Tee Time?

michael johnson

A couple of weeks ago, I spoke with Michael Johnson about what he thought the budget’s proposals for pensions would be. He reminded me of this paper he had sent me in April and suggested that the Budget would be radical.

Here is his paper, delivered in April -before the election – which I suspect has been quite influential. We need to review tax-relief on pensions; it isn’t fair and in the new world of freedoms it doesn’t work. I am not a conservative, an economist or particularly good on tax, but I do understand Michael’s argument and fundamentally support his approach.

I have included the Treasury’s eight consultation questions at the end of this blog. Read them after you’ve read the paper.

Today, two disparate worlds

The savings landscape is characterised by a fundamental schism.  Saving within a pensions framework provides tax relief on the way in (“EET”), whereas subscriptions to New ISAs (“ISAs”) are made with post-tax income, but withdrawals are tax-free.[1]  Consequently, ISAs are “TEE”.


Over the last six years, stocks and shares ISA subscriptions have increased by 90%, to £18.4 billion in 2013-14, taking the total market value to £241 billion.[2]  In the same year, an additional £38.8 billion was subscribed to 10.5 million cash ISA accounts, taking the ISA cash mountain to £228 billion.  Clearly, engagement with ISAs is high, confirmed by industry surveys, and acknowledged by the Chancellor when he raised the annual subscription limit by 30%, to £15,000, in the 2014 Budget.  Importantly, the ISA brand is still reasonably trusted. 


Conversely, over the same period, the amount contributed to the EET world of private pensions reduced by 25%, to £7.7 billion in 2013-14, a figure which includes basic rate tax relief.[3]  Official data excludes SIPPs and SSASs, which attracted perhaps another £6 billion.


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.  In addition pension products are increasingly at odds with how people are living their lives, particularly Generation Y (broadly, those born between 1980 and 2000).  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, they are missing out on upfront tax relief: an EET tax framework for retirement saving is failing the next generation.


The 2014 Budget


Following the 2014 Budget, there is now no obligation to annuitise a pension pot.  This shatters the historic unwritten contract between the Treasury and retirees, that the latter, having received tax relief on their contributions, would subsequently secure a retirement income through annuitisation. 


This expectation was made clear by Lord Turner’s Pensions Commission, which explicitly linked the receipt of tax relief with annuitisation, thereby reducing the risk of becoming a burden on the state in later life.  “Since the whole objective of either compelling or encouraging people to save, and of providing tax relief as an incentive, is to ensure people make adequate provision, it is reasonable to require that pensions savings is turned into regular pension income at some time.”[4] 


In addition, a subsequent review of annuities by the Treasury stated that the fundamental reason for giving tax relief is to provide a pension income.  Therefore when an individual comes to take their pension benefits they can take up to 25 per cent of the pension fund as a tax-free lump sum; the remainder must be converted into a pension – or in other words annuitised.[5]


It is patently clear that tax relief and the 2014 Budget’s liberalisation are incompatible: the door is wide open for wholesale reform, not tinkering, of tax relief.  This has been recognised by the Treasury Select Committee which, in its response to the 2014 Budget, commented that in light of pensions’ improved flexibility, ISAs and pensions will become increasingly interchangeable in their effect.  It went on to suggest that the government should work towards a single tax regime to reflect this, and also examine the appropriateness of the present arrangements for the pension 25% tax free lump sum.


The committee chairman, Andrew Tyrie MP, was clear: in particular, there may be scope in the long term 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.  This would be a great prize.


Pensions tax relief: expensive


Today’s tax-based incentives for pension saving are hugely expensive, totalling over £52 billion in 2013-14, in the form of:[6]


(i)      upfront Income Tax relief on contributions (£27 billion);


(ii)     NICs rebates related to employer contributions, facilitated by salary sacrifice schemes.  These take advantage of a tax arbitrage at the Treasury’s expense, and cost some £14 billion annually (a figure that will accelerate with auto-enrolment);  


(iii)    roughly £4 billion on the 25% tax-free lump sum; and


(iv)    some £7.3 billion in respect of the investment income of both occupational and personal pensions schemes assuming relief at the basic rate of tax.  HMRC does not make an estimate of the relief provided for capital gains realised by pension funds.


To put this into perspective, this is over 93% of 2013-14’s Total Managed Expenditure the Education (£56 billion), and substantially more than Defence (£43 billion), and about the same as the combined budgets for Business, Innovation and Skills (£33 billion), Transport (£14 billion) and Energy and Climate Change (£8 billion).[7]


Pensions tax relief: inequitable


Income Tax is progressive, so tax relief is inevitably regressive.  Consequently, the broad acceptance by society that higher earners pay higher rates of Income Tax is nullified because affluent baby boomers are able to minimise their Income Tax by harvesting tax relief on pensions contributions.  And for those within touching distance of the private pension age of 55, shortly thereafter, they can access their pots to withdraw the 25% tax-free lump sum and, in many cases, drop down to a lower tax bracket before making further (taxable) drawings.  Only one in seven (roughly) of those who receive higher rate tax relief while working go on to ever pay higher rate Income Tax in retirement.  In this respect, tax relief is not Income Tax deferred, as claimed by proponents of higher and additional rates of tax relief.  


Consider some evidence.  In 2012-13, 10.8 million workers received tax relief of £28 billion on their (and employer) contributions, while a similarly sized pensioner population of 11.4 million paid only £11.5 billion in Income Tax.[8]  This latter figure will rise as the population ages, but there is no prospect of the Treasury recouping its investment through Income Tax paid by pensioners.  Higher and additional rates of tax relief are at a huge net cost to the state: they are a bad investment of taxpayers funds.  Recurring budget deficits are one by-product of this financial largesse (which makes a nonsense of the headline 40% and 45% rates of Income Tax), and the accumulating debt mountain will loom over the next generation. 


Another consideration concerning fairness is that Treasury-funded tax relief boosts the volume of assets that fund managers have to manage, and therefore their income.  Indeed, the Treasury is the fund management industry’s largest client: since 2002, it has injected, through people’s pension pots, over £300 billion of cash, on which charges and fees are levied.[9]  This is akin to a state subsidy of one of the highest paid industries in the world.  


Pensions tax relief: ineffective


The purpose of a tax relief is to influence behaviour.  However, it is evident that for many of the wealthy, tax relief on contributions to pension pots is primarily a personal tax planning tool, rather than an incentive to save: they would save without it.  Consequently, it is extraordinary that we accept a framework which provides the top 1% of earners, who are in least need of financial incentives to save, with 30% of all tax relief, more than double the total paid to half of the working population.  This inequitable distribution of tax relief partly explains why the huge annual Treasury spend has failed to meet the policy objective, which is to establish the broad-based retirement savings culture that Britain desperately needs. 


In addition, tax-based incentives to save have been found to be largely ineffective because most people (perhaps 85% of the population) are passive savers: they do not pro-actively pursue such incentives.  Default (“nudging”) policies are deemed to be far more effective for broadening retirement savings across those who are least prepared for retirement, i.e. lower-income workers, in particular.  The Danes, for example, concluded that for each DKr1 of government expenditure spent on incentivising retirement saving, only one ore (DKr 0.01) of net new savings was generated across the nation.[10]  Given that Denmark is not wildly different to the UK (both culturally and economically), one could conclude that much of the UK Treasury’s spend on upfront tax relief is wasted.  So, what to do?


Savings tax unification: inevitable?


Successive saving-related policy initiatives taken by the current government could be interpreted as stepping stones towards the ultimate merger of pensions and ISAs.  These include:


(i)      several reductions in pensions’ lifetime and annual allowances, from £1,800,000 and £255,000 respectively in 2010-11, to £1,250,000 and £40,000 today (with the lifetime allowance being further cut to £1 million in 2016);


(ii)     significant increases in the ISA’s annual limit (up 30% to £15,000 in the 2014 Budget) and, with the addition of a Help to Buy ISA (2015 Budget), an expansion of the ISA range;


(iii)    the end of pensions’ so-called “death tax” (announced at the Conservative Party conference), followed by its abolition for ISAs (2014 Autumn Statement); and, of course,


(iv)    the annuitisation liberalisation announced in the 2014 Budget, effective April 2015. 


There was also a hint in the 2014 Autumn Statement that NICs rebates on employer contributions to pensions could be under review, when the Chancellor said that the Treasury would be taking measures to prevent “payments of benefits in lieu of salary”.  Ending them would equalise the tax treatment of employer and employee contributions, and finally put an end to salary sacrifice schemes, long overdue.


The Treasury’s perspective: TEE preferred


From a Treasury cashflow perspective, moving the whole savings arena onto a TEE basis would be hugely attractive.  The cash outflow would move back in time, by up to a generation, as upfront tax relief, paid out to today’s workers, would be replaced by Income Tax foregone from today’s workers, once they had retired a generation later.  In addition, transition would provide the Chancellor with an opportunity to make a significant reduction in the deficit.  This could be The Great Trade to do.


Implementation: the Australian experience


Until 1983, the tax treatment of Australian retirement savings was EET, i.e. as per the UK today, with lump sums taxed at 5%.  The first transition step was to increase tax on lump sums to between 15% and 30%, depending upon the recipient’s income.  Then, five years later, in 1988, Australia introduced a 15% tax on contributions and income, and a 15% tax rebate on retirement income: essentially a “ttt” arrangement, where the small “t” denotes an effective tax rate below the individual’s marginal rate of Income Tax.  This framework endured for nearly 20 years until, in 2007, Australia removed any tax liability on retirement income in respect of contributions that had already been taxed: “ttE”.  Lump sums at retirement attract the lower of the retiree’s marginal rate and 16.5%, up to a size cap, with the marginal rate on sums above the cap.


Australia’s ttE is not so different to TEE: the burden of taxation in both cases falls at the time of saving, with retirement income being tax-free.  Australia has pondered whether to go to tEE, i.e. to remove any tax burden during accumulation, but with almost A$2 trillion of assets sitting in the pension system, the government could not afford to leave it completely untaxed. 


Big Bang preferred


Australia’s transition experience to ttE was not ideal; it has left savers and providers  having to keep track of pots with three different post-retirement tax treatments, depending upon the timing of the contributions.  In the interests of simplicity, the UK should grasp the nettle and adopt a clean “Big Bang” approach, to avoid some form of protracted, progressive, transition.  The Treasury should identify a date when EET simply ceases in respect of all future contributions.  Existing pension pots would close to further contributions, to be left to whither naturally, with the saver paying his marginal rate of Income Tax on withdrawals. 


So, what should replace private and occupational pensions in a purely TEE savings arena?


The Workplace ISA


The Workplace ISA beckons and, for those without an employer sponsor, alternative (competing) providers should be available, including NEST (the NEST ISA).  These ISAs could incorporate a form of risk pooling in decumulation (i.e. auto-protection), to spread the post-retirement inflation, investment and longevity risks that few of us are equipped to manage by ourselves.  Participation, however, should be optional, enabling savers to embrace the 2014 Budget’s post-retirement liberalisations (notably, to take cash from pension pots).


Workplace ISAs should include one or more features that maintain employer participation in retirement saving provision: today, employers contribute roughly 75% of all pension contributions.  Any financial incentives, such as NICs rebates on employer contributions (note that TEE refers to the saver’s Income Tax, not employer NICs) should, however, probably be accompanied by some form of “lock-up” period.  Certainly, employers should be consulted.  Workplace ISAs should be included in the auto-enrolment legislation, and excluded from means testing purposes, as per today’s pension assets. 


Finally, we could explore evolving TEE into “Taxed, Exempt, Enhanced”, redeploying some of the savings from having ended upfront tax relief into post-retirement top-ups: particularly appropriate given today’s interest rate environment.  The Swiss, for example, subsidise annuities, which perhaps explains why they have the highest level of voluntary annuitisation in the world (some 80% of pension pot assets).  We could extend the concept to include drawdown.  A forthcoming paper will go into more detail.


A version of this article first appeared in CSFI’s Financial World magazine, April 2015.

Michael can be contacted on majohnson@talktalk.net                Twitter: @Johnson1Michael


[1] Retirement savings products are codified chronologically for tax purposes.  Pensions are “EET”, as Exempt (contributions attract tax relief), Exempt (income and capital gains are untaxed, bar 10p on dividends), and Taxed (capital withdrawals are taxed at the saver’s marginal rate).  Conversely, ISAs are “TEE”.

[2] HMRC; Individual savings accounts statistics, Tables 9.4 and 9.6, August 2014.  In 2013-14, 3m people contributed an average of £6,163 to their stocks and shares ISA.

[3] For 2012-13, HMRC; Table Pen 2, Personal pensions, February 2014.

[4] A New Pension Settlement for the Twenty-First Century: The second report of the Pensions Commission (2005).

[5]  HM Treasury (2006), The Annuities Market.

[6]  HMRC; Cost of Registered Pension Scheme Tax Relief , Table Pen 6, February 2015.

[7] Available at: www.gist.cabinetoffice.gov.uk/oscar/2013-14

[8] HMRC (2013); Personal Pension Statistics.

[9] HMRC; Personal Pension Statistics, Table Pen 6, February 2015.

[10] Chetty R, Friedman J, Leth-Petersen S, Nielsen T, and Olsen T (2012),  Active v. passive decisions and crowd-out in retirement savings accounts: evidence from Denmark. NBER Working Paper, No. 18565. Available at: obs.rc.fas.harvard.edu/chetty/crowdout.pdf.

The Treasury’s Eight Consultation questions

The government has today launched a consultation on a root-and-branch reform of the tax treatment of pensions. Here are the eight questions it wants answered.

1. To what extent does the complexity of the current system undermine the incentive for individuals to save into a pension?

2. Do respondents believe that a simpler system is likely to result in greater engagement with pension saving? If so, how could the system be simplified to strengthen the incentive for individuals to save into a pension?

3. Would an alternative system allow individuals to take greater personal responsibility for saving an adequate amount for retirement, particularly in the context of the shift to
defined contribution pensions?

4. Would an alternative system allow individuals to plan better for how they use their
savings in retirement?

5. Should the government consider differential treatment for defined benefit and defined contribution pensions? If so, how should each be treated?

6. What administrative barriers exist to reforming the system of pensions tax, particularly in the context of automatic enrolment? How could these best be overcome?

7. How should employer pension contributions be treated under any reform of pensions tax relief?

8. How can the government make sure that any reform of pensions tax relief is sustainable for the future?


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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3 Responses to Tee Time?

  1. andyjags says:

    Good to read that Michael is aiming to produce a paper where E is Enhanced rather than Exempt in decumulation.
    I have suggested regularly on twitter and to ministers that the money spent enhancing the interest rate offered to higher income pensioners with larger savings pots via “pensioner bonds” should have instead been used to enhance annuity rates for those with smaller pots, say up to £50,000 invested in an annuity and if necessary restricted to people with total pension entitlements less than some not too large sum – obviously the funds available AE limited and should be suitably targeted. That could have enabled some of the risks from the Freedom Agenda to be more attractively mitigated.

    • henry tapper says:

      Well we can expect to see enhancements to lower earner’s pots. This won’t be painless – especially for high earners, but we are moving away from feeding the rich to starve the poor – I hope

  2. brianstansted62@hotmail.com says:

    A thought provoking interesting article. Which if the changes suggested were to be adopted would lead to some benefits as described. However, more worryingly they would also lead to complexity and the partial destruction of the financial services industry amongst providers, advisers and fund managers. One of the things that AE has done is drive down the cost to the member of investing, but equally it has greatly reduced the quality and choice of funds in which members can invest. Whilst a great idea in theory, the Workplace ISA idea would lead to a reduction in the number of people taking advice before investing in risk based investments, leading to a preponderance of glidepath tracker funds. If retirement and lifetime savings are combined how can a “glidepath” be appropriate? If someone wants to withdraw money in 2024 for a deposit for their child’s first property, they would need to decide in 2015 that this is likely or else they might have their money in a retirement pot due to start being taken in 2044. Who will advise on the personal investment choice? Employers will not pay for employees to have advice. There could be target dated funds for different years, but these would almost certainly be tracker index funds with no real active management. In other words the Motley Fool approach of “keep costs low and don’t worry about the actual investments chosen”. If there is no difference between funds saved for retirement and funds saved for living before retirement how do we ensure that all the money is not spent before retirement if withdrawals are easy as with ISAs at the moment? Would there be a government bonus for contributions that are not accessed until retirement? If so would this only be added at the end life with a Home Buyer ISA? Thereby missing out on years of growth and investment returns? I am in favour of redistributing relief away from the very top earners to those with less income but am very concerned at the side effects of these suggestions. I suspect the overarching reason that the Government want to make changes is simply for the shorter term cost savings (the passing down one generation comment). Regardless of the ” we are the party that represent hard working families” lies spouted, this is a Tory government with a very Tory chancellor. He may be radical in his approach but Osborne is an out and out old fashioned Tory. I think there are a whole number of faults with the current EET system, particularly the net pay situation for occupational schemes, and there is regressiveness in that higher rate tax relief is given but only basic rate tax paid on income in most cases, but this does not mean that we then move the same way as Australia. This is going to lead to disaster and compromise. Mark my words.

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