Proposed new UK pension system will make future tax raids easier

The UK Chancellor faces a stark choice in the coming months, with the outcome of a Government review of the pension tax system likely to have a dramatic impact on both public finances and attitudes toward long-term savings.  

Under today’s system, individuals are exempt from paying tax on anything they invest into a pension. Instead, pension income is taxed in retirement, creating a deferral that sees the Government forgo income tax until individuals start spending their retirement savings.

This system is often referred to as “exempt-exempt-taxed” (abbreviated to EET), with contributions and investment growth exempt from tax, while withdrawals are subject to income tax.

HM Treasury insists the review currently being conducted may not result in any major changes to the current system. But the consensus view is that we are set for an overhaul nonetheless.

Government have suggested moving away from the EET system in favour of a taxed-exempt-exempt approach (TEE). Under such a system, pension contributions would be paid in after income tax but with no tax on growth or withdrawals.

Crucially, however, it would also break the tax deferral that currently exists, allowing Government to benefit from income tax on pension contributions upfront, without waiting until individuals reach retirement.

The net cost to the Exchequer from pensions tax relief in 2013-14 was £21.2bn. Bringing tax receipts forward would create a net tax gain for the Government since more income tax would be taken during savers’ working lives, when for many their rate of income tax will be greater (the majority of retirees pay no more than the basic rate of income tax).

However, many maintain that to introduce this system would be a catastrophic mistake for the country and future generations of savers.

While it would provide a sticking-plaster for the current fiscal deficit, the gamble with tomorrow’s public finances is enormous. It would require successive Governments of whatever political hue to defer expenditure, holding back tax receipts in the short-term to fund the future costs of an ageing society.

The problem is compounded by future demographic changes. The UK’s Office for National Statistics figures show a marked increase in the estimate of the old age dependency ratio due to growing numbers of elderly people.

Even with the increase in state pension age (SPA), it is expected that by 2037 there will only be 2.7 people of working age for every person over SPA. The figure is currently around 3.2 people.

This will also have an impact on key public services like the NHS, where average spending for retired households is nearly double that for non-retired households.

With a greater proportion of the future retired population potentially paying no tax on their income, it will increasingly be down to the generations in work to provide funding for government spending.

While it is inevitable that tax receipts from working-age households must subsidise those in retirement, removing the tax deferral in-built in the TEE system will place huge responsibility on Government to ensure they provide for the future.

It is not difficult to foresee a scenario in which the contributions of a proportionally smaller workforce struggles to keep up with the state pension provision and other public expenditure while an ageing population pays no tax on its retirement income. The full effect might be more than 30 or 40 years away, but we can see a perfect storm brewing.

In addition to the risk of managing a tax take that will plateau and then fall in value terms, moving to a TEE system threatens consumer confidence in long-term saving. TEE asks voters to place a huge amount of trust in future governments not to retrospectively apply tax on withdrawals (a ‘TET’ approach) during hard-times.

Pensions have historically been an easy target for quick wins to generate tax revenue and a parliamentary session or budget hardly passes without further tinkering of the pension tax system. The track record thus gives people little reason to believe policymakers will keep to their side of the deal 20 or 25 years down the line, and the temptation for savers would be to remove savings from pensions at the earliest opportunity in order to avoid a snap-tax on pension income.

This would be a disaster for personal savings in the UK, significantly reducing the options available to individuals to secure a sustainable income in retirement.

Worse still, without the incentive of tax-relief on contributions, those that fear the Government may renege on the promise of tax-free growth and withdrawals may elect not to save into a pension at all.

There is an alternative, however, which could strengthen the incentive to save for the long-term. Moving to a flat rate of pension tax relief, in which all savers received an equal incentive to save, would simplify the current tax-relief system. To ensure the Treasury can afford to fund the bonus to a greater number of pension savers, there should be a reduced annual contribution limit, negating the need for a lifetime limit.

Retaining the EET system but reforming tax relief so that all pension contribution received relief at 33pc regardless of the individual’s marginal rate of income tax, would reduce the spend on tax relief for higher earners while still giving everyone a strong incentive to save. Badging it as “buy two get one free” would make the savings incentive far simpler for savers to understand.

 

For a comprehensive review of your retirement provisions, or to learn more about the recent changes to pension legislation and what they mean to you, feel free to contact the Intelligent Investments’ team today.

Advertisements

2 thoughts on “Proposed new UK pension system will make future tax raids easier

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s