Another Budget, another potentially radical shake-up of UK pensions! That’s the headline from yesterday’s emergency Budget in which the Chancellor signalled the start of a consultation on potentially turning the current EET system of pensions tax relief on its head. The Chancellor also confirmed plans to taper the annual allowance for higher earners, announced a consultation to begin shortly on the pension transfer process and exit charges and signalled the Government’s intent to press ahead with plans for the creation of a secondary annuity market.
Reforming pensions tax relief
It seems that almost every Budget is proceeded by (what eventually turn out to be) unfounded rumours that the Government is going to change the current system of tax relief for pensions. Until yesterday, that is, when George Osborne confirmed that the Government is considering overhauling the way in which pensions are taxed to help “strengthen the incentive to save”.
In his Budget speech, the Chancellor announced the start of a consultation process which will examine the case for reforming pensions tax relief. The Government is interested in views on the various ways in which the current system could be reformed. These range from a fundamental reform of the system (for example moving to a system which is “Taxed-Exempt-Exempt” (TEE) like ISAs and providing a government top-up on pension contributions) to less radical changes (such as retaining the current system and altering the lifetime and annual allowances), as well as options in between.
Moving from the current “Exempt-Exempt-Taxed” (EET) system to a TEE system would be another major reform of the UK pensions system, following hot on the heels of auto-enrolment and freedom and choice. It raises a number of issues, including:
- the prospect of providers and schemes having to segregate savings built up under the current EET tax regime from those built up under the new tax regime
- how upfront tax would be collected on employer contributions
- how any new tax system would operate in the context of defined benefit schemes
- the difficulty of individuals with savings built up under the ‘old’ and ‘new’ systems understanding how their retirement savings will be taxed and deciding on the most tax efficient way to access them; and
- whether there might be any (doubtless controversial) methods to combine the new and old systems into one, such as transfers of “old” benefits into “new” wrappers or imposing a tax charge on accrued benefits and savings to level the playing field.
No doubt these, and many other issues, will be raised as part of the consultation which runs until 30 September 2015.
Tapered annual allowance for higher earners
As expected, the Chancellor has announced that from 6 April 2016 the Government will taper the annual allowance for those with adjusted annual incomes over £150,000. An individual’s 'adjusted income' will include employer and employee pension contributions, to prevent individuals from avoiding the restriction by exchanging salary for employer contributions. For those in defined benefit or cash balance arrangements, the value of the employer contribution will be calculated using the annual allowance methodology. That is, the employer contribution will be the pension input amount for the arrangement, less the amount of any contributions made by or on behalf of the individual during the tax year.
To ensure this measure is focussed on the higher and additional rate tax payers, those with income, excluding pension contributions, below a £110,000 threshold will not normally be subject to the tapered annual allowance. However, anti-avoidance rules will apply so that any salary sacrifice set up on or after 9 July 2015 will be included in the threshold definition.
The rate of reduction in the annual allowance is £1 for every £2 that the adjusted income exceeds £150,000, subject to a minimum annual allowance of £10,000. So an individual with an adjusted annual income of £210,000 or over would have an annual allowance of £10,000.
Where an individual is subject to the money purchase annual allowance, the “alternative annual allowance” will be reduced by £1 for every £2 by which their income exceeds £150,000, subject to a minimum of £10,000.
The carry forward of unused annual allowance will continue to be available, but the amount available will be based on the unused tapered annual allowance.
In order to facilitate the introduction of the taper, legislation will be introduced to align pension input periods for annual allowance purposes with the tax year. The rules for this are complex, but potentially generous in the current tax year. Details of how this will work have been published by HM Revenue & Customs.
The other pensions-related announcements in yesterday’s Budget include:
- the Government confirmed that it plans to press ahead with the creation of a secondary annuity market, albeit that this will be pushed back until 2017. Further details on this will be set out in the Autumn;
- as expected, the Government will consult before the summer on options aimed at making the process for transferring pensions from one scheme to another quicker and smoother, including in relation to any excessive early exit penalties. If there is evidence of such penalties, the Government will consider imposing a legislative cap on these charges for those aged 55 or over;
- the Government is extending access to PensionWise to those aged 50 and over, and is launching a comprehensive nationwide marketing campaign to further raise awareness of the service;
- as previously announced, the Government will reduce the Lifetime Allowance for pension contributions from £1.25 million to £1 million from 6 April 2016. Transitional protection for pension rights already over £1 million will be introduced alongside this reduction to ensure the change is not retrospective. The Lifetime Allowance will be indexed annually in line with CPI from 6 April 2018;
- the Government has said that it will actively monitor the growth of salary sacrifice schemes and their effect on tax receipts;
- as announced at Autumn Statement 2014, the Government will reduce the 45% tax rate that applies on lump sums paid from the pension of someone who dies aged 75 and over to the marginal rate of the recipient from 2016-17; and
- the Government will consult on tackling the use of unfunded EFRBS to obtain a tax advantage in relation to remuneration.
This Budget could signal yet another radical shake-up of the UK pensions system. Attention now turns to the consultation process that is under way which is sure to stimulate heated debate within the industry about the best way forward. Changing from the current EET system to TEE would be a major shift and could add considerable complexity to an already complex system. The Government has indicated that it is open to considering all options for change and therefore it is possible that a middle way will be adopted.
Changes to the annual allowance were expected but, as ever, the devil is in the detail and employers, trustees and providers need to get to grips with this so that they can understand the impact on their staff and members and communicate the change effectively. The new rules and the transitional arrangements are complex and early action should be taken to allow time to plan for this change. Affected individuals should be encouraged to take independent financial advice to understand what action they might want to take in advance of 6 April next year.