The current UK pension taxation regime gives preferential treatment to Defined Benefit (“DB”) savers relative to Defined Contribution (“DC”) savers at both theAnnual Allowance (“AA”) and Lifetime Allowance (“LA”) levels. The current taxation system is overly complex, with two tiers of allowances, and inconsistent, particularly in the way DC savings are taxed. Scrapping the LA would be a constructive first step in creating a simple and consistent approach to pension taxation, aligning taxation and provision. There is also benefit to be had from tackling the AA.
Pension contributions enjoy tax relief in order to incentivise savers to lock their income away for the long-term. This state of affairs is not unique to the UK – there is recognition in a wide range of countries that many people require a carrot to defer immediate consumption to a date some way in the future. This incentive is ultimately recovered, to varying degrees, as the resulting pension income is taxed. Tax is also generated from the activities supporting private pension provision. The LA and AA were introduced to seek to limit the tax relief provided as well as prevent abuse of the relief.
There has been an attempt to reduce the tax breaks that incentivise pension savings in recent times. What about the consequences of these diminished incentives? The proposed reduction of the LA in the 2015 Budget, supposedly to protect public finances from the growing cost of Income Tax relief, was expected to affect less than 4% of savers approaching retirement – in the short-term. The long-term picture looks somewhat different, particularly as Automatic Enrolment starts the savings process earlier for many savers. The Conservative Party’s pre-election pledge to reduce tax relief on pension contributions for those earning over £150,000 in order to fund an increase in the Inheritance Tax threshold penalises the long-term plans of affected savers to address a short-term campaign promise. The proposal also further complicates the tax system. There are, however, ways to simplify matters without reducing the overall tax take. Some groups will inevitably pay more tax, although only to the extent they benefit from the underlying pension provision.
Eliminating the LA and managing the tax relief that DC savers enjoy via the AA would simplify matters for these savers. The end of the LA would mean that those savers whose investments perform well would not be penalised for their success. The Government would benefit from this success too, in the form of higher income tax receipts as and when the accumulated fund is taken as income.
Tax relief ‘provided’ to DC savers by scrapping the LA can be made up, and then some, by more accurately reflecting the value of DB benefits, and taxing them accordingly, than is currently the case. The elimination of the LA would render a discussion around the conversion of income to taxable benefit at retirement for DB savers at a rate of £20 of taxable benefit for each £1 of income irrelevant. The AA would then become the binding factor in DB pension taxation but the AA enjoys an even more favourable conversion rate for DB savers (of £16 taxable benefit for each £1 income) at the moment! Addressing the conversion rate is key to the reform process:
- There are a number of variables that affect the economic value of the conversion rate including real interest rates for benefits now accruing, the ages of the beneficiaries and the point at which the benefit becomes payable;
- The number of variables used to calculate the conversion rate for AA purposes might reflect the trade-off between accuracy and ease of application that the Government wishes to strike. In theory, each DB saver might have their own conversion rate – easily created and communicated in today’s on-line world. Broader-brush rates might be created, using a limited number of variables, to reduce HMRC’s computing/work-load. The conversion rate should, at a minimum, reflect interest rates prevailing at the start of the tax year (or some pre-determined interval before the start of the year); and
- The conversion rate would be set (at the start of the tax year) to seek to link the DB and DC AAs in the relevant tax year. For example, if the DC AA is £40,000 for the tax year and the conversion rate is 40 then the saver’s tax-advantaged accrual of DB benefits in the tax year would be limited to a benefit of £1,000 per annum.
Breaking the explicit link that currently exists between the AA and the revaluation of past DB accrual does create a risk that attempts might be made to game the system by aggressively increasing pensionable salary after the point of taxation for those with final salary benefits. This risk might be mitigated by limiting the increase in the salary used to calculate the pension benefits to the corresponding increase in the salary upon which tax relief has been claimed. If the pensionable salary increase is limited by scheme rules to the change in the Consumer Price Index, then this is already consistent with the current DB AA calculation. Past accrual can be addressed by creating a base reference point for pensionable salary using the salary upon which relief has been claimed in the most recent tax year that the saver has filed a return (most probably 2013/14). Using the return already filed seeks to eliminate the risk that this approach will be gamed.
The current DC AA already provides a straightforward approach to limiting tax relief arising from pension contributions. It also caps the benefits that higher earners enjoy given its flat nature (currently £40,000 per annum). How about using this existing base as the reference point for creating simplicity and consistency across the pension taxation landscape? Consistency between DC and DB savers can be achieved by creating conversion rates linked to prevailing market conditions and the true value of the benefits provided. Specifying the DB AA in terms of an accrual amount (i.e. the DC AA divided by the conversion rate) also serves to simplify the measure. Individual tax calculations for each DB saver are already required, so no added burden is being created for the taxpayer. The other leg of the simplification process is the abolition of the LA. What is the likelihood that the new Government will create a simple and consistent pension tax regime?