Pensions tax relief. Let’s just ditch the whole sorry mess.

I wrote recently about the challenges in operating a flat system of pensions tax relief. The condensed version is ‘to get flat tax relief done means 40% taxpayers having a) less take-home pay, b) tax bills on employer pension contributions and c) less pension in retirement’. Not impossible, but judging by the comments on this article, perhaps not popular either.

Of course, flat rate relief is not the only way of changing tax relief on pensions. Another one is to abolish pensions tax relief altogether and to operate a system that looks more like ISAs. 

The current pensions tax relief system is often referred to as ‘EET’ – that means it is tax Exempt on contributions, tax Exempt on growth and Taxed on payment. 

By contrast, ISAs are ‘TEE’; that is; contributions come from Taxed income, but growth is tax Exempt and payments are also tax Exempt. 

Well, that sounds promising already. ISAs are easy, and if we’re just rejigging the order of tax, maybe this is simple to do. Forgive me while I don an anorak and get dull by taking a look what moving to a TEE approach might mean.

To begin with, we can’t ignore the fact that the current pension system is actually EEE for a quarter of the assets – because you can take 25% of your fund as a tax-free cash sum. So if we’re moving to TEE, we need to uplift initial contributions to compensate. Let’s take a 10% uplift as our starting point.

For a basic rate taxpayer, in the current EET system, if they contribute £100 from net pay, and we ignore investment returns, it becomes £106.25 once they ultimately take benefits (my working out is at the bottom of the page).

For the same basic rate taxpayer in our new TEE system, if they contribute, there will be a 10% uplift, making £110. At retirement, there is no tax, meaning they receive £110.

The very fact that I didn’t feel the need to put my working out somewhere else illustrates the simplicity of this system. Once the money is in, that’s what the fund is worth. No smoke, no mirrors, no taxes.

But as we found with flat rate relief, the position for the higher rate taxpayer is trickier.

For the higher rate taxpayer, in the current EET system, if they contribute £100 from net pay, and we ignore investment returns, it becomes £141.67 once they ultimately take benefits (my working out is again at the bottom of the page.).

Under the TEE system, the higher rate taxpayer will receive £110 at retirement, exactly the same as the basic rate taxpayer. 

But employees are rarely just paying £100 in isolation. In my previous article, I said that employer contributions would need to bear a tax charge if there wasn’t to be an arbitrage opportunity. That logic would also apply here. If a higher rate taxpayer is going to be 23% worse off at retirement, then maybe a 23% tax on employer pension contributions has some logic.

Let’s take a look at a higher rate tax paying employee earning £60,000. They are in a matching pension scheme such that if they pay 5% of their salary, their employer pays 10%. To contribute their 5% of salary costs them just 3%, because of the 40% relief. That’s £150 a month off their take-home pay to contribute £250 a month. In addition, their employer contributes 10%, or £500 a month. Total contributions are £750 a month. Once they come to retire, take 25% tax free and pay 20% tax on the rest, this £750 will equate to £637.50. 

In a TEE with a 10% uplift model, the 40% taxpayer would have two choices as to how to respond. They could continue to maximise the employer contributions, or they could choose to carry on paying the same net amount.

Route 1 – continue to maximise employer contributions. Let’s first assume they continue to maximise. This would mean they’d need to contribute 4.55%, which would then get a 10% uplift to get back to 5%. So their own £250 a month contribution would now cost them £227.50, where it used to cost £150, meaning their take-home pay has dropped by £77.50 a month – a pay cut. 

But there is also the employer contribution that will need to be taxed. As mentioned above, a 23% tax on employer contributions might be broadly equivalent. So what was an employer contribution of £500 might need to be taxed by £115 every month. The total contribution is now £635 (£500+£250-£115) and this is what they will receive at retirement, because there is no more tax to pay.

So in summary, our 40% tax paying employee will take home £930 a year less, and the employer contribution will be subject to a tax charge, but the individual might receive broadly the same amount at retirement. The individual will have to pay more now to receive broadly the same amount in future. 

Route 2 – maintain current take-home pay. If the individual can’t find the extra £77.50 a month, the alternative is that they carry on contributing the current £150 a month net, which gets grossed up to £165 a month after a 10% uplift. That’s almost 3.5% of gross salary. Assuming the employer continues to double the employee contribution, it might contribute 7%, or £350 a month. That might attract a 23% tax charge of £80.50, meaning that total monthly contributions might be £434.50 (£165+£350-£80.50). £434.50 would be the value at retirement, leaving this individual £203 worse off, a reduction in pension of almost a third from the current £637.50.

So whatever the route, heads, the taxman wins, tails, the 40% taxpayer loses. 

A switch from EET to TEE would also beg a number of questions:

• Can we trust future politicians not to tinker with pensions, given how irresistible they have proven to date? Can we be sure that TEE won’t mutate into TET?
• Evidence from overseas suggests perhaps a lack of trust on this aspect. In the US, many employees can choose between traditional (EET) and ‘Roth’ (TEE) styles of DC pension. Use of traditional outweighs Roth by 3:1, illustrating that, in the US at least, employees clearly prefer the bird in the hand approach of tax relief up front. 
• Would government not having a tax interest once money has gone in translate into less subsequent government intervention in pensions?
• Would employers stick with their current contribution designs if they led to tax bills for many employees? We see many employers offering cash alternatives to those affected by the Annual Allowance. Would that trend spread?
• What would happen to accrued funds? Would the two systems run in parallel? Would or could existing assets be converted from EET to TEE (presumably after a one-off tax charge)? A recent study of global pension assets estimated UK DC assets at USD 620bn. A one-off tax charge on that would be an eye-catching (and eye-watering) sum of money, but might do little to engender trust in pensions.
• How can DB work in this model? Who pays the tax on the notional employer contributions of unfunded plans? If DB members over 55 wanted to take all their benefits as a one-off lump sum, tax free, are plans adequately funded to cope with this? How would government finances cope if members of the unfunded public sector schemes (the NHS, the Teachers, the Principal Civil Service Pension Scheme, etc) chose to take their benefits in this way?
• Less money going in is less money in the system for providers. Will their commercial models still remain valid? Will charges go up?

A shift to a TEE model has to be able to address these and many other questions. It would constitute the biggest ever change to UK pensions, dwarfing even auto-enrolment’s impact, affecting millions, and it might have many unintended and unforeseen consequences.

The calculations:

Basic rate taxpayer, current system. A £100 contribution is grossed up to £125 after 20% relief. At retirement, 25% can be paid tax free, which is £31.25. The other £93.75 is assumed to bear 20% tax, leaving £75. Altogether, that makes £106.25.

Higher rate taxpayer, current system. A £100 contribution is grossed up to £166.67 after 40% relief. At retirement, 25% can be paid tax free, which is £41.67. The other £125 is assumed to bear 20% tax, leaving £100. We’re not expecting them to pay 40% tax in retirement. Altogether, that makes £141.67.

Throughout, I’ve ignored the effect of National Insurance and the possibility of operating salary sacrifice, in an optimistic attempt at simplicity.