Strengthening the incentive to save: a
consultation on pension tax relief
A response from the London Pensions Fund Authority
September 2015
Strengthening the incentive to save: a consultation on pension tax
relief
A response from the London Pensions Fund Authority
1. Introduction
This paper is a response from the London Pensions Fund Authority on the government
consultation paper “Strengthening the incentive to save: a consultation on pensions tax relief.
The paper focuses on answering the questions set out in Annex A of the consultation paper,
namely:
ƒƒ To what extent does the complexity of the current system undermine the incentive for
individuals to save into a pension?
ƒƒ Do respondents believe that a simpler system is likely to result in greater engagement with
pension saving? If so, how could the system be simplified to strengthen the incentive for
individuals to save into a pension?
ƒƒ Would an alternative system allow individuals to take greater responsibility for saving
an adequate amount for retirement, particularly in the context of the shift to defined
contributions pensions?
ƒƒ Would an alternative system allow individuals to plan better for how they use their savings
in retirement?
ƒƒ Should the government consider differential treatment for defined benefit and defined
contribution pensions? If so, how should each be treated?
ƒƒ What administrative barriers exist to reforming the system of pensions tax, particularly in
the context of automatic enrolment? How could these best be overcome?
ƒƒ How should employer pension contributions be treated under any reform of pensions tax
relief?
ƒƒ How can the government make sure that any reform of pensions tax relief is sustainable
for the future?
Our response is structured as follows:
ƒƒ An overall executive summary. This summarises our overall message
ƒƒ Eight sections which address each of the consultation questions in turn
2. Executive Summary
In our view there is little case for moving away from the current system of Pensions Tax
Relief – either as a matter of quantum or structure. Notwithstanding, there are a number
of opportunities to simplify the system which, we believe, will encourage people to save for
their retirement.
We welcome the intent of government to establish a clear and stable Pensions Tax Relief
system for the long term. Providing that there is a clear (and reasonably straightforward)
incentive to save for retirement, stability will gradually lead to greater engagement and
higher levels of Pension savings.
That said, we strongly advise government to consider any change proposed on a holistic
basis, incorporating the social and financial costs of supporting retired people who are unable
to do so for themselves and consider the risks of changing the current Pensions Tax Relief
regime in that overall context.
2.1 Little case for moving away from the current EET system of Pensions Tax Relief
The Treasury consultation paper identifies the three current government incentives to
encourage Pensions saving, namely:
ƒƒ Deferment of tax payment, potentially to a time when overall income levels are lower and,
therefore lower marginal rates of personal taxation will apply
ƒƒ National Insurance relief on employer contributions
ƒƒ 25% tax free allowance at retirement (up to the Lifetime allowance)
An analysis of cost is provided in section 2.4 (et al) of the consultation paper; however, in
our view the analysis is flawed (overestimating the cost to the exchequer) for two reasons:
ƒƒ Most importantly, because the analysis set out in the consultation paper is only concerned
with costs in relation to pension savings itself rather than a holistic consideration of social,
medical and other costs associated with the retired population
ƒƒ Secondly, because the time-value-of-money argument mentioned in the consultation
paper does not allow for two key considerations, namely:
-- EET reduces some of the exchequer risks otherwise associated with an aging population
-- The strong likelihood of real economic growth in the UK means that the roll up of initial
pensions contributions is almost certain to far outweigh the impact of time-value-ofmoney factor leading to a lower overall cost of the EET system – i.e. the net cost to the
Treasury is rather less than the headline 25% tax free allowance at retirement (plus the
National Insurance premia foregone)
Leaving aside opportunities to improve and simplify the current EET approach to Pensions
Savings Tax Relief, which we consider in the next section, it is clear from chart 2.A in the
consultation paper that the current EET approach leads to a significant level of Pension
savings. Accordingly, any change would need to have sufficient advantages to outweigh the
likely significant costs involved (in both operational implementation and explanation to the
UK working population) and the risks inherent to current Pension saving levels.
We agree with the National Association of Pension Funds that we have been unable to find any
better approach to Pensions Tax Relief than the current EET method. For example:
ƒƒ TEE is simpler, but would have involved significant administrative costs for (at least) DB
schemes and increase the cost of Pensions Tax Relief overall. As a mechanism similar to ISA
it will be better understood by individuals but it is unlikely to incentivise pension savings
unless the Government can convince people that the relevant parts of the tax regime will
not change in the future (i.e. individuals will look for stability of treatment before saving)
ƒƒ Reducing the Lifetime allowance will reduce the cost of pensions tax relief and is simple in
concept; however, it is relatively retrospective and unpopular. It penalises good investment
and the government is already seeing historical and planned Lifetime Allowance reductions
acting as a disincentive to save. In any case, the Lifetime Allowance concept has significant
associated administration costs and we suggest that government consider its abolition in
section 2.2 below
ƒƒ Reducing the Tax Free allowance at retirement will reduce the cost of pensions tax relief
and is simple in concept; however, it is difficult to implement equitably (it is even more
clearly retrospective than a reduction in Lifetime Allowance) and is likely to result in a
significant disincentive to save
ƒƒ A single rate of tax relief for all (e.g. 33%) is relatively easy to implement but results in
double taxation of higher rate tax payers
ƒƒ A short term levy on pension scheme assets similar to the approach used by the Irish
Republic is simple and relatively low cost to implement; however, it would be very inequitable
between funded and un-funded pensions arrangements (i.e. most central government
pension schemes) and is likely to be seen as a “tax raid” providing a strong disincentive to
save
(The reason that TEE increases the cost of Pensions Tax Relief (in the absence of other
modifications) is because within the EET regime real economic growth rolls up within the
wrapper before being taxed at/after retirement whilst within the TEE regime real economic
growth is tax free to the pensions saver)
2.2 Opportunities to simplify the current EET system
Whilst we argue above that EET should be retained, there are a number of opportunities to
simplify the current approach which are worthy of consideration, either because there is a
good chance that they will encourage future pensions savings or because they will reduce
the cost of Pensions Tax Relief. In summary these are:
ƒƒ Remove the Lifetime Allowance concept. Whilst we accept that breaching the lifetime
allowance ceiling is far more relevant to higher rate and/or additional rate tax payers, the
existence of lifetime allowance limit and its implication must be explained to all pensions
savers and, as a mechanism which penalises good investment over a longer timeframe, it
represents a significant disincentive for pension savings.
ƒƒ Codify limitations on contributions and limits on contribution tax relief for the long term,
particularly in conjunction with removal of the Lifetime Allowance concept set out above.
In our view the most important factors are simplicity and stability of treatment, with the
limits being placed to balance cost and incentivisation.
ƒƒ Enable partial access to pension savings during the period up to retirement. For many
people saving for their pension is difficult to afford, whatever the tax incentive. Allowing
limited access to their savings pot during the roll-up period will make pension savings
rather less of an illiquid asset and thereby encourage savings
2.3 Public Sector Pension Schemes
Few private sector defined benefit pension schemes remain open to future accrual. Accordingly
a debate about differential treatment between DB and DC schemes is increasingly a debate
about differential treatment between Private Sector and Public Sector Pension Schemes.
Government should not underestimate the formidable administrative difficulties that a change
in systems of pensions tax relief is likely to cause for Public Sector pension schemes. For
example, without additional legislation/regulation, the introduction of a TEE approach would
almost certainly cause existing (TEE) schemes to close, opening up new schemes within the
TEE environment. The former would trigger very significant formal EXIT payments from all
employers involved.
3. Our Response to each of the Consultation questions
3.1 To what extent does the complexity of the current system undermine the
incentive for individuals to save into a pension?
We recognise that in general the UK population has a limited understanding of personal
finance in general, investments and pension savings in particular; however, the current
pension savings structure (as exemplified by Chart 2.A in the Treasury consultation paper) in
conjunction with auto enrolment means that significant pension savings is taking place with
incentives being provided to both employers and employees.
We agree with the consultation paper that few employees really understand the current
system; however, in general, younger people do recognise that there will be a stage in
their lives when they will not be working (at the least from their living relatives in their
grandparents generation) and that they need to make some sort of provision for this time if
and when they can afford to do so.
Employer based pension schemes, and now auto enrolment, enable the current level of
pension savings without the need for a good understanding of incentives by employees
through explicit employer contributions. Whilst the relative illiquidity of the pension savings
pot will always act as a disincentive to pension saving, we suggest that employer contributions
are the most obvious feature and incentive to save for most employees and, consequently,
that explicit employer contributions within “pay packets” is an important feature to retain in
any future approach.
Not withstanding, we believe that there are opportunities to simplify the current EET approach
and we set these out in section 3.2
In the private sector Defined Contribution has quickly become the dominant scheme structure.
Within the DC environment good investment returns are the key to achieving adequate
pension provision. We are concerned that in general the comprehension of such matters
within the UK population is low. In combination with IFA advice seen as expensive by many,
we suggest that investment of itself may be too complex for many individuals undermining
the incentive to save. We suggest that the government consider either or both:
ƒƒ The provision of free/low cost investment education on a widespread basis starting with
school curricula.
ƒƒ The public definition of a small number of savings strategies, e.g. “high risk, medium risk
and low risk” to be implemented through limited cost private sector wrappers
3.2 Do respondents believe that a simpler system is likely to result in greater
engagement with pension saving? If so, how could the system be simplified to
strengthen the incentive for individuals to save into a pension?
In our view simplicity will not of itself result in greater engagement, partly because it will
only serve to demonstrate the relatively low level of financial incentivisation inherent in the
current EET regime.
In our view greater engagement requires at least three elements to be brought together into
a coherent package:
ƒƒ A meaningful financial incentive both to encourage individuals to save for the long term and
to manage their spending in retirement so as to reduce the risk of significant government
support at that stage in their lives. Increased incentivisation now should be seen as being
financed by lower government social care costs in due course.
ƒƒ Simplicity so that the value and importance of pension provision can be better understood
by the majority of the population. As we mention in section 3.2 above, we are already
concerned that the growing dominance of DC schemes within the private sector already
acts as a disincentive to save
ƒƒ Stability (or certainty); because, in our view the many changes that have been made to
Pensions Tax relief since the millennium have acted as a significant disincentive to save
of themselves
The package could be further enhanced by measures to reduce the illiquidity of the pensions
savings pot during the savings period, for example by permitting limited access to the savings
pot during the period to retirement.
3.3 Would an alternative system allow individuals to take greater responsibility for
saving an adequate amount for retirement, particularly in the context of the shift to
defined contributions pensions?
In section 3.1 above, we suggest that most people have little genuine understanding of
current Pensions Tax incentives – rather they rely on general media commentary.
It is clear to us that some form of tax incentive is essential to encourage long term / illiquid
pensions savings. Otherwise the most obvious key incentive is explicit employer pension
contributions within pay packets.
Taking a holistic perspective we suggest that the current level of pension tax relief represents
relatively good value for Government:
ƒƒ The nominal tax cost is the 25% tax free allowance at retirement, but this should be
discounted to todays prices by reference to expected real economic growth (because this
accumulates within the pensions savings wrapper)
ƒƒ To the extent that individuals prepare financially for their retirement, government will need
less provision for the social and medical costs of the retired population
So far our response to this section applies equally to DC and DB schemes, or, because few
private sector DB schemes are still open to accrual, Private Sector and Public sector schemes.
Whilst DC is the dominant structure within the private sector, it is still relatively new; as such,
we suggest that individuals do not easily understand that within a DC environment investment
returns are even more important, becoming the critical consideration.
As we mention in section 3.1 above, we suggest that for most people effective investment
is too complex and IFA advice to costly to contemplate. In section 3.1 we propose two
government initiatives, which, we believe, will encourage pension savings in the longer term.
3.4 Would an alternative system allow individuals to plan better for how they use
their savings in retirement?
Under recently introduced provisions, individuals have considerable flexibility as to when
and how they take their pension benefits after retirement. We cannot think of any practical
alternative system that would enable retired individuals to plan better how they might use
their savings in retirement.
The situation is rather different for working people. Here, the pension savings pot is effectively
illiquid and, as a result, some sort of meaningful tax incentive will be necessary to encourage
people to save.
We suggest in section 3.2 above that government consider permitting limited access to the
pension savings pot during working life.
3.5 Should the government consider differential treatment for defined benefit and
defined contribution pensions? If so, how should each be treated?
Before long there will be little in the way of Defined Benefit Pension schemes within the private
sector. Thus, differential treatment between DC and DB will also be seen as differential
treatment between Private and Public Sector. Such an approach is perfectly possible, but
Government will need to be aware of the implications and potential consequences.
As far as most individuals are concerned, their expectation is simply that DB pensions will
get paid. Accordingly, whilst economic developments over the last 15 years mean that they
have an interest in the strength of the employer covenant, they have relatively little interest
in investment returns.
Although DC is rapidly becoming the prevalent pension scheme structure in the private sector,
it is still a relatively new development for most people. In our opinion, there is still little
recognition that in a DC scheme investment returns are fundamentally important.
We suggest that most individuals are poorly prepared to take responsibility for long-term
investment. In the context of the size of the pension pots involved, it is little surprise that the
majority of individuals regard IFA based investment advice as expensive.
Accordingly we suggest that government could provide support and at least some incentivisation
for pension savings through a free/low cost DC investment advisory service
Turning to public sector defined benefit schemes, the impact on any significant change should
not be underestimated - long-term reforms are only just coming into effect following lengthy
discussions between the Government, employers and scheme members.
One consideration, as we point out in section 3.6 below, is that any change that requires
existing LGPS arrangement to close to future accrual will typically result in the payment of
significant EXIT payments under existing LGPS regulations.
3.6 What administrative barriers exist to reforming the system of pensions tax,
particularly in the context of automatic enrolment? How could these best be
overcome?
This is a difficult question to answer from a general perspective. Administrative arrangements
are in place for both DB and DC schemes as they exist today and almost any change will result
in administrative costs of some kind.
The lowest administrative costs are likely to arise from a tax levy on Pension Fund assets
similar to that applied by the Irish Republic; although government should note that such a
move would be very inequitable between funded and un-funded pensions arrangements (i.e.
most central government schemes) unless terms were compulsorily adjusted for un-funded
schemes as part of the proposal. In any case such a move would likely be seen purely as a
“tax raid” and would act as a strong disincentive for further saving
At the other end of the scale, administrative barriers are likely to be highest for the introduction
of a TEE approach, because, whilst simple and familiar (similar to ISA) in concept it requires
the identification and separation of current EET contributions/benefits/funds from future
contributions/benefits/funds. In any case, whilst the UK continues to deliver real investment
growth it is hard to structure TEE in such a way that it reduces the cost of Pensions Tax Relief
(because in the current EET approach, rolled up investment returns are eventually taxed as
earnings).
An additional consideration is that in the absence of additional legislation/regulation, any
reform to the systems of pensions tax that required existing schemes to close to accrual
would be catastrophic for LGPS – because a closure to accrual would require each employer
involved to make a formal EXIT payment to their Administering Authority. In the case of
most Employers and Administering Authorities, the EXIT payments required would be very
significant.
More general considerations are that any significant change to Defined Benefit tax relief could
require
ƒƒ Significant modifications to LGPS regulations
ƒƒ Modification of LGPS terms achieve inter-generational equity
ƒƒ Additional LGPS rules to reduce opting out (for example, if the change had the impact of
reducing take home pay)
An example of the administrative complexities for LGPS DB schemes follows: Contribution rates
for individual members vary from 5.5% to 12.5% of net pay. These differential contribution
levels were partly designed to take account of the impact of higher rate tax relief being
received by higher paid members. It follows that any change to the tax treatment of LGPS
pension contributions would likely require a review of contribution rates.
3.7 How should employer pension contributions be treated under any reform of
pensions tax relief?
Whilst it is possible to envisage a number of ways in which employer pension contributions
could be treated in the future, we suggest above that explicit employer pension contributions
within pay packets is the single most obvious incentive supporting the current level of overall
pensions savings for many individuals.
Accordingly, we believe that it is important to provide employers with either a legal obligation
or financial incentive to continue their support for pension savings.
Whilst we understand that government will always wish to consider options to reduce the
level of financial incentivisation given to achieve a given level of overall pension savings,
we suggest that a decision that might directly lead to a reduction in the level of employer
involvement in the pension savings process should be seen as particularly courageous.
3.8 How can the government make sure that any reform of pensions tax relief is
sustainable for the future?
We see this question as having two aspects:
ƒƒ The first is about the sustainability of the cost of tax relief
ƒƒ The second is about the sustainability of incentives to save
On the first point, it is our view that the current level of financial incentivisation is relatively
low (although individuals benefit from a 25% tax free lump sum on retirement, the Treasury
benefits from taxing the real economic growth captured from investment returns over working
life). An additional benefit to the Treasury is the current EET approach reduces the risks to
overall UK tax receipts otherwise caused by an aging population.
On the second point, we believe that government should recognise that the many changes
made to UK Pension provision since the millennium have caused confusion and thereby acted
as a disincentive to save. We welcome the intent of government to establish a clear and stable
Pensions Tax Relief system for the long term. Providing that there is an incentive to save for
retirement, stability will gradually lead to greater engagement and higher levels of pension
savings.