It seems unlikely that there will be any tightening of fiscal policy once a new Prime Minister is “elected” on 5 September 2022. It is difficult to see how there can be, given the parlous state of the economy and the two candidates’ desire to ameliorate the cost-of-living crisis. This doesn’t necessarily rule out changes to the pensions tax regime as individual “takeaways” can be more than offset by “giveaways” elsewhere, but much of the current media focus on pensions is pushing in the opposite direction, driven by concerns about senior clinicians leaving the NHS early.
Once we arrive at the other side of a General Election, the gloves come off, but we don’t know how soon that will be – only that it must take place by January 2025 – nor which party (or parties) will form the next government, nor what the prevailing economic outlook will be at that time.
The cost of pensions tax relief is undoubtedly many billions. However, Parliamentarians often cite numbers that appear almost wilfully misleading. On 10 August 2022, the government stated that “Pensions tax relief is one of the most expensive reliefs … In 2019-20, income tax relief on total contributions and National Insurance relief on employer contributions for pension savings cost the Exchequer £61 billion, with around 60% of relief being claimed by higher and additional rate taxpayers”1.
The £61 billion number (which includes income tax relief on pension funds’ investment income, as well as tax and National Insurance relief on pension contributions) takes no account of the tax that will fall due when benefits derived from 2019-20 contributions are received. £27 billion of the £61 billion relates to the fact that employees do not pay tax upfront when employers pay money into their pensions for them. It recently emerged that one of the assumptions HMRC makes when calculating this £27 billion number is that active members of defined benefit (DB) schemes could be taxed not only on employer contributions (including deficit recovery contributions – DRCs) made in relation to that person, but also on a share of DRCs made in relation to deferred pensioners and pensioners of that same scheme, plus a share of DRCs made for deferred and pensioner members of other, often entirely unrelated, (closed) schemes2. It would seem practically and politically impossible to collect such tax and any endeavour to do so might also infringe human rights. Focusing on other factors, the Institute for Fiscal Studies has previously questioned the government’s costing methodology, arguing that “the true cost of income tax and NICs relief on pension saving is less than half the official estimate” and they were referencing an official estimate that netted off tax paid by current pensioners (£19 billion in 2019-20), which the £61 billion number does not”3.
The economic environment moves the dial on pensions costs without any change to the controls, anyway. If there is earnings growth (latest available estimate is an average of 5.9% for the private sector for the year to July 20224) there might be a corresponding increase in pension tax relief (where contributions and/or benefit accrual are linked to earnings), but with both the annual and lifetime allowances (AA and LTA) fixed in absolute terms, there would also be a fiscal drag effect that would lead to more people hitting the AA/LTA and either facing a real charge or implementing behavioural change to avoid this (eg movement out of pension). Alongside this, if there is economic growth that starts to deliver real returns on investments, defined contribution (DC) pots may reverse any recent losses and increase towards (or surpass) the LTA rather more quickly than might happen in a low-inflation environment.
In addition, there will be fiscal drag arising from freezing the income tax allowances and thresholds at their 2021-22 levels, through to 2025-265. Earnings growth will push more non-taxpayers into taxation and some basic and higher rate taxpayers into the next band. All of this will mean an increase in tax relief on pension contributions, but also an increase in tax collected (the State Pension is increasing and with the personal allowance (PA) frozen, pensioners will have less of PA available for private pension income).
In contrast, if there are income tax cuts, tax relief on pension contributions and tax on pension income would both reduce.
Having tightened the pensions tax regime repeatedly, it is no longer easy to squeeze savings out of it – the low-hanging fruit has already been picked. And it would be even more difficult to do so now, in the middle of a cost-of-living crisis.
Some – possibly many – would argue that there is now a stronger case for increasing thresholds than reducing them. By way of context, had the LTA been uplifted in line with the original intention (RPI) since 2012, its level in 2023 would be close to 2.5 times its current level6.
While the government might aspire to reduce the cost of pensions tax relief, the NHS confederation, the British Medical Association and other industry bodies are pushing vociferously in the opposite direction, citing the pensions tax regime as one of the reasons why doctors, and other senior clinicians, are leaving the NHS early. Their previous lobbying, on a related point, was successful, leading to the AA taper thresholds being uplifted in 2020.
Within one of the PM candidate debates, Liz Truss said that “I’ve met a lot of doctors who’ve gone into retirement because of the specific issues around their pensions. I need to sort that out”7. The BMA/NHS Confederation will, no doubt, remind her of this, if her bid to be Prime Minister is successful.
One of the proposals being put forward by the NHS Confederation8 is to amend the AA uprating of opening value so that pension growth attributable to rapidly increasing inflation within a tax year does not lead to an AA tax charge. This seeks to address the fact that there is currently a disconnect between the CPI figure used to uprate pension benefits and that which is used for AA purposes. For AA purposes, it is already known that the benefit opening value at 6 April 2022 will be uprated by 3.1% (CPI increase to September 2021). If the actual increase granted on pension rights for 2022-23 is based on inflation later in 2022-23, this will be considerably greater than 3.1% (the Bank of England is currently predicting a CPI peak of 13%9, although for the NHS scheme it is the September 2022 index that would be relevant).
This issue extends beyond the NHS schemes into the private sector, to open Career Average Revalued Earnings schemes and open DB schemes in which pensionable salary keeps pace with inflation. When the government had been considering how to address the concerns raised by the BMA/NHS Confederation previously, the then Chief Secretary (Liz Truss) made a statement to Parliament that “the House will recognise that the same tax rules must apply identically to everyone in the same situation, regardless of their employer. It is simply not possible for the tax rules applying to senior clinicians in the NHS to be different from those that apply everywhere else”10.
The CPI uplift of AA opening values was introduced in 201111 and, when the government was considering this, it said that the “appropriate policy on revaluation needs to have regard to fairness between … the valuation of active and deferred pension rights”12. Subsequently, it confirmed that “inflation-linked increases … for deferred members of schemes will not count towards the annual allowance charge”13.
The suitably of CPI as an uprating mechanism for AA purposes appears not to have been discussed when the broader legislation introducing this was considered within Parliament14. Moreover, it is not known whether the prospect of rapid in-year inflation increases had been considered when setting the operational details (the maximum 12-month CPI increase since 1989 had been 3.3% (Sept 2008), with the norm very considerably lower than this15).
Arguably, fairness between the valuation of active and deferred pension rights has now been lost. There is no AA test for deferred pensions, provided that annual increases are in line with the rate specified in scheme rules (with some caveats) or, if there was no specified rate, in line with the CPI, but to a date falling within the relevant input period as chosen by the scheme.)
To deliver fairness where there is rapid in-year inflation, the government could amend the legislation, introducing a regulation-making power to change the uprating of the AA opening values for specific years if certain conditions are met. This could be a flat percentage, CPI + x% or any other approach deemed appropriate. Although such a change might feed through into costings, that would seem to be only by reference to behavioural change/AA charge not collected on an AA excess that the government had not previously modelled to arise (and so didn’t feature within original costings). Many also suggest that the nature of how this charge is now arising is unfair.
Removal of higher-rate tax relief would be seen as taking money out of people’s pockets. For higher-rate taxpayers in a net pay scheme, removal of higher-rate tax relief on contributions would reduce their take-home pay. Those in a relief at source scheme would be unable to claim a refund of any higher-rate tax paid on pension contributions. It would also be fraught with practical difficulty in a DB scheme.
Moving to a flat-rate (above basic rate) of relief would result in winners and losers – with the latter being higher-rate and additional-rate taxpayers. Such individuals might typically be more likely to be traditional Conservative voters. And it’s no simpler (potentially more difficult) for DB than removing higher-rate relief.
Any move away from marginal rate relief would exacerbate the current high-profile problem within the NHS where doctors are retiring early. The pensions tax regime is cited as a significant influencing factor and government would surely think twice about solving (assuming it does) the AA issue, only to then introduce tax on pension contributions. In addition, the NHS (and other public sector schemes) currently operate tiered member contributions, where higher earners pay greater percentage contribution rates to fund the same accrual, with the government acknowledging that “tiering has also allowed the scheme to recognise through higher contribution rates the beneficial effect of income tax relief on contributions …”16. With changes being implemented to the NHS contribution tiering structure in October 2022, it would seem unlikely and unwise to counteract this by making more fundamental changes to higher-rate tax relief.
The government could move to single controls for pension savings, operating the LTA for DB and the AA for DC. This could be fiscally neutral (initially) and would, to some extent, address the NHS concerns However, such a change would introduce new problems eg, how to deal with hybrid schemes and how savers with both types of benefit should be treated.
Removing NICs relief on employer pension contributions would increase employment costs and seem unlikely to promote economic growth. And imposing employee NICs on employer pension contributions would directly reduce take–home pay and would also be regressive as modest earners would be charged NICs at 13.25%, but people earning more than £50,270 would face “only” a 3.25% charge. (These figures would revert to 12% and 2% under Liz Truss’s proposals.)
Reducing or abolishing the tax-free cash entitlement would be hugely unpopular as it is possibly the only part of the pensions tax regime that is readily understood and cherished. It is questionable whether the government would be able to remove the lump sum retroactively (ie the lump sum attributable to pension savings already accrued) and if it were removed or reduced only in relation to future savings, it would, at least in the near–future, deliver little in the way of revenue. The IFS proposed an interesting reform of the PCLS17. “At the moment, for every £1 taken from a pension, 25p is tax-free if taken as a lump sum, saving a basic-rate taxpayer 5p (20% of 25p) and a higher-rate taxpayer 10p (40% of 25p) in income tax. Instead, the government could top up pension savings by, say, 5%, and then charge income tax on the full amount taken from the pension. For a basic-rate taxpayer, a 5p top-up for every £1 of pension savings would be broadly equivalent in value to the tax-free lump sum. … It would stop favouring lump sums over regular incomes. It would benefit those who were not income taxpayers in retirement, and not be worth more to higher-rate taxpayers than to basic-rate taxpayers”. As with most proposals though, there are many practical challenges/questions:
Imposing a general levy on pension scheme assets would be technically simpler than most other options and could raise considerable sums (a 0.15% levy could raise around £4.5 billion a year). However, this would punish employers for pre–funding their DB schemes to a healthy level, as opposed to leaving them in deficit with an aim to pay later. In DC arrangements, it would, in effect, be an additional charge to absorb before real returns were positive, undermining the government’s desire to improve outcomes for members. It would also be politically very difficult for a Conservative party to implement, having spent years attacking the Labour party for Gordon Brown’s 1997 “raid” on pension funds.
As the above has demonstrated there are no easy solutions to the pensions tax conundrum and making any change at a time when the UK economy is struggling will be politically-challenging to say the least. Whoever emerges as the new Conservative Party leader and Prime Minister will arguably have greater and more immediate problems to resolve than pensions, although the NHS challenges and the vigorous lobbying by NHS bodies to keep their concerns in the media may force pensions tax issues up the government’s priority list.
1 Department of Health and Social Care response to petition to make NHS scheme unregistered.
2 Personal and stakeholder pensions statistics.
3 Taxation of private pensions.
4 Average weekly earnings in GB (August 2022 release).
6 LTA £1.8 million, 5 April 2012. Assuming RPI uprating and RPI inflation in September 2022 of 13% (it was 12.3% in July 2022 and BoE is predicting 13% CPI inflation later in 2022), there had been no LTA resetting (cuts), its level in 2023 would hit £2,636,600.
7 Sky News leadership debate (4 August 2022).
8 NHS confederation letter to Chancellor (August 2022).
9 When will inflation start to come down?
10 Urgent question on NHS pensions, taxation (July 2019).
11 S235(3) FA04, substituted by Finance Act 2011 Sch 11 para 11(3).
12 Restriction of pensions tax relief (para para 2.16).
13 HMRC draft legislation and explanatory note and tax impact and information note.
14 Absence of coverage when Finance Bill 2011 pensions clauses considered by Standing Committee (column 476).
15 ONS CPI Time Series pensions.
16 Government response to consultation on increasing member contributions from April 2022.
