New analysis published today by consultants LCP examines the potential for changes to pension tax relief as part of the October 30th Budget. The paper points out that with the Labour manifesto pledge not to raise rates of income tax, National Insurance, VAT and corporation tax, the Chancellor is likely to be taking a keen interest in pension tax relief – with a net annual cost estimated by the Treasury at around £48 billion.
The authors argue that some changes, such as introducing ‘flat rate’ tax relief – though potentially lucrative – are highly unlikely politically. This is especially true because a significant group of beneficiaries of higher rate relief are mid-ranking and senior public sector workers, a group which the government is unlikely to want to alienate.
However, there are other aspects of the system where the Chancellor may judge that there is the potential to raise significant additional revenue.
The three considered in the paper are:
- Employer NI to be levied on employer pension contributions – at present, where a worker is paid a wage, that wage is subject to both employee NI contributions (now at 8%) and employer contributions (at 13.8%). But if that same remuneration is paid into a pension, no NI is levied on either the worker or the firm. Because of this difference, in many workplaces an HMRC approved system of ‘salary sacrifice’ is in place where workers agree to a pay cut in return for a deal whereby their individual pension contributions are also made by their employer in order to reduce the overall NI bill. The Government estimates that the cost of not charging NI on the pension contributions made by employers is around £23.8 billion.
Options for reducing the cost of this relief include:
- Simply applying full NI to all employer pension contributions.
- Creating a new (lower) rate of employer NI and applying it to employer pension contributions
- Abolishing ‘salary sacrifice’ for pensions
Levying full NI on employer contribution in one go would be a huge increase to the costs of businesses. This could damage the government’s growth objective and would also be likely to reduce the amount of money firms were willing to spend on their workers’ pensions – and therefore reduce retirement incomes.
More likely therefore is the introduction of a new rate of NI on employer contributions, starting relatively low but with the potential to generate additional revenue. Alternatively, the government could simply say that ‘salary sacrifice’ schemes would no longer generate NI savings for employers and employees, which would also increase NI revenues.
Commenting, Steve Webb, partner at LCP said:
“The Chancellor will be looking for relatively simple changes which can be introduced quickly and will raise large sums with least voter anger. Changes to taxes on business may fall within that category, and the large cost of exempting employer pension contributions from National Insurance Contributions will not have escaped the Chancellor’s attention”.
- A cap on tax-free lump sums – in most pension arrangements it is possible to take part of the pension at retirement in the form of a tax-free lump sum; the current lifetime limit on these lump sums is £268,275; the Chancellor might consider capping this at a much lower level – such as the £100,000 which has been suggested by the Fabian Society amongst others; this might be thought politically achievable because most savers may not think they are near having a £400,000 pension pot from which a £100,000 lump sum could be taken.
However, in the short-term, LCP modelling suggests that many public sector workers with long service in their public sector pension scheme may well be caught by a cap at this level. Whenever pension tax relief limits have been cut in this way in recent years, a system of ‘transitional protection’ has been introduced for those already over the limit or set to be so. It is likely that a cut in the cap on lump sums would also have to be accompanied by a complex system of protections. But this would dramatically reduce the short-term revenue that would be raised from such a measure, whilst still leaving the government open to opposition for reducing tax-free lump sums – not least because of the suspicion that having once been reduced, the cap could be reduced further in future. It seems likely that the balance between revenue raised and political flak may make this option ultimately unattractive.
Commenting, Alasdair Mayes, partner at LCP said:
“Capping tax-free lump sums sounds simple in theory but would be complex in practice. Complex transitional rules would need to be designed for those who would otherwise be unfairly affected by the change, and this could mean it would take months or years to implement. This would also reduce the revenue-raising potential of the measure and may mean the Chancellor decides it is not worth the political pain”.
- Reducing the tax privileges of pensions on death – An anomaly which the Chancellor might look at is the rules which allow people to inherit a pension pot free of income tax where the person who died was under the age of 75. This distinction based on the age at death could be removed but is expected to raise relatively little revenue.
Balances held in a pension pot on death are typically excluded from an estate for Inheritance Tax (IHT) purposes whilst other assets such as ISAs are included. The Chancellor could decide to remove the exemption from IHT for money purchase pension pots. However, this could create a new unfairness as transfers between spouses are exempt from IHT, whereas transfers between couples who cohabit are not, and therefore cohabiting couples could be harder hit by such a change.
In the short-term, including pensions in IHT might raise relatively modest amounts, partly because much pension wealth is in the form of Defined Benefit pensions where IHT does not (and we assume would still not) apply. There may also be calls for some form of protection for those who have planned their entire retirement finances on the basis of the existing rules. In addition, there may well be a strong behavioural reaction to such a change with retirees finding other ways to shield their wealth from IHT if the relatively simple device of leaving the money in a pension was no longer available. Overall, we may once again be in a situation where the political flak from the change was large relative to the short-term revenue raised.
Commenting, Tim Camfield, senior consultant at LCP said:
“Pension pots currently offer significant tax benefits upon death, generally being shielded from Inheritance Tax. While it can be argued that reform could encourage the use of pensions for income to the saver and their spouse rather than inheritance, any changes must be weighed carefully to avoid unintended consequences such as penalising unmarried partners.”