Jonathan Stapleton looks at some of the implications of any shift to flat-rate pension tax relief
George Osborne launched his consultation into pensions tax reform - Strengthening the incentive to save - in July last year.
The chancellor said the consultation would make sure the system of pensions tax relief ensured individuals were supported to save for their retirement with clear, simple and transparent incentives that were also sustainable for the government over the longer term.
Osborne is set to release the government's response to the consultation in his Budget on 16 March. While the government may retain the status quo, speculation is growing that more radical changes could be implemented.
Indeed, an article published by the Financial Times earlier this month said HM Treasury was now working towards the abolition of the current system of pensions tax relief in favour of a single, flat-rate relief of between 25% and 33% - a move that would boost the relief on offer to lower earners, limit the amount that can be claimed by higher earners and potentially also give the government a tax windfall.
The pensions industry is also expecting change to be announced in the Budget and consultants and advisers are already getting in touch with scheme clients to help them prepare for any such announcement.
The introduction of a single, flat-rate relief will have profound practical implications for schemes - and potentially give rise to a huge amount of work for employers, scheme professionals and trustees.
The major implications of change
JLT Employee Benefits head of technical John Wilson (pictured left) believes the first thing that will need to happen should the government decide to implement a single rate relief is that any schemes that currently use net pay arrangements for employee contributions will need to move to relief at source (see box below: The difference between net pay arrangement and relief at source).
Wilson says this would be necessary because under net pay arrangements - used by the majority of occupational pension schemes - employee contributions are paid over to schemes before any tax is deducted.
Under a flat-rate system, this would mean higher rate taxpayers would get too much relief and basic rate taxpayers may not get enough tax relief on their contributions -necessitating a shift to a relief at source system where contributions are paid net of tax and grossed up by the scheme.
Wilson believes employer contributions will also need to go through payroll under a single rate system to ensure the tax relief is applied at the correct rate and to make sure individuals can't get around the rules by using salary sacrifice or getting employers to make additional contributions on their behalf.
Currently all employer contributions get paid into the pension scheme on a gross basis - no matter whether the scheme uses a net pay or relief at source arrangement.
Pensions and Lifetime Savings Association head of policy and research Jackie Wells (pictured right) agrees. She says: "The way we think this will work in practice would be that all contributions will have to be paid into the pension scheme net of the individual's marginal income tax rate, which means putting them through payroll.
"That has a number of implications - not least that payroll systems will have to be adjusted to take tax from the employer contribution as well as the employee contribution, something which has implications for both employers who operate net pay arrangements and relief at source."
Wells says this will be reasonably straightforward for DC schemes operating on a relief at source basis but says there will be significant complexities for net pay DC arrangements.
She explains: "If you are a net pay scheme you have got the payroll changes, you have got to make some really quite important accounting changes to move to relief at source. You have system changes, you potentially have to renegotiate your administration arrangements as the administrator will be doing more under relief at source and, if your administrator can't or won't operate relief at source, then you have got to change administrator. It is much more complicated."
JLT Employee Benefits head of technical John Wilson explains that net pay arrangements and relief at source are tax arrangements governing how member contributions receive tax relief.
He says they only apply to direct contributions - not those paid through salary sacrifice arrangements - and have no impact on employer contributions.
With some exceptions, group personal pension schemes (GPPs) use RAS and occupational pension schemes use NPA.
The fundamental distinction between NPA and RAS is that under net pay arrangements gross contributions are deducted from pre-tax pay and under relief at source net contributions are deducted from post-tax pay.
Under NPA, marginal rate relief is received immediately and the gross contribution is invested along with employer contributions. So, if the contribution is £100 then £100 will be deducted from the member's gross pay and paid into the pension arrangement.
Under RAS, contributions are made net of basic rate tax, along with employer contributions and the member contributions are then ‘grossed up' by the pension provider. The provider claims back the basic rate relief from HMRC (at least quarterly, but often more frequently) and members claim, if applicable, higher and additional rate relief via self-assessment. The extra relief is given by extending their basic rate income tax band by the total of their gross contributions. So, if the contribution is £100 then £80 will be deducted from the member's net pay, but £100 will be invested because the amount deducted is grossed up by the provider.
Wilson says the additional processes involved in RAS mean many providers consider RAS to be inefficient and costly.
However, one advantage of RAS is that low earners, even if they do not pay tax, still make contributions net of basic rate tax and their contributions are still grossed up by providers.
For schemes that operate RAS, it is possible for members to get immediate, marginal rate relief by making contributions via salary sacrifice.
How the changes will affect DB schemes
If the shift to single, flat-rate pensions tax relief will be complex for net pay arrangement DC schemes, it is nothing like the complexity that will be faced by defined benefit schemes.
Wells explains: "In DB it is much more complicated because you are not putting the contributions through, you are putting the value of the accrual in that year through - it is rather like what schemes have to do at the moment for the annual allowance contributions but at the moment they only have to do it occasionally.
Wells says that if the government makes the shift to a flat rate system of taxation accrual calculations will have to be done for every active member of the scheme - either at the end of each year or, if HMRC wants to have something more regular, something that has a monthly payroll element to it with either an approximation of annual accrual or an accrual for the month approach.
She says: "There are huge issues for both the employers operating DB schemes and the schemes themselves, working out what the accrual is."
Wells says there will also be issues in calculating, recovering and repaying tax relief once the value of accrual has been calculated.
And she says that, as there could be less tax relief going into schemes - especially in schemes with lots of higher earners - there could be questions over funding and benefit levels as well as cash flow concerns.
She explains: "You have a question about what the benefits are for individuals in the scheme - are they the same or are they different? Do you have to change the benefits to reflect the fact that less money is going into the scheme? There is also a cashflow issue for the scheme as the employer is having to pay the tax and less cashflow is coming into the scheme and the amount you get back, especially if you have lots of higher earners, is going to be less."
"This is horrendously complicated as it is not just about cashflow, it is about funding and there is a potential for the funding gap to increase."
Association of Consulting Actuaries chairman and KPMG partner David Fairs (pictured left) broadly agrees but says the method used for calculating deemed contributions for annual allowance purposes could be too simplistic for calculating contributions under a flat-rate system.
He says the challenge is that the current annual allowance methodology doesn't take account of things like people's age, salary progression and length of service - something that would leave it open to manipulation - but a more rigorous calculation for each individual would be hugely complex.
"The challenge for the government is to try and find something in the middle which is reasonably accurate but also reasonably simple for schemes to apply."
Fairs suggests possible solutions could include banding schemes into different levels of generosity and having standardised tables to allow for the calculation of deemed contributions.
However Fairs says putting a value on the accrual is only the first challenge - and notes the scheme would also need to introduce some system of ‘scheme pays' to ensure higher rate taxpayers did not have to pay a tax charge at the end of every valuation period.
He also believes this system would also need HMRC to offer some sort of incentive for DB schemes as part of this.
He says: "So you would place a value on an individual's pension accrual, a tax value would be placed on it, the scheme would then pay that tax charge to the revenue but you would also get an incentive back from the revenue to the pension scheme so there would be a kind of netting off of tax charge and incentive.
"From a scheme point of view you would have to build a whole new module onto your administration system that facilitates working out those calculations and the net credit or debit you end up with."
The future for occupational schemes
Fairs believes a shift to flat-rate relief would pose hefty challenges for DB schemes still open to future accrual. He says: "You have got the end of contracting out, you have potentially got GMP equalisation hanging over you and then if you start to put additional requirements to administer a new tax charge, then I think undoubtedly some schemes will decide that is just too much."
He adds: "The government has a challenge - if it wants to maintain DB then it has to create a system that is manageable and affordable for DB pension schemes."
Wilson says the changes would be challenging for everyone in pensions. He says: "If we move to a single rate regime, this will be the biggest change to the pensions tax regime since 1970 - much bigger than the A-Day reforms in 2006 - and if that is the direction of travel, it is going to be a very busy year."
13 things schemes will need to consider if flat-rate pensions tax relief is introduced
- Schemes operating under net pay arrangements will need to switch to relief at source.
- All pension contributions - employer and employee - will need to go through payroll.
- Changes could create cashflow issues for net pay arrangement schemes.
- There will be huge complexities for DB schemes in calculating accrual.
- DB schemes may also need to consider benefits payable and there are also potential funding issues.
- DB schemes may also face a complex ‘scheme pays' regime to ensure higher-rate taxpayers do not have to pay up-front tax charges as a result of the change.
- There will need to be significant communication exercises to ensure members understand the changes.
- Net pay schemes will have to renegotiate third-party administration contracts.
- Short-term anti-forestalling measures could cause additional complexity.
- Payroll and employers will also face significant challenges.
- Public sector defined benefit schemes will also be affected by the change.
- Fears are growing the changes could be implemented on a timescale as short as one year.
- HMRC will also have to update its systems to cope with changes.
While any changes to the pension tax regime will have a significant impact on the pensions industry, they will also affect employer payroll at a time when it already has to deal with a number of other government initiatives.
Chartered Institute of Payroll Professionals policy & research manager Helen Hargreaves says the impact of any change on payroll would depend on how they were implemented but says it could be a challenge.
She says: "For those that are on relief at source it would be relatively straightforward. For those on any other kind of arrangement we know there will be problems along the way."
She urged the government to provide as much lead time as possible to enable employers and payroll providers to cope with changes.
Hargreaves explains: "Payroll professionals are dependent on good quality payroll software and payroll software providers usually work on an 18 month lead in time - anything that is rushed through runs the risk of not being as complete and able to provide that support. The more rushed it becomes, the more potential there is for problems to occur."
She adds: "Any shift to single rate pensions tax relief is going to bring a much greater administration burden for payroll and we need this to be recognised."
