Fundamental changes to tax relief are coming and everyone agrees that an ISA-style system won't work - but is a flat rate the answer?Sara Benwell, digital editor of Pensions Insight and Engaged Investor explores the alternatives.
Since George Osborne suggested the UK could move to an ISA-style TEE system, speculation has been rife as to what the future of pensions tax relief could look like.
These days it's hard to find anyone who thinks that an ISA-style system would be for the best.Michael Johnson, an independent pensions expert and researcher at the Centre for Policy Studies, has rightly pointed out that the allure of tax relief is not enough to get people saving, while the simplicity of ISAs continue to appeal.
In a paper released ahead of last year's budget he said: "It is clear from the manner in which basic rate taxpayers are saving, 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.
"In addition pension products are increasingly at odds with how people are living their lives, particularly Generation Y.
"Ready access to savings is the key requirement, valued above tax relief. Indeed, Generation Y is so disengaged from private pensions that the industry's next cohort of customers could be very thin.
"Consequently... an EET tax framework for retirement saving is failing the next generation."
Following a consultation on the future of pensions tax relief it became clear that the industry is violently opposed to a shift to an ISA-style system.This makes sense. It would likely alienate the employers responsible for providing pensions systems, and the shift to auto-enrolment means that many lower-earners are saving into a pension for the first time.
For those lower earners a shift could be catastrophic. At the moment, tax relief favours the rich, but abolishing it altogether would harm the poor.Even if tax relief doesn't encourage saving, auto-enrolment does. And the current tax system gives people more bang for their buck. It also encourages employers to provide more generous DC contributions.For those lower earners a shift could be catastrophic"
According to reports from the Financial Times, the Treasury is leaning towards a flat-rate system where everyone gets the same level of tax relief regardless of earnings.
The rate is likely to be set between 20% and 40%. 25% would save the government GBP 6bn from the current GBP 21bn tax relief bill, but 33% has been mooted as fiscally neutral. Crucially – the latter is a smaller saving for the government.
While experts are united in the belief that an ISA-style system would be catastrophic for the industry, there is disagreement about the impact of a flat-rate.
What is the best route forward for pensions tax relief?
1) Keep things as they are
2) Change to a flat rate system
3) Pension ISAs
Graham Vidler, director of external affairs at the Pensions and Lifetime Savings Association votes for no change at all:
"At the most extreme end, government could move from the current EET system to TEE (taxing pensions 'like ISAs'). This would be disastrous for pension savers with higher rate, basic rate and non-taxpayers all losing out under such a regime. And future Chancellors might find it irresistible to look again at that final 'E' as they find themselves unable to tax a growing proportion of the population.
"When surveyed, 82% of our members believed TEE would reduce pension saving and 63% said it would add more than 10bp to member charges. Additional payroll costs for employers could be anything from GBP 20,000 to GBP 800,000, depending on the size of the scheme, and additional administration charges are estimated between GBP 25,000 and GBP 1m.
"However, if you believe some newspapers, the Treasury is moving towards imposing a single rate for all pension contributions. Less damaging perhaps? Not once you realise this would amount to aGBP6bn+ a year raid on pensions, bigger even than Brown's GBP 5bn raid on pensions in 1997.
"Some suggest that single rate would benefit the many at the expense of the few, but this simply isn't true. A single rate meeting the government's test of sustainability would likely be set at 25% or lower, producing a relatively small additional benefit for basic rate taxpayers, whilst drastically reducing the attractiveness of pension saving for the 4.6m higher- rate taxpayers.
"As higher-rate tax payers stump up a high proportion of pension schemes' costs, any reduction in their pension savings means everyone faces higher costs.
"We argue there should be no change to pension tax relief. The changes on the table would do the very opposite of incentivising more pension saving and risk unravelling the good work done by automatic enrolment.
"No change is the right decision for all savers."
"I vote for 'flat rate' relief," says Steve Webb, Director of Policy at Royal London:
"If the Chancellor wants to save money through reforming pensions tax relief, it becomes all the more important that what help is available goes to those who need it most, which is far from the case at present.
"Arguments about tax neutrality are for the purists – the simple truth is that tax breaks for pensions cost society money today and we have a choice to make about who gets the benefit.
"A flat rate of relief offers the potential to communicate tax relief in simple language – something not currently possible. A flat rate can be described as a matched contribution – for example, 'you put in a pound, your employer puts in a pound and the government puts in a pound'.
"Whilst there is no evidence that the current structure of tax relief incentivises higher savings levels, there is clear evidence that when employers offer matched contributions this does lead to higher saving - so why not build on that principle for tax relief?
"The great prize from a move to flat rate relief would be if we could then lock in a simple headline rate of relief and leave it alone for a generation (or even a Parliament would be nice!). If it could be coupled with abolition of lifetime limits and simplification of the annual allowance, there would be potential for a real win.
"Whilst flat rate relief would create some administrative cost and complexity, this is as nothing compared with the potential impact of turning the system upside down through a 'Pensions ISA'.
"If the Chancellor wants a system which is cheaper, simpler, stable and easy to explain, flat rate relief is the only game in town."
The impact of this year's Budget, including any changes to tax relief will be explored at this year's Workplace Pensions Live conference on 11 and 12 May at Edgbaston, Birmingham. Sessions will also examine The Pensions Regulator's 21st Century trusteeship campaign, and look at how the latest political developments, including a possible Brexit will affect schemes. Delegate places, which are free to scheme staff and trustees, can be booked at www.workplacepensionslive.co.uk
