Why pension tax-relief isn’t about income tax anymore.

This is a remarkably candid statement from someone who has made it his business to understand the nature of tax relief and I’d urge you to read the article behind his statement.

HMRC published its latest “personal pensions statistics on 29th September.  The “new information is summarized in one simple table quoted by Willis Towers Watson.

In WTW’s commentary on this table, this statement stands out.

If National Insurance relief is included, 86% of relief on contributions relates to money paid into pensions by employers. Yet many proposals for “reforming” tax relief on pension contributions fail to mention how employer contributions would be treated.

We are obsessed by the impact of losing higher rate tax relief because the people who worry about pension tax relief are making decisions around tax mitigation. In the overall scheme of things, revenues from the Annual Allowance , Lifetime Allowance and the Money Purchase Annual Allowance don’t really matter.  For instance the total value of LTA charges reported by schemes in 2019 to 2020 increased by 21% to £342m.

This distortion of perspective seems mainly down to the importance to the financial services industry of wealth to the exclusion of all else. But to the Treasury, the wealthy are not the problem, the problem is in the money being paid into pensions by corporations and by Government itself, which otherwise would have generated revenues for HMRC and HMT.

There are of course ironies. Much of the money paid into funds by the Local Government Pension Scheme is deferred pay for Government officials and should be offset the cost of public sector pay. Most of the deficit payments that form the bulk of DB contributions are being ploughed into Government debt, meaning the cost of borrowing for Government remains artificially low. You could argue that pensions are doing the Treasury a favor in both respects.

But this is well known to WTW and to readers of this blog. What was not known was how HMRC value the loss of revenue when companies make deficit payments. This is explained in a new note from the Treasury on how the Treasury works out the cost of corporate contributions to pensions (especially DB pensions). The Treasury actually calculate their loss of income tax by the income tax that would have been paid if employer pension contributions had been paid as income.

Contributions by employers are valued as though they were extra income to the beneficiaries

For funded DB schemes HMRC’s modelling allocates DRCs to members in private DB schemes based on the weighting of their employer contributions, therefore a member with larger employer contributions will be allocated a larger value of DRCs. Employer contributions are then treated in a member’s income stack ‘sitting’ above their individual contributions.

Because HMRC are now using real time information on individuals, a lot of these contributions will be given notional income tax relief at the saver’s marginal rate, this will often be at a higher rate of 40% or even 45%.

HMRC recognizes that employer contributions to both DC and DB do not attract tax relief, by imputing these contributions to the individual beneficiaries, they are counting back the NI given up by the amount of NI that would have been payable by employer and employee if the pension had been paid as salary

But HMRC only loses corporation tax revenues at  a  much lower rate.

 “better estimate suggests the true cost of income tax and NICs relief on pension saving is less than half the official estimate. Taking into account the impact of taxes at the corporate level – corporation tax on normal returns and stamp duty on purchases of shares and property – would reduce this figure further.” – WTW

What’s more, the deficit contributions are stacked on members accruing (only 11% of members eligible to go into the PPF are accruing). So if you are accruing , you are counted for picking up the costs of securing benefits for deferred members and pensioners. Which could make you a fantastically high earning individual getting mega tax-relief. It would be interesting to see what the pension -adjusted salaries of those in the parliamentary contributory pension fund would be (but I digress).

This partly explains why moving to TEE from EET would be so hard (and why Government ditched plans to do so in 2016). Allocating corporate DB contributions to active members of DB schemes could bankrupt the members or cause them to rack up a humungous “scheme pays” bill. There is too small a base of active DB savers to meet the demands of a TEE system unless we started taxing deferred and actual pensioners for the deficit contributions paid on their behalf.

The joy of salary sacrifice

But if Government persists with an EET system, more and more of the pension contribution will be paid by the employer and less and less will go to the revenue by way of income tax and national insurance. NI is a particular thorny issue as while HMRC gets income tax back from pensioners, pensioners pay no NI on their pension.

Arguably the net cost of NI to the Treasury is higher than the net cost of income tax , something that will increase in 2022 when NI rates go up for both employers and employees. All monies paid into pension schemes by companies do not attract NI. Frankly if there is low hanging fruit , it may be in creating an NI charge on certain pension payments.

For now, the simplest tax arbitrage there is , is to avoid NI by encouraging staff to sacrifice salary for pension contributions.

The good news

What looks good news is that the increased cost of tax relief in 2019-20 was down to new savers coming into the pension system through auto-enrolment and especially all AE savers seeing their AE minimum contribution rates rise. What this is saying is that tax-relief is subsidizing the cost of participation in workplace pensions to those who had previously  been excluded.

This is of course not the case for those who pay contributions and don’t pick up the incentive and I have no idea how this can be regarded as fair. The net pay/Ras lottery that means that a saver into NOW overpays a saver into NEST by 25% has got to end.

The other bit of good news is mentioned above, most of the cost of pensions to HMRC is being overstated as it assumes the payments into DB schemes would otherwise have been paid as income to those in those schemes, while the actual loss to HMT is at corporation tax rates.

If , as the IFS estimate, the £26.6bn opportunity cost of employer contributions is half that, then the overall cost of tax relief looks a lot more manageable. The gains from denying higher rate relief to savers would be negligible and might be wiped if there was a rush to salary sacrifice as a result.

So long as the Government hasn’t got a way to properly account for employer contributions into DB schemes and persists with the current system for employers contributing into DC schemes, I can only see LTA, AA and MPAA as its levers to manage the current inequalities. It knows from the Doctors, that over egging these limits can have unexpected consequences. So I see the scope for HMT to reform pensions as currently very limited. The one vulnerability is national insurance and especially the free ride that regular employer contributions into pensions are getting.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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4 Responses to Why pension tax-relief isn’t about income tax anymore.

  1. John Mather says:

    The basic concept of EET is in danger of being destroyed because the U.K. can no longer pay its way.

    Which? has recently published the results of its latest study of thousands of its retired readers. It found that there are three levels of retirement lifestyle annual spending:

    Essential, Comfortable and Luxury.
    * Essential is £13,000 for singles and £18,000 for couples
    * Comfortable is £19,000 for singles and £26,000 for couples
    * Luxury is £31,000 for singles and £41,000 for couples

    Which? calculates that a couple would need a fund of:
    * between £29,000 to £47,000 to provide the essential lifestyle
    * between £154,700 to £265,400 provide the comfortable lifestyle
    * between £442,000 to £757,000 to provide the luxury lifestyle

    The lower cost assumes taking a regular income from the fund. The higher cost assumes buying a guaranteed annuity from an insurance company.  

    The Pensions Commission suggests the average retiree should aim for a retirement income of around 67% of their pre-retirement income, so someone earning, say, £40,000 should aim for a retirement income of £27,000.

    It looks as if the have/have not divide will get worse

  2. John Mather says:

    Incidentally what do you think about this “guidance” should it mention the age at which the annuity starts If the income is before or after tax or even if inflation has any impact.

    No wonder that so few get income beyond work right

  3. John Quinlivan says:

    Excellent article. The gordian knot of employer relief with salary exchange, and whether and how this falls on individuals, combined with deficit funding and local authority / civil service levied tax on DB for me make a move from EET to TEE a challenge

  4. Great read. I liked the whole post very informative. Thanks for sharing such article.

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