Why the industry fears 'ISA pensions'

 

Not content with unleashing the biggest shake up of retirement saving in decades less than 18 months ago, this week George Osborne launched a consultation on completely overhauling pensions tax relief.

The aim is to create a more sustainable pension system by promoting saving and addressing the issue of improved life expectancies. Delivering the summer Budget on 8 July, Osborne said he was "open to further radical change" on the accumulation side.

The consultation is wide reaching, inviting industry leaders to recommend a variety of ways the system could be improved. It also acknowledges that the current EET - exempt, exempt, taxed - system may not be the most appropriate model. This is where tax relief is given on contributions and investment income, with the benefit is taxed in retirement instead.

Osborne said pensions could be taxed like ISAs. This would be the TEE - taxed, exempt, exempt - model. People be would contribute from their after tax income but the pension would be tax-free at decumulation. There could also be a government top-up in the middle.

The consultation - Strengthening the incentive to save: a consultation on pensions tax relief - coincides with confirmation that the annual allowance will be cut for higher earners on at least £150,000 a year. This measure was originally published in the Conservative's pre-election manifesto.

Workers would effectively lose 50p of annual allowance for every extra pound earned between £150,000 and £210,000. Somebody at the top end of this income range would have a yearly allowance of just £10,000. The Institute for Fiscal Studies (IFS) previously raised concern the plan would bring forward tax receipts rather than necessarily increase them.

Industry pundits also warned the cuts could deter people from saving into a pension and make the system more complex. But the green paper notes that further changes to the annual and lifetime allowances could actually improve the system.

There is also the potential to implement former pensions minister Steve Webb's idea of single rate tax relief of 30%. He said this would encourage lower earners to save, unlike the current system which gives a greater in incentive to higher earners.

One organisation in favour of this approach is Hargreaves Lansdown. Head of pensions research Tom McPhail says: "If the Treasury simply started treating pensions like ISAs it risks undermining the existing (and very important) incentives to make long-term retirement savings, which is why this is a consultation and not a policy announcement.

"If reform is inevitable (and it probably is) then our preferred answer is something close to Steve Webb's model of a flat rate incentive for all, combined with the abolition of the lifetime allowance.

Another advocate of scrapping the lifetime allowance is current pensions minister Ros Altmann.

In her former guise as the older workers champion, Altmann was vocal about removing the lifetime allowance for defined contribution (DC) savers. This would prevent "penalising" savers if the value of their pots grew strongly, she argued in her personal blog.

The ISA pension

The industry is likely to propose a vast range of tax relief changes in the consultation. But Osborne was careful in his wording when delivering his Budget speech. He made a specific comparison with ISAs, and this has caught the imagination of most commentators. It is also a policy idea that has been floated by the Centre for Policy Studies (CPS).

CPS fellow Michael Johnson has estimated such a move could net the Treasury £10bn a year. A long-standing critic of the current tax relief system, Johnson has said the EET model was "patently failing the next generation".

Experts have welcomed the consultation, acknowledging that tax relief is ripe for reform. But many question the suitability of an ISA approach. The National Association of Pension Funds (NAPF) chief executive Joanne Segars says the government was wise not to rush into wider reforms.

However, she adds: "For this review to succeed it must look at taxation of pensions in the bigger picture of what genuinely incentivises people to save consistently over the long-term for their retirement.

"Major changes in the taxation of pensions, such as a move to TEE, ask savers to believe a future government will be able to keep the promises made by a Chancellor today. And when it comes to the rules governing pension taxation, experience shows events rarely turn out that way."

Like Segars, Aon Hewitt senior partner Kevin Wesbroom is worried that political wrangling on pensions would compromise the chance of long-term stability.

He says: "This would appear to be a genuine consultation on whether the pension tax system needs to change, rather than how the system should be changed. But we cannot ignore the influence of the fiscal imperative to get a suitable outcome in terms of tax revenue."

Wesbroom proposes a ‘buy one, get one free' model, also championed by Johnson, where the tax relief is converted to an explicit addition to the pension pot. He says this has "high intuitive appeal" but the price would be the switch to ISA-style taxation.

Wesbroom adds: "This switches the tax timing for a generation, and would have huge appeal to the Treasury. Individuals may have less confidence in trusting future governments to honour promises on maintaining the tax-free nature of pension pay outs."

Pinsent Masons partner Simon Laight agrees tax relief needs to be simplified and that the ISA model is already well-understood. But he argues against moving towards ‘ISA pensions'.

Laight says: "Moving to an ISA tax system brings forward tax receipts for the Exchequer. It also takes higher rate tax relief away from all higher rate taxpayers but only gives tax relief at that rate to those of them whose pensions would also be taxed at the higher rate.

"Let's hope that the stated aim of incentivising people to save isn't a Trojan Horse precipitating a more general raid on pensions."

Society of Pension Professionals president Duncan Buchanan asks whether existing pension savings would be taxable under the current system or the ISA regime if the landscape changes.

Buchanan says: "Over the last 20 years, the pension system in the UK, where contributions and investment returns are exempt from tax but the emerging pension benefit is taxable (apart from the lump sum), has steadily been eroded- first by restricting tax relief on investment income and then by significantly restricting contribution levels.

"Pensions are a long-term investment and, unlike ISAs, benefits cannot be withdrawn before a minimum age. If pensions start to be taxed like ISAs it is likely that most people would prefer the flexibility (and better reputation) of an ISA over a pension product so where would this leave auto-enrolment?"

Towers Watson senior consultant David Robbins says the proposal would effectively abolish the tax-free lump sum. The effects of this are unclear because there is no guidance on what the government top-up would be.

Robbins says: "Depending on how cheap the government wanted the new system to be, basic-rate taxpayers could conceivably gain. But everyone would have to trust future tax-hungry governments not to come back to their pension pots for a second helping."

Norton Rose Fulbright senior knowledge lawyer Lesley Harrold says a switch from EET to TEE would take time to adjust to.

She adds: "I'm not sure in the long run how fair that would be because most people, I think we can assume, earn or have a lower income in retirement than they did during their working years.

"They'd be foregoing whatever rate of tax relief they would have had under the current system on their contributions and only getting relief on the way out at the lower rate."

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• Topics
• Industry
• defined benefit
• defined contribution
• George Osborne
• Michael Johnson
• NAPF
• Summer Budget 2015
• ISAs