current system of savings incentives suffers from low awareness and understanding, complexity, and low trust. Most respondents to the WRIC review believed that pensions should be more tax favoured than other forms of saving. Respondents argued that pensions fulfilled a particular social policy objective and needed to be treated differently, and others argued special incentives were needed to persuade people to lock away savings for the long term. The WRIC concluded that Getting the best value from tax relief and ensuring that it visibly acts as an incentive to save is essential 10.

JLT EMPLOYEE BENEFITS 9 More recently, the Pensions Policy Institute (PPI) 11 observed that There is limited evidence around the effectiveness of tax incentives in encouraging pension saving [in particular, it does not match its target group as it does not adequately incentivise people with lower or middle incomes to save]. However, such evidence as there is suggests that tax relief is not very effective in incentivising saving. Reasons for this ineffectiveness related directly to the tax relief system include: Understanding around the tax treatment of pensions is low, something that is likely to dilute its effectiveness as an incentive to save. Tax incentives on pensions have redirected more money from other savings into pensions rather than incentivising saving overall. One reason for this is that tax relief does not match its target groups as higher earners, who may be more likely to save, are more likely to respond to incentives. There remains a Savings Gap, the difference between the amount people need to save to achieve a reasonable retirement income and the amount they are actually saving. This may not in itself mean that pension tax relief has not incentivised pension saving; however it does mean that it has not incentivised pension saving to the extent that individuals save enough for their retirement. So - The current pensions tax relief system is not properly understood nor is it incentivising pension saving (especially amongst lower and middle income earners) The matching and single rate ideas are viewed as attractive in terms of addressing this (and there is also more recent support for them, such as the former Pension Minister s proposal for a single rate of relief of 33%) However, the difficulties in making alternative systems work for all types of pension scheme are acknowledged Arguably, saving for retirement is different from other forms of saving. 4. http://www.webarchive.org.uk/wayback/archive/20070717120000/http://www.pensionscommission.org.uk/index.html 5. http://researchbriefings.files.parliament.uk/documents/sn05901/sn05901.pdf 6. Ibid. 7. Sandler Review: Medium and Long-Term Retail Savings in the UK, 2002. 8. Towards More effective Savings Incentives, 2011. 9. Final Report, 2011. 10. Ibid. 11. Tax relief for pension saving in the UK, 2013.

10 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 There are arguments against a single rate of relief. For example, the Institute for Fiscal Studies (IFS) has argued that giving everyone the same rate of relief, rather than giving more relief to higherrate taxpayers, is superficially attractive but fundamentally misguided. According to the IFS, the tax system should treat pension contributions and pension income in a symmetric way. 12 Also, the PPI highlight that a single rate of relief would be complex to implement. In addition to the DB issue, already mentioned above, they observe that - While it is relatively straightforward to give tax relief at an individual s marginal rate, it is more difficult to give tax relief at a single rate. It would be difficult to operate Net Pay Arrangements with a single rate of tax relief. In such cases employers could use alternate arrangements, which might require them to make changes to their payroll software. Alternately a compensatory mechanism could be used, for instance changes to the employee s PAYE code or the requirement for them to pay or claim back outstanding tax through the Self-Assessment system. 13 One point missing from all of this, in favour of a single rate of relief or matching system, is that current projections point towards many lower and middle income earners facing inadequate incomes in retirement 14. If one of the reasons for a review of the pension tax relief system is to decrease the number of older people who rely on means-tested benefits 15 then a single rate of relief, set above the level of the basic rate of income tax, could encourage lower and middle income earners to save more. The outcome would be an increase in people able to retire with dignity and a reduction of the burden that would otherwise fall on the shoulders of future tax payers. As an aside, if there were a single rate of tax relief for pension contributions and a single rate of tax for pension benefits, this would facilitate the convenience of cash-point pensions, where retirees could quite literally withdraw money from their pots via an ATM. Lessons to be learned might be that - We need to be very clear and transparent about the impact of and objectives for any change to current pension tax relief system (see, also, Sections 5 and 7) We also need to be cognisant of the changing shape of our society (with the working age population as a percentage of the total population reducing from 65% to 58% over the next 50 years 16 ), as well as advancements in technology and the pensioner experience when accessing their pension savings. 12. IFS Green Budgets 2014 and 2015 13. PPI, Tax relief for pension saving in the UK, July 2013, Executive Summary 14. https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/254321/framework-analysis-future-pensioincomes.pdf 15. Paid for by tax-payers, a population that is reducing as a proportion of people who are over state pension age. In 1970, the UK support ration was 4:3; in 2010, it was 3:6. 16. See, for example, The European Commission 2015 Ageing Report - http://ec.europa.eu/economy_finance/publications/ european_economy/2015/pdf/ee3_en.pdf.

JLT EMPLOYEE BENEFITS 11 4.3 PRINCIPLES FOR ANY REVIEW OF PENSION TAX RELIEFS Previous studies contend that there are two principal considerations behind attempts to review the tax advantages of pension savings - One is fiscal neutrality the desire to achieve a tax structure which, as far as possible, avoids discrimination between different types of activity and which leaves choices unaffected by tax considerations 17 The other is obtaining revenue, particularly from the elimination of tax expenditures subsidies to particular activities in the form of favourable tax treatment rather than explicit items of public expenditure 18. A tax regime which both raises revenue and is fiscally neutral in all respects is not feasible. Also, two kinds of incentive are important - the incentive to save, rather than to consume; and the decision to invest in one type of savings medium rather than another 19. Under the form of fiscal neutrality achieved by the current pensions tax regime, people have the choice of paying tax now or deferring it through pension savings and paying the tax when they take benefits. However, the rate of tax in retirement may not be the same. Further, as previously mentioned, there is the anomaly of the tax-free lump sum. As the comparison with individual savings accounts, below, illustrates, pension savings receive a considerable level of fiscal privilege relative to other forms of savings and investment. However, in return, those saving into a pension have to accept that they cannot normally access their savings until at least age 55. Pension v ISA Institute for Fiscal Studies figures show that, if someone is a basic rate taxpayer in work and in retirement, then contributing 94p to a pension delivers the same outcome as contributing 1 to an individual savings account (ISA). For a higher rate taxpayer in work who is a basic rate taxpayer in retirement, contributing 71p in a pension delivers the same as contributing 1 to an ISA. 17. Taxation of Occupational Pension Schemes in the UK (1985), Centre for Policy Studies 18. Ibid 19. Ibid

12 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 A review of pension tax reliefs must of course involve consideration of the reasons for pension savings being treated more favourably that other forms of savings and investment, including the relative effectiveness of pension schemes as a way of channelling savings into investment when compared to other savings mediums. Nevertheless, from what has been said so far, it is assumed that the following is generally accepted Pension saving (and more generally saving for later life / retirement) is desirable (because of demographic changes and the low level of the UK State pension relative to other countries 20, and to ensure there is reduced reliance on means-tested benefits) Pension saving is different from other forms of saving (savings locked away until later life). Before moving on to possible alternative pension tax regimes, one consideration that we do not consider to be relevant to the review of pension tax reliefs, if the objective of reform is a robust and sustainable system which incentivises the right people and helps protects future generations of workers from increased taxes, is the current state of the public finances. In other words, any change should not be motivated simply by the prospect of a short-term increase in public revenue at the expense of a much bigger, longer-term increase in public expenditure. 20. For an international comparison of State pension systems, see - http://researchbriefings.files.parliament.uk/documents/sn00290/sn00290.pdf.

JLT EMPLOYEE BENEFITS 13 4.4 OPTIONS FOR AN ALTERNATIVE TAX REGIME The UK s current pension tax relief system, illustrated below 21, is an EET system, and it is quite different from other forms of tax incentivised savings (such as individual savings accounts ISAs) and, of course, non-tax advantaged saving. Tax treatment of different savings vehicles Pension ISA Non-tax advantage Contributions Exempt from Income Tax Made from taxed income Made from taxed income Investments Exempt from Income and Capital Gains Tax Exempt from Income and Capital Gains Tax Subject to Income Ta and Capital Gains Tax Subject to Income Withdrawal Tax, apart from tax free lump sum of 25% of fund Exempt from Income and Capital Gains Tax Exempt from Income and Capital Gains Tax In terms of alternatives to the current system, and starting from the premise that private pension saving is desirable and pension tax reliefs should be better than tax neutral (because, unless there is some special advantage(s) to saving money in a form which means no access until later life, money will instead be saved in another form 22 ), numerous combinations are available. However, in terms of serious contenders, it seems that any change is likely to be either In this paper we focus on these contenders for an alternative system. In addition, changes to the rules on the anomaly that is tax-free cash on retirement are also considered. Investment returns could also be taxed (e.g. an ETE or ETT system), but such a change is likely to be complex and, for what it is worth, there are no real precedents for it in terms of pension tax relief systems in other countries (see Section 7). a move to a tax, exempt, exempt (TEE) system; or the introduction of a single rate of tax relief on pension contributions (but otherwise keeping the current EET principles). 21. The Second Report of the Pensions Commission 22. The Taxation of Private Pensions, Institute for Fiscal Studies (1993)

14 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 4.5 TEE There are a number of proponents of the Taxed, Exempt, Exempt (TEE) system 23. It is argued that, under a TEE framework, private and workplace pensions should be replaced with a Workplace ISA. Relative to the current EET system, advantages of the Workplace ISA include - For basic rate tax-payers, especially Generation Y, ready access to savings (which would be a feature of the Workplace ISA), is more important than 20% upfront tax relief (which has proved insufficient to overcome the complexity, cost and inflexibility of pension products, as well as distrust of the industry) Compatibility with the freedom and choice reforms announced in the 2014 Budget where, from April 2015, the effective requirement to annuitise was abolished and DC savers were able to take their savings as one or more lump sums Compatibility with automatic enrolment which, as we remarked in the Foreword to this paper, has been successful in getting people into the pension savings habit (although, communications would need to be revised to take account of the repeal of up front tax relief) The opportunity for a genuine fresh start and end to tinkering, including much needed simplification of the rules for tax approved (registered) pension schemes (annual and lifetime allowances, a myriad of different transitional protections, etc.) Scope for bringing the tax treatment of savings and pensions together to create a single savings vehicle that can be used with additions and withdrawals throughout working life and retirement 24. Potential downsides to the TEE model are - Loss of the financial discipline that is part of the current system 25 (whereby savers accept, in exchange for upfront tax relief and tax-free cash on retirement, that their money is locked away, potentially for several decades 26 ) Related to the above, the possibility of less employer engagement if workplace pensions become a less effective succession planning tool Increased moral hazard through savings being available in lump sum form and without any tax. Changing from EET to TEE is revolutionary, and the transition from EET to TEE could be complex and may involve two systems operating, at least in part, in tandem for a long time. Nevertheless, moving pensions towards a similar tax treatment as ISAs - where contributions of post-tax income and any returns are tax free has, according to one very recent survey, significant public support 27. 23. See, in particular, Michael Johnson s articles on the Centre for Policy Studies website (http://www.cps.org.uk/) 24. Andrew Tyrie, Chair of the Treasury Select Committee. 25. Early accessed to pension savings has recently been the subject of a consultation (https://www.gov.uk/government/ uploads/system/uploads/attachment_data/file/81326/call_for_evidence_on_early_access_to_pension_savings.pdf) but, the decision at the time, was to stick to the status quote; arguably, early access should be a separate debate to the correct tax relief system for pensions. 26. The current system also used to compensate savers for restrictions on the use of their savings, but this is less relevant in the post 6 April 2015 freedom and choice environment. 27. People want pensions to be taxed like ISAs, PWC (August 2015).

JLT EMPLOYEE BENEFITS 15 4.6 SINGLE RATE Michael Johnson in his paper for the Centre for Policy Studies observes that It is clear from the manner in which basic rate taxpayers are saving (i.e. 84% of all taxpayers) that the lure of 20% tax relief on pension contributions is insufficient to overcome pension products complexity, cost and inflexibility (until the age of 55), as well as a widespread distrust of the industry 28 What if, however, basic rate (20%) taxpayers (i.e. the bulk of the population who are not making adequate provision for retirement) were offered tax relief at a rate above the marginal income rate; e.g. 30% or even 33%? It has recently been suggested that, working on the basis that a rough average of the current rates of relief offered is 33%, this would enable the Treasury to give 1 of relief for every 2 saved 29 WOULD THAT BE A SUFFICIENT LURE? Our view is that it would be quite compelling and the potential advantages of the single rate of tax relief do not stop there - Targeting relief at those who need it most is arguably the best option to address the current uneven distribution of tax relief, which also exacerbates wealth inequality No disruption to the freedom and choice reforms Compatibility with automatic enrolment (although, communications would need to be revised to take account of the replacement of marginal rate income tax relief with single rate) Does not entail a tearing up of the existing rule book for tax approved (registered) pension schemes Retains the basic EET concept and encourages pension saving to be used for an income in retirement (by taxing lump sums, after tax-freecash, at an individual s marginal rate). OF COURSE, THERE ARE POSSIBLE DISADVANTAGES TOO - A single rate of tax relief could appear complex and be difficult for people to understand (even more so than the current system). However, it is argued that, if tax relief were presented as a matching contribution, the single rate will be easier to explain 30 It would be difficult to implement for DB schemes (although, as we explain in Section 4.9, this could be managed) There could be administrative complexity and cost (for example, changes to payroll software) Assuming that there would be a move to relief at source (RAS) for all pension schemes, further complexity could arise from the Scottish Rate of Income Tax (SRIT). 28. Time for Tee, July 2015 29. http://citywire.co.uk/money/pensions-plans-drawn-up-to-axe-higher-rate-tax-relief/a831204 30. Pensions Policy Institute, Tax relief for pension saving in the UK (2013)

16 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 There could also be increased costs for employers if the single rate does incentivise saving (a further reduction in opt-outs and members choosing to pay contributions at higher rates in schemes where there is a company matching contribution). However, opt-out rates are already very low and employers can, if they wish, re-design contribution structures. Further, the success of matching contributions as a means of encouraging additional pension saving just reinforces the single rate of relief expressed as a matching contribution argument. The matching contribution option would be even more compelling if the government match was set at a more generous level; for example, 50p for every 1 has a strong communication advantage. Of course, there are affordability consideration but the Turner review (see section 4.2) suggested a matching contribution of 43% and more generous match could be introduced when establishing a new system but varied, if need be, in future. A single rate relief is likely to be accompanied by retention, at least at outset, of a minimum pension age for accessing savings. Whether this is an advantage or disadvantage should, as we have indicated above, be considered as a separate issue.

JLT EMPLOYEE BENEFITS 17 4.7 TEE VERSUS SINGLE RATE To determine which is best - TEE or single rate - we have compared these two pension tax relief options against four fundamental criteria 1. Targeting the right people (as many of those facing inadequate retirement incomes as possible) 2. Addressing perceived unfairness in the current system (the amount of tax relief that currently goes to higher earners) 3. Facilitating simplification of the currently very complex pension tax rules and ease of communication 4. Not increasing the current cost to the exchequer of pension tax reliefs. Judged against these four criteria, our view is that a single rate of tax relief expressed as a matching contribution ticks the most boxes It is targeted primarily at those who are at most risk from inadequate retirement incomes It will result in a more even distribution of tax reliefs There will be no need for introduction of the complex tapered annual allowance and further simplification of the single tax regime should also be achievable The reform, properly managed and with our other proposals (see below), should be at least tax neutral. 4.8 TAX-FREE CASH Members of pension schemes usually have the option to take up to 25% (and sometimes even more) of their pension fund as a tax free lump sum when they take their pension benefits. The vast majority exercise this option. A number of arguments have been made for changes to the rules on tax-free cash or even for complete abolition of it altogether 31 The Institute of Fiscal Studies has argued that there is a powerful case for introducing a cash limit on the amount that can be withdrawn from a pension tax-free, at a level considerably below 312,500 (the current level, simply 25% of the 1.25 million lifetime limit on registered pension saving). Unfortunately, no reliable current estimate exists of the revenue that this would raise. The Pension Policy Institute found that changes to the 25% tax-free lump sum would mean pension tax relief was more evenly distributed. However, it said that it would not improve incentives to save 31. http://researchbriefings.files.parliament.uk/documents/sn05901/sn05901.pdf.

18 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 Under the current system, 77% of individuals have a lump sum of under 40,000 while only 24% of the tax on lump sums goes to these individuals. Similarly, while 2% of lump sums are worth 150,000 or more, they attract 32% of tax relief on lump sums. The projected cost of this tax relief on lump sums is 4 billion. If the tax-free portion of the lump sum were limited to 20% of the pension fund, the reduction in tax relief received would be proportionately the same for all individuals. In practice, any change would be likely to only apply to future contributions, so initial savings would be small and take a number of years to build up. If such a change were applied to current lump sums the cost of tax relief could decrease from 4 billion to 3.5 billion. We have already contended that the tax-free lump sum is an anomaly. In terms of reform, which ensures that pension tax relief is more evenly distributed whilst not entirely removing this popular option (which could be used to pay off debts 32 or for one off expenditures at or after retirement), our view is that some form of cap on the tax free lump sum is the right way forward. Based on research around the average tax-free lump sum paid out by pension schemes and the average outstanding mortgage for retirees, we propose that it be set at around 40,000 to 50,000 (with accrued tax-free entitlements protected) and then indexed. An alternative approach would be to cap the size of lump sums that are available tax-free. For example, a cap of 36,000 would mean that 75% of current lump sums would be unaffected but the largest 25% of lump sums would be capped. Again, this is most likely to be applied to new pension contributions so would not make significant savings for many years. If tax relief were limited to the first 36,000 of the current tax-free lump sums, the proportion of tax relief going to lump sums of 150,000 and over would reduce from 32% to 7%. The cost of tax relief on lump sums could halve to 2 billion. 32. Research published by MGM Advantage estimated that one in eight retirees (13 per cent) continue to pay off a mortgage in retirement, collectively worth 76bn, with an average of 47,458 owed per person.

JLT EMPLOYEE BENEFITS 19 4.9 IMPLEMENTATION The implementation of any reform will depend on the nature of the change. At this stage, in advance of any policy decision, we make only three observations 1. Depending on the form of change, consideration may need to be given to different treatment of DB schemes and DC arrangements; in this regard, the following are relevant The dwindling number of active DB members (at least, in the private sector) The risk of unintended consequences; e.g. differences in tax treatment for DB and DC could be used to promote the Government s defined ambition agenda, but it could also result in a form of arbitrage where employers offer DB to higher earners and DC to other workers 2. If there is to be any reform, it must be accompanied by simplification of the convoluted pension tax rules; ideally, the objective should be the single, simplified pension tax regime that the Finance Act 2004 reforms never achieved 3. Any changes to the tax-free cash rules must not be retrospective. Therefore, as an alternative to a cap on tax free lump sums, further reform of the annual allowance could be considered bearing in mind that, according to government figures, 98% of DC savers contribute less than 10,000 per annum 33. Cm8901, July 2014 (Freedom and choice in pensions).

20 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 MODELLING 5.1 THE COST OF PENSION TAX RELIEFS AND HOW THEY ARE DISTRIBUTED 34 COST OF REGISTERED PENSION SCHEME TAX RELIEF 35 2001-02 2002-03 2003-04 2004-05 2005-06 Income tax relief on:- Occupational Scheme Contributions By Employees 3,100 3,200 3,400 3,800 4,200 By Employers 7,900 8,900 10,400 12,300 14,400 Personal Pension Scheme Contributions By Employees 1,090 1,300 1,300 1,300 1,500 By Employers 700 800 800 1,000 1,200 Contribution to PPs and RACs by self employed 1,000 900 800 800 1,000 Investment income of pension funds 1 3,700 3,500 3,800 4,200 4,500 Total reliefs 17,600 18,600 20,400 23,400 26,900 Less tax liable on Pension payments 2 7,500 8,100 8,200 8,100 9,200 Refunds by funds to employers in connection with pension fund surpluses 110 60 40 20 10 Total deductions 7,600 8,200 8,200 8,200 9,200 Total 10,000 10,500 12,200 15,300 17,600 Memorandum item National Insurance relief on employer 5,400 6,200 7,300 8,400 9,800 contributions 3 PP = Personal Pension. RAC = Retirement Annuity Contract. p = mixture of provisional outturns and projections; r = revised 34. Source: HMRC. 35. https://www.gov.uk/government/statistics/registered-pension-schemes-cost-of-tax-relief.

JLT EMPLOYEE BENEFITS 21 2006-07 2007-08 2008-09 2009-10 2010-11 2011-2012- 2013-12 r 13 r 14 p 4,400 4,400 4,200 3,800 4,000 3,700 4,200 4,300 15,500 15,100 14,100 15,700 19,000 18,700 18,400 17,100 1,800 2,100 2,000 1,900 2,000 1,900 1,700 1,900 1,900 2,300 2,400 2,400 3,000 2,700 3,000 3,100 1,200 1,300 1,000 700 800 900 700 600 5,100 5,600 5,700 6,300 6,600 6,800 7,200 7,300 30,000 30,800 29,400 30,800 35,300 34,800 35,100 34,300 10,500 9,300 10,800 10,700 11,300 12,000 12,800 13,100 - - - - - - - - 10,500 9,300 10,800 10,700 11,300 12,000 12,800 13,100 19,500 21,500 18,600 20,100 24,000 22,800 22,300 21,200 10,400 11,700 11,500 12,900 14,500 14,800 14,700 14,000 PP = Personal Pension. RAC = Retirement Annuity Contract. p = mixture of provisional outturns and projections; r = revised

22 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 The table below shows the latest figures from HMRC on the income distribution of income tax payers, and the distribution of tax-deductible private pension contributions. In 2012/13, people with incomes over 50,000 accounted for around 10 per cent of income tax payers, but nearly half (47%) of private pension contributions attracting tax relief. The 1 per cent of income tax payers within incomes of 150,000 and above accounted for 14 per cent of pension contributions attracting tax relief. Income tax payers in 2012/13: income distribution of all income tax payers and pension contributions attracting tax relief Range of gross income Number of income tax payers Contributions to occupational and personal pensions attracting tax relief (a) From To thousands % total billion % total 0 19,999 14,350 47% 1.9 8% 20,000 29,999 7,210 24% 3.2 14% 30,000 49,999 6,080 20% 6.7 30% 50,000 69,999 1,500 5% 3.2 14% 70,000 99,999 746 2% 2.2 10% 100,000 149,999 394 1% 1.9 9% 150,000 and over 304 1% 3.0 14% Total 30,600 100% 22.0 100% (a) Deductions and reliefs are the amounts deducted from total income, along with personal allowances, to arrive at the amount of taxable income subject to an income tax charge. This table shows the sum of employees' superannuation contributions to occupational and personal pensions which attract tax relief.

JLT EMPLOYEE BENEFITS 23 PROPORTION OF THE COST OF INCOME TAX RELIEF ON PENSION CONTRIBUTIONS FOR VARYING INCOME RANGES AND YEARS % of the cost of income tax relief on contributions Income bands 10 11 12 13 14 2009-2010- 2011-2012- 2013-2014- 15 Up to 19,999 8% 6% 5% 6% 5% 5% Between 20,000 and 44,999 31% 32% 35% 37% 37% 36% Between 45,000 and 74,999 25% 26% 28% 32% 33% 34% Between 75,000 and 99,999 7% 8% 8% 10% 10% 10% Between 100,000 and 149,999 8% 9% 9% 7% 8% 8% 150,000 or more 20% 18% 14% 8% 7% 7% All 100% 100% 100% 100% 100% 100%

24 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 5.2 THE IMPACT OF ALTERNATIVE SYSTEMS AND THE INCENTIVE TO SAVE In this section, we consider and illustrate the incentive to save under different pension tax relief systems (including the current one). The modelling is based on a 22 year old with a State Pension Age of 68. The first chart, below, compares the tax relief a member receives over the course of a working lifetime to the tax paid over the course of their retirement. If the ratio is 1 then the individual s position is tax neutral. If it is greater than 1 then there is a financial incentive for the individual and, if it is less than 1, there is a financial disincentive. It can be seen that the current EET system provides a strong financial incentive for most individuals, with earnings between 20,000 and 80,000. In particular, when an annuity is purchased at retirement, individuals at all earnings levels have received a financial incentive. The lower paid receive a significant incentive where the basic rate relief received over their working lifetime then provides a pension that is partly tax free (through the lump sum and the personal allowance) and partly taxed at the basic rate. However, under the new pension freedoms, individuals can take their entire benefit as a lump sum. In this scenario, the lower paid can actually lose out as their basic rate relief is more than offset by the higher rate (and potentially additional rate) tax paid on the one-off lump sum. Ratio of tax relief to tax paid (>1 provides an incentive to an individual) 7.0 6.0 5.0 4.0 3.0 2.0 1.0 20,000 30,000 Incentives under the current taxation system 40,000 50,000 Current Annual Salary ( s) 60,000 70,000 80,000 Lump sum Regular income JLT calculations 36. Real investment returns net of fees are assumed to be 3% per annum and annual salary is assumed to increase in line with inflation. Income tax bands are assumed to change in line with increases in salary over the entire period modelled. Income in retirement includes the single-tier State Pension. Statutory Money Purchase Illustrations (SMPI) style annuity projections are applied. The annuity is nil escalating with a 50% spouse pension.

JLT EMPLOYEE BENEFITS 25 The next chart shows a comparison of the different taxation systems assuming a member takes benefits as a lump sum. The 25% tax free cash lump sum is maintained in this scenario. It can be seen that Single rate EET effectively solves this problem and provides an incentive for all TEE, on the other hand, provides a strong incentive for the lower paid, as they avoid being heavily taxed on the lump sum. The current EET system provides a disincentive for the lower paid, but an incentive for the higher paid Ratio of tax lief to tax paid (>1 provides an incentive to an individual) 2.5 2.0 1.5 1.0 0.5-20,000 30,000 Incentives under alternative taxation systems Benefits taken as a lump sum - with 25% tax free cash 40,000 50,000 60,000 70,000 80,000 Current EET Single Rate EET TEE Current Annual Salary ( s) JLT calculations The chart below shows the position if individuals choose an annuity in retirement, with 25% taxfree cash. Under the current EET system, there is a financial incentive for all However, single rate EET provides a smoother transition and a more even relative spread of incentives across earnings ranges TEE does not provide an incentive at any earnings level. Incentives under alternative taxation systems Benefits taken as a regular income - with 25% tax free cash 7.0 Ratio of tax relief to tax paid (>1 provides an incentive to an individual) 6.0 5.0 4.0 3.0 2.0 1.0 Current EET Single Rate EET TEE 20,000 30,000 40,000 50,000 60,000 70,000 80,000 Current Annual Salary ( s) JLT calculations

26 REFORM OF PENSIONS TAX RELIEF WHITE PAPER SEPTEMBER 2015 The impacts of alternative member options - taking all benefits as a taxable lump sum and taking no lump sum at all - are illustrated below in the final two charts. Outcomes under the first scenario are very income dependent, except for single rate and outcomes in the second scenario are similar to those above. Ratio of tax relief to tax paid (>1 provides an incentive to an individual) 2.5 2.0 1.5 1.0 0.5-20,000 30,000 Incentives under alternative taxation systems Benefits taken as a lump sum - tax free cash abolished 40,000 50,000 Current Annual Salary ( s) 60,000 70,000 80,000 Current EET Single Rate EET TEE JLT calculations Ratio of tax relief to tax paid (>1 provides an incentive to an individual) 3.5 3.0 2.5 2.0 1.5 1.0 0.5-20,000 Incentives under alternative taxation systems Benefits taken as an regular income - tax free cash abolished 30,000 40,000 50,000 Current Annual Salary ( s) 60,000 70,000 80,000 Current EET Single Rate EET TEE JLT calculations

JLT EMPLOYEE BENEFITS 27 SURVEY To better understand the views of individuals on the current EET pension tax relief system and the potential alternatives, we commissioned a survey of 1,000 employees 37. The key results of that survey, with our analysis, are set out below, under each of the questions that respondents were asked. Overall There appears to be support for a change to the current system Respondents favour a single rate of relief over both the current EET system and TEE Early access to pension savings is not a priority but the risk it poses to pension outcomes is recognised The exact impact of restrictions to or abolition of the tax-free lump sum on retirement is difficult to gauge In all events, neither a single rate of relief nor TEE would, at this time, guarantee a material, positive impact on the level of contributions respondents currently make to their pension arrangements. 1 Which of the systems for pensions tax relief would encourage you the most in terms of making additional provision for your retirement via pension savings? 100% 90% None of these 80% 70% 60% The current EET system 50% 40% 30% A TEE system, like ISA's 20% 10% 0% Totals Male Female Aged 18-24 Aged 25-34 Aged 35-44 Aged 45-54 Aged 55-64 Aged 65+ Social Class AB Social Class C1 Social Class C2 Social Class DE South East Midlands North England Wales & South West Scotland A system where everyone got a single rate of relief on their pension contributions (above the level of the basic rate of income tax) Of those who said that one of the above pensions tax relief systems would encourage them to make additional provision for their retirement via pension saving (i.e. discounting none of these ) - almost half (46%) indicated a single rate of tax relief as their system of choice; this compares to less than a third (32%) under a TEE system; and fewer than a quarter (22%) under the current system. Again discounting the none of these responses, amongst Social Class DE (Semi-skilled & unskilled manual occupations), 57% opted for single rate and only 28% chose TEE. The equivalent percentages for Social Class C2 (skilled manual occupations) were 56% and 32%. 37. Conducted on behalf of JLT Employee Benefits by ICM Unlimited.