Opinion: Suspending deficit contributionsPensions tax: pre-Budget perspective

As the Budget approaches we review the pressures on the current system and changes to look out for.

This article is written in advance of the 11 March Budget. To find out the outcome and our early views please join our webinar on Thursday 12 March by registering here

Executive summary

• Given the immediate pressures on the NHS, a taper tamper is most likely to balance the NHS challenge with a need for speed
• For the NHS it could be a case of “be careful what you wish for” as short-term cost mitigation measures (eg Allowance Allowance reduction) would impact more high rate tax payers
• Major reform to the pensions taxation system will take 3 to 5 years and, with wider implications, requires careful consideration
• It is possible that a consultation on major reform will be announced for a decision in the Autumn budget
• Removal of higher rate tax relief would in itself be a major reform and is likely to include employer contributions

Actions

• All employers should consider communicating any short-term changes to their senior employees, as well as reviewing their pensions policy for high earner
• If there is a wider consultation, employers with Defined Benefit schemes in particular should consider the significant potential implications and engage with the consultation process

Introduction

The matter of pensions taxation is not only vexing the pensions industry in the run up to the Budget, it is one of the most significant issues facing the NHS. Whilst this has been the case for some months, the recent offer to pay doctors’ 2019/20 annual allowance tax charges helped calm nerves. But it is coming back to a head with Covid-19 likely to require hospital clinicians and GPs to work extra shifts.

Based on recent press comment, most in the pensions industry appears to think the new Chancellor has kicked the can down the road again. However, doctors expect action and if nothing is done their adverse reaction will likely be very significant indeed. In the words of Baroness Neville-Rolfe last week, who was speaking in support of doctors “… there is much hope – including on my part - about next week’s Budget”. So how can these different perspectives be squared off?

Background

Briefly, whilst the Annual and Lifetime Allowances have been affecting more and more people over time (especially as Annual Allowance carry-forwards have been used up), it is the taper that is causing the greatest headache, especially for the NHS. The taper was introduced 3 years ago and was destined to be a major complication. But whereas private sector employers and their senior employees can work around it with pay and pension flexibility, the public sector is stuck. The NHS is in the spotlight because it has the most highly paid public servants and also has some specific issues around pensionable pay and pay patterns which can create some troublesome outcomes. But this isn’t just about the NHS or the public sector.

The other important thing to bear in mind is that Cameron’s coalition government looked long and hard at radical pension tax reform back in 2015 through an extensive consultation. It was shelved at the time, but many pensions commentators are calling for the same possible reforms to be revisited at this Budget because it would create a better system.  At the same time the government has committed to significant spending plans and we face difficult economic times. Whilst the total annual pensions tax relief figure can be debated it is big enough to catch any Chancellor’s attention and at times like these the possibility of clawing some of it back might be explored more seriously than before.

In short, whilst it is not possible to say how likely, it is more likely than ever before that the pensions tax system will be given an overhaul. The fact that we are the start of a new government with a healthy majority supports this view, taking into account the practical challenges explained below.

The is another pensions tax issue in relation to net payment arrangements for lower earners, which is difficult to resolve due to the wider ramifications. The government promised a review in its manifesto, but we expect more details of the review on Budget day rather than the review itself. This piece does not consider this issue in detail.

How will the NHS affect outcomes?

The doctors challenge could potentially be resolved in two ways. The first would be to change the tax rules. The second would be to change pay and pension rules in the NHS to enable the flexibilities afforded to the majority of employers and their senior employees. The government has tried the latter. In the Autumn they announced a consultation around pension scheme flexibilities and enabled NHS employers to pay salary supplements in lieu of employer contributions, but the BMA has rejected this as a sticking plaster. It is seeking tax reform.

The BMA is realistic in expecting any changes to the tax rules to apply to everyone and not just the NHS. It is not satisfied with a “taper tamper” which could involve raising all of the tax thresholds or even a removal of the taper. Instead it is gunning for a removal of the Annual Allowance for Defined Benefit schemes. It cites the fact that the Office for Tax Simplification has recommended this in conjunction with a removal of the Lifetime Allowance for Defined Contribution schemes.

A challenge with any of these is that they will reduce the Treasury’s tax take, which is not consistent with the current budgetary pressures and the new government’s significant spending commitments. It might come hand in hand with reduced Allowances or some other mechanism for balancing the books, unless the government considers that it is a reasonable price to pay to protect the NHS in these challenging times.

Taper tamper

A taper tamper, together with any cost mitigating adjustments, could be implemented immediately and could resolve the immediate concerns of all but the highest paid doctors. But it will be seen as another sticking plaster, and if the Annual Allowance is reduced for everyone, this will bring a new cohort of workers into the reach of the Annual Allowance. The knock-on implications for the NHS and also for those outside of the NHS is something to bear in mind. It could be a case of “be careful what you wish for”.

There are some other tweaks to the system which would be helpful to enable the Annual Allowance to be fairer for final salary schemes. For example, some doctors can receive catch-up pay increases after a five year period. This spike can lead to one-off Annual Allowance charges despite the spike not being reflective of their overall career pattern. Whilst more complicated, longer periods of carry forward, including the carry forward of negative balances would create more fairness.

Removing the allowances, as requested by the BMA, sounds simple and could feel like something which could be implemented immediately. But consider the complications in relation to people with concurrent Defined Benefit and Defined Contribution schemes or how to deal with accrued benefits. There would have to be complex rules around not switching from one to the other to game the system. If you scratch the surface, it would be unlikely this could be implemented without industry wide consultation.

Simplicity and fairness needed

The current pensions tax system is cumbersome to say the least. For higher earners there are many types of Lifetime Allowance protections, complicated Annual Allowance calculations and thresholds affecting an increasing amount of people. For everyone, higher earners in particular, tax relief is opaque and not understood by many, even those for whom it is particularly generous.

It is also not as fair as it could be – for example many high rate tax payers get high rate tax relief on contributions, only to then pay basic rate tax in retirement.

In our view the pensions taxation system should be reformed to be more simple, transparent and fair. This is not easy to achieve, and practicalities aside, is something that should not be rushed into.  A new system could have a very significant impact on the way people save and this connects to wider issues such as employment tax and long-term care provision.

Wider reform

A radical reform of the system, such as the introduction of a flat rate of tax credit for all, or even an ISA-like system, would have very wide ranging implications for all pension schemes and employers’ payroll practices. Our view is that it would take at least 3 years to implement. Furthermore, when you follow through the logic for defined benefit schemes, they would not only face a very significant administration burden, they would likely have to have a redesign of both contributions and benefits. With around 6 million current members of Defined Benefit public service schemes, this would require public service pensions reform too. So it could take as long as 5 years.

We should not forget National Insurance.  Employer contributions are currently NI exempt, for employers and employees. A new regime could change this with any new tax credits being set to balance the target level of revenues. It is possible that the current salary sacrifice schemes could be reviewed as a short-term measure.

Removing high rate tax relief – red herring?

In recent weeks the possibility of wider reform has been linked to the “removal of high rate tax relief”.  You might consider that this is about removing high rate tax relief on employee contributions – so for example an individual earning £60,000 paying a 5% contribution would lose £600 of relief. Whether you agree with this concept or not, it sounds eminently achievable. However, there are two issues:

1. The first is a practical one.  Without safeguards, the likely reaction of most employers would be to make their pension schemes non-contributory for higher earners, thereby reinstating full marginal rate tax relief. But the safeguard is to tax employer contributions as a benefit in kind. If you do this you need to introduce a new system for higher earners, involving the complications outlined above for Defined Benefit schemes.

The second relates to the level of savings. The maximum amount of high rate tax relief which could be removed on employee (and personal) pension contributions is limited to around £2bn a year based on the latest HMRC numbers. The fact that target savings above this level are being mooted would indicate that policymakers have their eye on tax relief on employer contributions also.

It is therefore highly likely any step to remove high rate tax relief would come in the form of  flat rate tax credit system. For the individual above, if their employer pays 10%, a move to a 20% credit would cost £1,800 a year.

What next?

By now you will realise that whilst something has to be done from April 2020, no significant changes can be made for a number of years. So there is very likely to be a short term fix with the distinct possibility of a longer term review.

It is likely that the NHS Pension Scheme flexibilities will be introduced alongside tax changes, which is the start of a new journey for public service pension schemes.

An immediate taper tamper may be the minimum required to manage the NHS issue, without having to claw back tax relief through other means. Maybe using up some of the estimated £1bn a year brought in by the taper would be a reasonable price to help get doctors back to work. In which case lifting the taper earnings thresholds by £40,000, say, could mean that the majority of doctors could be removed from its reach. It follows that this will be a temporary sticking plaster and further changes will be required.

We might see some immediate cost mitigation in the system (eg a reduction in the Annual Allowance) to balance the books of a taper tamper.

The pressure for a better system and the Treasury’s interest in a slice of the overall current cost of pensions taxation to meet spending plans would indicate the distinct possibility of a wider review. It is understood that the Chancellor has deferred some matters through to the Autumn budget. Maybe the 2015 consultation will be dusted down and a decision will be made in the Autumn. Whilst this could mean changes within this Parliamentary term, it would be a very significant challenge and has wide implications, for Defined Benefit pension schemes in particular, for the way we save and therefore for the financial services sector as a whole.