The malaise with pension taxation goes much deeper than the immediate symptoms, the complexity of the Annual and Lifetime allowances, the obscurity of the money purchase annual allowance and the perversity of the running both net pay and relief at source.
When a tax incentive turns into a productivity disincentive, as has happened with highly paid public servants, then the outcry is immediate. We can meet doctors who aren’t working weekends or lates for (pension) tax reasons.
But when a tax incentive is denied, as it is being denied to up to 1.7m low paid earners who have the misfortune to have their pensions managed under net pay, there is no noise. They will not experience the harm of not getting their promised top-up for years to come, and when they get their pensions, they may never know they have overpaid for it by up to 25%.
The money purchase annual allowance may be breached but never reported, even the HMRC’s Real Time Initiative (RTI) cannot pick up everything (though it looks capable of picking up a lot more than the pensions dashboard).
All of these obscure taxes combine to make people nervous about their pensions. People crave tax-free benefits. You can see this by looking at how ordinary people, without sophisticated financial advice, simply draw down their pot as a lump sum.
The vast majority of “pension plans”aren’t being used as pension plans but are fully withdrawn well before state retirement age
Within the drawdown cohort, the vast majority of plans are being drawn at a rate of 8%+ – a rate generally considered unsustainable.
and it is clear from the chart above that only when pension pots grow to a decent size (let’s say £30k) that there’s much attempt to turn pot into pension.
In short our retirement savings structure is now about creating a capital reservoir from which people can buy things, it is no longer a pension system, designed to protect future tax-payers from the cost of providing for the current generation. It is no more than ensuring independence for those in later age. In short it is not doing its job.
It is clear to me that the current system of pensions taxation is so complex that most people simply take their money and run – they often find they have to give back much of their pot in emergency tax and those who have the gumption or a little help from organisations like Pensions Wise, TPAS and CAB are drawing down their tax free cash and leave the rest of the pot alone.
I spoke to one person who is doing this and asked why, I was told that she feared that by entering “taxed drawdown” she would have to do self-assessment of her taxation, something that had cost her friend dearly in accountancy fees. I don’t think she is alone, people don’t understand the taxation of drawdown.
They don’t understand , they don’t trust it and they don’t use it. The take up of the most tax-effecient form of drawdown -UFPLS is tiny.
Far from treating their retirement savings as a pension, people are treating them as taxed ISAs. It is clear that people would rather have control of their money where they cannot understand or trust the repayment of their savings where pension providers, advisers and HMRC are taxing them,
The ISA comparison has been made many times before but it is the transparent model that people revert to.
The long term solution
A great number of people read my blog yesterday, probably because it was raining , but maybe because the issues of pension taxation which I talked of, resonate with many people – and not just doctors.
In 2015, Her Majesty’s Treasury issues a major consultation on tax and George Osborne promised the nation a root and branch reform of the way Government savings incentives worked. The Treasury were explicit that they did not think that the tax-payer was getting value for money for the (then ) £36bn in tax-foregone – from pension savings.
The general conclusion was that higher rate tax-relief on pensions would go – the outgoing pensions minister Steve Webb, said as much,
But my information suggests that the Treasury were considering a long-term solution that would have abolished tax-relief at the point of payment and replaced it with a system where all money drawn from the pot was tax free.Technically this is known as moving from Exempt Exempt Taxed (EET) to Taxed Exempt Exempt (TEE).
This would of course be a great boon to the public purse in the short-term. It would certainly be welcomed by low earners who are currently getting TET and most basic rate tax-payers would prefer an ISA system than what they have now, the benefits of which few basic rate taxpayers seem to value.
It would mean that those on high earnings receiving big pension accruals would be hit with big upfront tax bills which they – like some doctors today, would not be able to meet from their own resources.
Inevitably , the introduction of TEE would involve a gif increase in the use of the scheme pays tax collection system where defined benefits are reduced to meet tax charges levied upfront.
Why is this solution for the long term?
The abandonment of this plan in 2016, resulted from political expediency. Osborne and Cameron were told that moving to TEE would cause a back-bench revolt that might put in jeopardy the result of a referendum inducing a (shock) vote for BREXIT.
It is hard to consider any Government in today’s climate having the confidence to take on the massive vested interests that regard EET as untouchable.
Last week I talked with the head of policy for one of our two pension trade bodies. I asked why his body were reluctant to promote solutions to the net pay problem and I was told that it did not want to upset the apple cart.
In short, the current paralysis on pension taxation is all about the apple cart and the possibility that – should we push the Treasury too hard, they might push politicians to take away the tax privileges on which so much wealth is founded.
I do believe that the fundamental inequalities that lead to 80% of pension tax incentives being enjoyed by the 20% of the nation that is already financially independent is unsustainable.
Sooner or later, a strong Government will emerge, with social justice as its cornerstone and with leaders who are strong enough and principled enough to change things.
But I’m not seeing that happen in the short term.