What would a flat rate pension tax relief system mean in practice?

Steven Cameron, pensions director at Aegon, outlines three issues the government would need to resolve if it decides to introduce a flat rate of pension tax relief.  

There’s much pre-Budget speculation that the chancellor may be reconsidering a radical reform of pension tax relief, potentially moving to a “flat rate” of relief for all.

Currently, individuals receive tax relief at their highest marginal income tax rate on their personal contributions, so moving to a flat rate somewhere between basic and higher income tax rates would be good news for non-taxpayers and basic rate taxpayers, while higher and additional rate taxpayers would see their government top-ups reduced.

In terms of simple appeal, a flat rate relief of 33% would see the government add £1 for every £2 from individuals. But if set below 30%, higher rate taxpayers expecting to pay higher rate tax in retirement might find pension saving unattractive, undermining the success of automatic enrolment which “works” because pension saving is in virtually everyone’s interest.

While there are benefits in flat rate relief, when the government considered such changes back in 2015, it found there are many complexities to consider, and unless these are thought through and solved, changes could do more harm than good.

The three biggest areas of complexity relate to the tax treatment of employer contributions, how to avoid a “salary sacrifice loophole”, and how to apply such an approach to defined benefit schemes.

We urge the chancellor and his team to avoid going too far too fast and instead to engage with the industry to resolve issues. We also recommend testing any new approach with savers to understand how it might change retirement savings behaviours.

Three issues to resolve

Employer contributions: at present, employees typically pay personal contribution and their employer also contributes towards their pension. The tax treatment of employer contributions is completely different from that for employees. Employer contributions are treated as a business expense, so will reduce the employer’s corporation tax bill. The employee is not liable to any income tax on employer contributions. Any reforms need to consider not just employee contributions but also if there is a need to change the tax treatment of employer contributions to avoid any unintended consequences.

Salary sacrificeone added complication is that some schemes and employers currently offer “salary sacrifice” arrangements under which employees can ask their employer to pay contributions on their behalf, in return for a cut in salary. This means the total contribution is classed as an employer contribution with corresponding tax treatment. This can offer tax benefits to some employees and employers, and also has an added advantage in that employer, but not employee, contributions are exempt from National Insurance. In future, if the flat rate of tax relief was below an individual’s income tax rate, they would benefit from going down this path. The chancellor would need to close this loophole or fail to cut the pensions tax relief “bill”.

Defined benefit pensionsone of the biggest problem areas is how to move to a flat rate of tax relief for defined benefit schemes. While there are now very few of these schemes “open” in the private sector, they remain common in the public sector and attract a high proportion of overall pension tax relief. This means that it would be hugely divisive to reform defined contribution scheme treatment but leave the system for defined benefit schemes unchanged.

For example, this would mean higher rate tax-paying employees in a public sector defined benefit schemes would get preferential treatment over a similar individual contributing to a private sector defined contribution scheme. But in defined benefit schemes, while employee contributions are fixed, contributions from employers change over time to deliver promised benefits and are not “earmarked” for individuals.

Looking at the overall funding of such schemes, if tax relief across all employee contributions fell, the employer would be left having to pay more to compensate. Much detailed thinking is needed to decide how to make flat rate relief work for members and employers with defined benefit schemes.

Steven Cameron is pensions director at Aegon.

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