27 February 2020

Forget scrapping reliefs, the whole pension system needs a radical overhaul


Many of us put off saving for retirement in the belief that the state pension will provide for us in old age. But even with the full 35 years of qualifying National Insurance Contributions (NICs), the new State Pension currently pays just £168.60 per week, or £8,767.20 a year.

Although the government is committed through the so-called ‘triple lock’ to increase state pension payments in line with average weekly earnings, inflation or 2.5% (whichever’s greater), we’re still unlikely to see any significant increases for the foreseeable future.

Thankfully, as a result of ‘auto-enrolment’ which was introduced by the coalition government in 2012, most people in Britain are now contributing to a workplace pension. But the majority of us still aren’t saving anywhere near enough to live comfortably in retirement. The average UK defined contribution scheme pension pot currently stands at just £71,000. To put this into context, to purchase an annuity which would provide the same income as the new State Pension, you’d need a pot worth over £280,000.

In a recent piece for CapX, Sam Bowman made the case for maintaining the current system of pensions tax reliefs, unless, that is, the Government were to go for “wholesale reform”. With the Budget coming up shortly, I believe the new Chancellor Rishi Sunak should seize the opportunity to do just that and radically simplify the system.

Currently, any money paid into a pension is effectively made before income tax is deducted. If you’re a member of a workplace ‘salary sacrifice’ scheme, pension contributions are made without income tax or NICs having been paid. If you’re a member of a personal ‘relief at source’ pension scheme, the government will automatically credit any pension contribution with an additional 20% in tax relief. If you’re a higher rate tax payer, you can also claim additional tax relief so that your pension saving aren’t taxed ‘on the way in’. In retirement, however, any income you withdraw ‘on the way out’ is taxed at your marginal rate of income tax.

One of the criticisms of the current system is that it’s seen to benefit higher earners as they’re able to reduce the amount of tax they pay at the higher rate by adding money to a pension. In most cases, they’re then able to withdraw the money in retirement at a lower rate of tax. But just as importantly, the current arrangements also fail to incentivise the majority of us to save adequately. Roughly 74% of us either don’t understand how the tax relief system works, or don’t even realise it exists at all.

To address these problems, the current tax relief regime should be disbanded. Instead of adding tax relief to pension contributions and then taxing pension income in retirement, the government should simply take pensions out of the tax system altogether. This is how ISAs work. Any savings you place into an ISA will have been made after income tax has been deducted. But withdrawals are then made tax-free.

In 2017, the government launched the Lifetime ISA. These accounts aim to encourage people to save either for their first home or for retirement by HMRC adding 25% to contributions. Making the maximum £4,000 annual subscription therefore automatically translates into £5,000 of savings, with no income tax or capital gains tax due on withdrawals.

Were the government to move to a regime in which workplace pensions worked more like Lifetime ISAs, the whole system would become immeasurably less complex. For example, if for every £1 an employee contributed to a workplace pension the government added 30p and the employer added 70p, far more people would recognise the benefits of pension saving, and would almost certainly save more as a result. Who wouldn’t fancy doubling their money, right?

It would also lead to a more equitable system and, potentially, save the Chancellor money too. In 2018-19, pension tax relief cost HMRC £2.2bn. The Pensions Policy Institute estimates that around 64% of this relief was claimed by higher rate tax payers. Replacing higher tax rate relief with a flat governmental top-up could therefore save millions.

Moving to such a model would also remove the need for the myriad of complex rules surrounding the current system such as the Tapered Annual Allowance (which has plagued high earners such as NHS doctors), Money Purchase Annual Allowance (MPAA) and Lifetime Allowance (LTA), each of which inflict punitive tax charges for those wishing to make contributions above a certain level.

It would also resolve the ‘net pay anomaly’ suffered by low earners. It’s currently estimated that there’s around 1.75m employees with jobs that pay less than the £12,500 personal allowance and who contribute to a pension through a ‘net pay’ arrangement. In such schemes, there’s no automatic 20% tax relief added, meaning low paid workers miss out on an estimated £111m a year in tax relief.

Admittedly, moving to a totally new system couldn’t be done overnight and would need to be implemented gradually. Because contributions made under the current regime would’ve been credited with tax relief, they’d need to be placed into separate arrangements which would continue to be subject to tax upon withdrawal. But any additional contributions could then be treated under the new rules.

There is a precedent for this incremental approach to pension reform. At the moment, individuals who reached their state pension age before 6th April 2016 still receive their State Pension based on pre-2016 rules. They therefore claim the Basic State Pension along with any additional entitlement to SERPS or S2P. People who retire after 6th April 2016 meanwhile simply receive the New State Pension. The two systems run in parallel.

Our pension system is long overdue a comprehensive shakeup. Simplifying the rules in this way would help everyone from the lowest earners within ‘net pay’ arrangements, to the highest earners currently subject to the Tapered Annual Allowance and LTA.  It would also save money, make the whole experience of saving for retirement more appealing and easier to understand, and would almost certainly increase people’s propensity to save. What’s not to like?

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George Maggs is a political economy researcher at the University of the West of England