With just weeks to go before the new government’s first budget, Steve Herbert considers the factors and options that may shape any changes to pension provision.
Last week, former Liberal Democrat MP Sir Steve Webb claimed that placing national insurance charges on employer pension contributions could raise billions for the nation’s coffers.
An analysis by LCP, where Webb is a partner, estimated that tax relief on pensions cost the government around £48.7 billion in 2022/23 alone.
Whether changes to pension tax reliefs are likely is something I have been asked repeatedly in both business and personal conversations in recent weeks.
Ultimately, only the chancellor Rachel Reeves and her team in the treasury really know what will be announced at the end of the month, yet it is nonetheless possible to make some valid speculations on what those decisions may be.
To do this we need to consider all the competing factors (not just the pension savings/industry ones) in play.
What to consider
Firstly, we need to accept that the nation’s finances are in a parlous state, so raising revenue and reducing state outgoings will be a non-negotiable in this Budget statement.
And with so many potential tax income sources out of scope following manifesto promises not to raise taxes, the chancellor now needs to find some other “big-ticket” wins to balance the books.
Pensions changes
Secondly, we need to recognise that the tax reliefs inherent in pension savings are vast at around £50bn every year.
It follows that even relatively small changes to the current system can yield large returns for the Treasury while still potentially leaving pensions as an attractive and tax-efficient option for savers.
Another factor to consider is the government’s and Prime Minister’s stated intention to let the better-off shoulder the greatest financial burden of any taxation changes.
This is likely to be front and centre of political thinking given the widespread media and electorate backlash in relation to the winter fuel payments decision.
Managing changes
The government will likely be keeping in mind whether any changes to pensions tax relief are easy to deliver and administer.
More complex changes will be difficult to enact, and could encourage the development of tax avoidance strategies to mitigate the impact on savers.
From a political point of view any changes must also pass the “smell test”. The changes need to be seen as fair, proportionate, and progressive.
Likewise, any announced changes cannot be so penal that people opt out of saving altogether, as that will ultimately lead to a greater reliance on state support in retirement.
Lastly, we really must remember that the only viable route out of much of the UKs evident financial mess is improved economic growth.
Businesses will struggle to grow at the rate needed if they encounter significant new and unexpected pension costs.
What are the viable options?
With all the above factors in mind there are possibly just three viable “big ticket” items for the chancellor to consider in the pensions space:
Option 1: Remove tax-free cash sum at retirement
Sounds simple (and probably is – but only if applied to everyone equally), but the backlash from all those that have saved with the expected 25% tax free element in mind would be huge.
The compromise would be to offer some protection for cash sums already accrued, which is complex, clunky, and will massively reduce those much-needed short-term financial gains for the government.
Option 2: Apply National Insurance (NI) to employer pension contributions
This option is getting a lot of air play at the moment and doubtless sounds attractive to HM Treasury given that this would represent a 13.8% increase in National Insurance payments on all employer pension contributions.
Most savers would not really understand this change, and costs would fall on businesses rather than scheme members so not a big vote loser for the government.
Yet with employer pension contributions now a legal requirement, this measure would represent a really significant increase to employment costs in a still near stagnant economy. It’s therefore very hard to see how this option could avoid acting as a drag on wider UK economic growth.
Yet the Treasury might still be attracted to this method, particularly as it would significantly reduce the appeal of the widely used salary sacrifice payment route.
Any changes must also pass the ‘smell test’ – the changes need to be seen as fair, proportionate, and progressive.”
There is a sting in that particular tail, however, as the NI savings associated with the salary sacrifice mechanism of paying pension contributions are routinely used by employers to fund other benefit offerings (such as medical insurance).
If that saving were to be removed, then many good employers will have to think again about what level of wellbeing support they can afford to provide to their workforce.
That would be bad at any time, but with the NHS currently (in the government’s own words) “broken” it is clearly essential that company-funded medical insurance and other support continues.
Ultimately the need to keep Britain’s workforce fit, healthy, at work, and (importantly) productive is vital to the wider economic growth mission.
Option 3: Level tax relief on employee contributions
Last but certainly not least is the old chestnut of levelling tax relief on pension contributions.
Those on higher earnings should need less financial support to save for their retirement, yet tax relief at the highest marginal rate on pension contributions favours those big earners over basic-rate taxpayers.
It follows that there is a simple case to be made for reducing tax relief for all to (say) the basic rate.
Simple to communicate and deliver, easy to understand, and financially lucrative for the Treasury, this option offers the Labour government the political bonus of targeting high earners over the masses on more moderate incomes.
This would also limit potentially damaging headlines and voter backlash.
Meanwhile, leaving basic rate relief in place ensures that pension savings remain an attractive option for all.
Difficult decisions
To be clear, none of the options above are as straightforward as they may first appear, and there are many inconsistencies between Defined Benefit and Defined Contribution offerings, public and private sector pensions, decumulation options and taxation of the rich and poor.
But Option 3 is surely the cleanest, quickest, and least controversial route for the government, and offers a significant financial gain to the Treasury without any notable drag on the economy and growth.
But logic in such important decisions often plays second fiddle to the pressure exerted by bean-counters and lobby groups. And other options may yet be mooted and considered, not least the tax treatment of pension funds on death.
Only time will tell, and I will be watching this particular statement with a more than usual level of interest.
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