A] Prelude*
* For general and detailed information about the UK retirement system and pension systems in general, feel free to visit our dedicated webpages:
https://expatpensionholland.nl/uk-expat-pensions
https://expatpensionholland.nl/global-pillars-systems
The start of a new parliament is a good time to stand back and ask some pretty fundamental questions about the UK pension system. Much of the complexity in the current system has arisen as a result of piecemeal changes. Often because the government of the day was short of a billion or two to balance the books.
But the promised pensions review under a potential new government offers a long-awaited opportunity to think strategically about the system as a whole and thence to provide some stability over the medium term.
By the way, a recent BW report shows that for the first time, contributions paid by the FTSE 350 defined benefit (DB) scheme sponsors into defined contribution (DC) schemes exceeded those paid into DB schemes. BW conducted an analysis of the FTSE 350 companies with DB pension schemes over the last twelve months to 31 May 2024. The data reveals that contributions totaling £8.1 billion were paid into DB schemes while £9.9 billion was paid into DC schemes.
The contribution data signals a decisive moment in the pension industry. While DC has been the preferred form of pension benefit in the private sector for many years, it is only this year that DC contributions have exceeded DB contributions for the FTSE 350 DB scheme sponsors.
Which is the consequence of a large fall in DB contributions, reflecting the material improvement in funding positions and the reduction in the cost of DB pension accrual, rather than a step up in the level of DC contributions being paid. Concerns about DC pension adequacy remain, with the level of contributions generally considered to be too low to support good member outcomes. The reduction in DB pension costs and the emergence of DB scheme surpluses could provide companies with the means to redress this imbalance without materially impacting the bottom line.
B] Pension Tax Relief
One element of a government pension review is likely to be pension tax relief. With the main parties having pledged to maintain current rates of income tax, national insurance contributions and VAT, sources of additional revenue are likely to be in short supply.
As the bill for pension tax relief runs into tens of billions of pounds, it is hard to imagine that Treasury officials will not be sent away to come up with options for savings from this source, as well as to examine whether the money that is being spent could be better directed.
So, what might a reformed system of pension tax relief look like? An important starting point is to be clear what the system is trying to achieve. Fiscal purists would argue that tax relief is simply a way of moving tax from when money is earned (during your working life) to when you actually benefit from it (during your retirement).
Viewed through this lens, giving tax relief on the way in and levying tax on the way out of pension saving is ‘fiscally neutral’ and appropriate. But any other reliefs, such as tax free lump sums or the ability to pass on pensions free of inheritance tax, would not fit this model.
A new government with a big majority, willing to come up with a coherent reform package, would most likely be a once-in-a-generation opportunity.
An alternative viewpoint is that pension tax relief could be used to reward and incentivize pension saving, particularly amongst those on lower and middle incomes who may otherwise end up with a very modest standard of living in retirement.
One way of doing this that is often floated – including by the current shadow chancellor in the recent past – would be to have a flat rate of pension tax relief regardless of income. This would in part deal with the issue that the lion’s share of the bill for pension tax relief is currently spent on those on higher incomes, who have least need of a leg up.
Such a flat rate could be set at a revenue-neutral level, so that the overall cost of the system was unchanged, or, more likely, would be set at a level that provides a net uplift to the Treasury as well as doing more to help lower earners.
However, one of the objections to flat rate tax relief is that it adds considerable complexity to the system, especially for the millions of public sector workers still accruing rights under defined benefit pension arrangements.
C] Separate DB/DC Pensions?
But what if we were willing to be really radical and have a separate system for DB and DC pensions? With fewer than a million workers now accruing DB rights in the private sector, and that number declining every year, in the future DB will be largely synonymous with public sector.
So if one of the purposes of reforming tax relief was to tilt support from higher to lower earners, one way this might be achieved could be through cutting contribution rates for lower earners and raising them for higher earners, without needing to tinker with tax relief.
Or if the goal was to raise money overall, the generosity of the public service scheme could be reduced, again without needing to create new complexity in the tax relief system.
Indeed, if DB pensions were ring-fenced, you could probably do away with the annual allowance altogether, which would greatly simplify the system.
D] Rebranding tax relief
In the DC world, starting from a blank sheet of paper would offer the potential for radical reform. For example, why not simply regard tax relief as a government incentive for pension saving and load that incentive heavily towards those of modest means?
Pension tax relief could be rebranded as ‘matching’ or a ‘government top-up’ and could be restructured to give a big boost to lower earners. For example, suppose savers were told that for the first £5,000 each year they put into a DC pension the government would also add £5,000, for the next £5,000 the government would add £2,500 and for the rest (up to a cap) the government would add £200 per £1,000.
This could greatly simplify the whole business of pension saving with no need for complex annual allowances and could make topping up your pension as easy as transferring your money between bank accounts. Matching contributions would be much easier for people to understand and may be more likely to incentivize voluntary pension saving.
One reason why this is all so much easier in a DC world is that we already have the concept of tax relief delivered via the relief at source method. This is the approach used by personal pensions and also by some occupational schemes such as the government’s Nest scheme. As ever, with pension reform, the devil would be in the detail on a change of this sort.
Under the relief at source approach, people pay into a pension out of their take-home pay and then the government makes a contribution directly into their pension equivalent to basic rate relief on the gross contribution. This means that for each £80 you pay into a pension the government adds £20. Higher rate taxpayers can claim back higher rate relief through their tax return.
But what if we stopped regarding these payments as ‘tax relief’ and simply saw them as a government match or top-up? We could do away with the business of higher earners claiming additional relief and could tier the government top-ups towards low earners in the way described above.
This could really incentivize voluntary pension saving for low and middle earners, something that is likely to be especially important given the Treasury’s continued blocking of increased rates of auto-enrolment contributions.
E] Finally
As ever, with pension reform, the devil would be in the detail on a change of this sort. Having different regimes for DB and DC pensions could create tricky border issues, such as the treatment of DB to DC transfers, or how to treat hybrid schemes with elements of both DB and DC. But these are unlikely to be unsurmountable.
The start of a new government with a big majority, willing to look across the pensions landscape and to come up with a coherent reform package, is a once-in-a-generation opportunity.
It is time to end the constant incremental changes to pension tax relief and to consider whether the huge sums involved could not do a great deal more good through a more radical shake-up.