Strengthening the incentive to save: a consultation on pension tax relief

by Charles Cotton, CIPD Adviser, Performance and Reward

Within their firms, many HR professionals have shared or sole responsibility for the selection, communication and administration of contract-based defined contribution (DC) pension schemes. Their responsibilities include:

  • selection of the pension scheme
  • decisions over fees and charges for the default and other funds
  • transfer of the appropriate HR and payroll data in the format required by the pension provider
  • educating employees and communicating with them about scheme details and the importance of saving for retirement
  • helping employees to value and appreciate the employer contribution
  • dealing with member queries, as well as directing them to relevant sources of further information, advice and guidance.

For our members, workplace pension schemes are an important part of both their employee wellbeing and talent management strategies. That is why around three fifths of pension contributions to DC schemes in the private sector come from the employer.

Therefore, any government proposals to change how pensions in general, and DC pensions in particular, operate will have a significant impact on the value of such schemes in helping to attract, develop, deploy, retain and exit staff, as well as on the work opportunities sought by older employees. Any alterations to workplace pension procedures and outcomes will have an influence on how employees perceive the value of saving for their own retirement with implication for the design of the organisation, work and jobs.

Members’ views
Unsurprisingly, the CIPD has responded to a Government consultation on how to strengthen the incentive to save for retirement, which looks at the role of pension tax relief in encouraging employees and employers to contribute to a workplace pension. To help inform its response, the CIPD invited members to give their views on the ideas presented in the document and over 100 did so. In addition, we held a workshop for reward professionals to give us detailed comments and views regarding some of the issues identified by our survey.

The Government calculates that the gross cost to it of pension tax relief in terms of foregone income tax and national insurance contributions was £50 billion in 2013-14; therefore, it is keen to get value from this expenditure. However, some of our respondents questioned whether this tax relief is a cost, because as soon as employees start to receive an income from their pension pot that income will become eligible for tax. In other words, taxation has been postponed rather than avoided (other than the tax-free element of the pension income).

They have also questioned the Government’s sums, given the varying tax rates and contribution levels that have existed over an employee’s working life. Further, the cost of annuities mean that most high paid DC members would require a significant sum to be in a position to buy one that would stop them dropping down a tax rate.

Of course, the new pension freedoms and choices mean that someone with a DC pension pot no longer need to buy an annuity, but can draw down income from their pension pot – though this means that they may go up a tax rate if they withdraw a large sum.

TEE up?
One suggestion raised in the consultation document is that a system where pension contributions are taxed up front (a ‘Taxed-Exempt-Exempt’ system or TEE, rather like the existing arrangements for ISAs) and topped up by the Government could be simpler and incentivise workers more than the current pension arrangements (‘Exempt-Exempt-Taxed’ system). This is because the Government contribution might be more transparent to individuals and they would no longer need to consider the future tax implications of their pension choices or work out how much their pension pot is worth given their expected tax rate in retirement.

Most members thought that this was not a good idea for the following reasons:

  • Employees would have to find their pension contributions out of post-tax pay. This may lead to some of them cutting back on the amount they pay in because they would have less spare cash. The only ones who may increase their contributions would be those who could afford to do so and like the idea of not paying tax on their pension when they retire.
  • Workers would not react positively when they had to start paying tax on the employer’s contribution as it would become a benefit in kind.
  • Because individuals tend to discount the value of future rewards, it would be hard to help them appreciate the importance of saving for retirement because of these changes. As a respondent notes: ‘It’s difficult for people to feel the value of having a degree of untaxed income in the future verses the tangible effect of saving via tax and NI concessions at the moment. I feel such a proposal will cause people to save less for their retirement.’
  • Employers would have to find their pension contributions out of post-tax income as national insurance would now be due. Given there is no cost benefit for the employer, some firms may decide just to contribute the minimum legally required and offer salary instead of a higher pension contribution as the cost would now be the same.
  • Employers would have to pay more to plug their defined benefit (DB) pension deficits if they were now required to pay national insurance.
  • Administration for employers and providers would become complex, as one member said: ‘I fail to see how a change to TEE, which will take decades to flow through as past contributions will still have to be treated on the current ETT basis, will do anything except further complicate pensions.’
  • There were concerns that subsequent governments may change their mind and start to tax pensions.

One rate of tax relief
While the members are hostile towards TEE, they are more supportive of the proposal to have one rate of tax relief on offer to all employees irrespective of their pay. As one member says: 'A standard rate of pension tax relief would reflect the reality of what’s been going on in the workplace. Over the past 20 years, terms and conditions between management and employees have been harmonised. If employees and managers are in the same company pension, why shouldn’t they both get the same tax relief? The government has already harmonised tax relief on childcare vouchers, so why not pension contributions?’

However, for it to work, the Government would need to have a well-funded financial education and communication strategy to explain to employees that, for instance, for every £2 they saved the Government would give them another £1, plus they would receive contributions from their employer.

While such an approach could (through proper education and communication) boost pension savings for low to moderate earners, it could result in high earners switching from saving through the workplace pension into other investment vehicles and so become less bothered with the company plan.

However, of more concern is the administrative complexity of making such a shift. While not impossible, such a change would be complex and organisations would require a number of years to prepare their systems. It was noted that over the next few years, many employers and the pension industry would be dealing with auto-enrolment, re-enrolment and the increase in minimums contributions, not to mention grappling with the impact of the new pension freedoms.

Here at the CIPD we think that:

  • now is not the time to change the pension tax-system
  • an independent commission should be established to make workplace pension policy, so reducing the incentive for policy makers to tinker with the system.

If the Government has to change the existing tax relief arrangements for pension contributions, the following changes would be least unfavourable:

  • there should be one rate of tax relief for all employees rather than TEE, which would reduce employee and employer contributions and be complex to administer
  • if the lifetime allowance could be scrapped, we would support the annual allowance being brought in line with average earnings
  • the amount of pension that can be taken as tax-free could be limited
  • sufficient time is given to allow stakeholders to update their policies and procedures.

Charles Cotton

Charles Cotton

Research and Policy Adviser, Performance and Reward

Charles has recently led research into the business case for pensions, how front line managers make and communicate reward decisions, and managing reward risks, as well as the creation of a good practice guide on the annual pay review process. He is also responsible for the CIPD’s public policy work in the area of reward and is a Chartered Fellow of the CIPD.


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