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What next for pension taxation?


What have we lost by putting off changes to pension taxation? Assuming they have only been postponed, how should the breathing space be used? A new research paper from Fowler Drew answers these questions:

  1. Simplification by scrapping all allowances in favour of flat-rate relief should be brought in as soon as possible.

  2. Further reforms are pointless unless they deal with the largest source of the tax cost, occupational pensions, where relief does not even function as an individual incentive and accounting rules conflict with the growth objective.

The European referendum has driven changes to pension taxation off the agenda for the foreseeable future, according to media reports of unattributed Treasury briefing. By drawing flak to the Pension ISA, a pointlessly high-risk and expensive reform, the Chancellor appears now to have lost the opportunity to introduce the one reform that was widely supported by pensions experts: flat-rate tax relief.

“Hopefully this setback will prove temporary” says Stuart Fowler, co-author of the paper. “A flat rate of relief, all physically paid into the saver’s pot, could have broadly matched the revenue effects of the complex, arbitrary and trap-filled framework of annual and lifetime allowances. Successive governments keep adding to this hated complexity to try to get it to counter the incentives arising under marginal relief. Instead of braking harder and harder to counter the foot pushing equally hard on the accelerator, flat-rate relief was the same as lifting the foot off the accelerator. The Chancellor on 16th March could have scrapped the entire framework of allowances, relying on the rate being self policing, and claimed genuine simplification – a victory for everyone except pensions advisers like ourselves.”

In their research paper, Reform postponed: what next for pension taxation?,originally timed to anticipate on March 16th the end of marginal tax relief, pensions adviser David Anderson and pension fund manager Stuart Fowler demonstrate that, if the Government wants to make a significant difference to the cost of tax relief without weakening incentives to save, it has to focus on occupational ‘Defined Benefit’ (DB) instead of personal ‘Defined Contribution’ (DC) pensions. This follows logically from the fact that the vast majority of the implied cost of tax relief is still accounted for by DB. But it also follows from ‘doing the maths’ for individuals in different situations to show that all the untried ways to squeeze more money out of DC, such as capping tax free cash, would create unfair outcomes and undermine the trust that pension-fund savings rely on.

By going back to the questions posed by the Treasury about the purpose and economic cost-effectiveness of tax incentives, the paper shows how pointless as well as expensive is the tax regime applied to DB schemes.

  • They are contractual rather than discretionary and so are not even responsive to tax incentives or changes made to the incentives.

  • Tax relief was designed to stimulate long-term productive (and risky) investment, producing a ‘growth dividend’ that ensured there was little transfer between generations. In another example of accelerating while braking, this justification was compromised when international accounting standards for DB schemes acted to discourage risky investment in favour of matched or insured liabilities. One result rarely mentioned is that a large part of the estimated historical cost of tax relief on contributions relates not to new accruals (which are most comparable to personal contributions) but to payments forced upon sponsors to plug the deficits resulting from the new valuation approach.

  • Though the rationale linking tax relief and risk-taking is now quite different as between personal and occupational pensions, tax policy still tries to create an artificial equivalent of the allowances restricting personal pensions, even though equivalence is neither technically feasible nor necessary.

“When tax incentives are correctly linked to the principle of risk taking”, argue the paper’s authors, “it becomes logical to tax the product of investment risk more heavily for DB (where individuals are indifferent to risk and sponsors face perverse risk incentives) than for DC (where risk is essential for the logic of pension saving both for individuals and for society as a whole). That change could be simply implemented by taxing cash lump sums from DB.”

Of the total tax cost that cannot operate as an incentive, more than half is accounted for by the unequal treatment of NI between occupational and personal schemes. Personal pensions are mostly paid out of income after NI but most occupational accruals avoid NI. This anomaly could be addressed but at a high frictional cost in implementing ‘net pay’ arrangements.

Tackling wasted tax incentives in DB clearly forms part of a wider battle to trim the cost of public sector pensions, pitting governments against unions. There are no easy wins – except for the simplification of the DC regime that the Government has (at least temporarily) squandered.

Read the paper


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