Should we return to pension simplification?

At a basic level, a pension is a simple idea – you save money during your working life to fund your retirement.

The problem is that pensions are governed by layers of legislation built up to address different issues at different times, which creates complexity. So in 2006 the Labour government of the day simplified the tax system. Eight different pension tax regimes were streamlined into one, and annual and lifetime allowances were established to ensure we all got our fair share of tax relief.

However, many commentators believe constant government ‘tinkering’ with the rules over the past 14 years, particularly in relation to tax relief, has taken pensions far away from the aims of simplification. So how can we get back on track?

Is pension tax relief on the line again?

EY associate partner Jason Whyte points out that higher and additional rate taxpayers do not necessarily pay as much into the tax system when they retire as they have received from it in the form of tax relief. Whyte is of the opinion that this has prompted the government to start seeing pension tax relief differently.

“It has become popular recently for the Treasury to look at pension tax relief as a cost to the government or leakage from the tax system, which is different from the way it traditionally looked at it,” he says. “Pensions were seen as deferred remuneration, so it seemed sensible that you didn’t pay tax on what you put aside, but paid it only when you drew on it. But the way we are working now creates asymmetry.”

Pension tax relief is controlled through annual and lifetime allowances. When introduced in 2006 the limits were £215,000 and £1.5m, respectively. After successive cuts in recent years they now stand at £40,000 and £1,055m, so that many commentators question whether both are needed.

“The irony of pension simplification is we have a system that is ridiculously complex – much more so than before,” says SimplyBiz Group head of pensions technical Keeley Paddon. “The fact there’s penal testing on contributions going in, and then again on benefits coming out, is unfair.”

Lost in all the meddling

Phoenix head of regulatory delivery Alistair Hardie says that, in the 14 years since pension simplification took effect on ‘A-Day’, the fundamental principle seems to have been lost amid government tinkering with allowances.
“There is clearly an opportunity to revert to the well-intended design principle of simplification for pension savers,” he says.

“Setting a simple annual allowance for tax-relievable pension contributions and having no limit on the lifetime allowance could be steps towards this.”

St James’s Place head of pensions strategy Claire Trott points out that pension simplification in 2006 tried to make all pension schemes comparable. “This has been the cause of most issues, because not all schemes are equal and can be tested in the same way,” she says.

Some commentators feel it would be simpler if the government acknowledged the differences between today’s defined contribution and defined benefit schemes by managing tax relief differently – applying the annual allowance to DC schemes and the lifetime allowance to DB schemes, instead of both limits applying to both types of scheme.

Legal and General head of defined contribution Emma Douglas views the lifetime allowance as “essentially a penalty for prudent saving and good investment returns” and would prefer to see one simple annual allowance with no complicated tapering.

Looking back to 2006, Smarterly head of proposition Steve Watson is not sure what has been simplified. “For the two extremes – younger employees and higher earners – pensions in their current state are just not cutting it – and the middle lot are no more engaged,” he says.

“I think a simpler system of a flat per cent government bonus, just like a lifetime Isa with no tax at the end, would work far better and requireno complexity.”

Some commentators point out that simplification is continuing and didn’t stop after A-Day.

“The state pension is an example of that. We had quite a curious system of mixed state pension ages in 2006 – it is simpler now,” says Standard Life head of global savings policy Jamie Jenkins. “Pension simplification also brought together the regimes for trust-based and contract-based pensions, and they continue to be close in design, tax treatment and governance.”

However, Intelligent Pensions technical director Fiona Tait says pension simplification is “probably the most well-known oxymoron in the business”, but it needn’t have been that way.

“If the government had stuck to the policy of managing tax relief by altering the levels of the annual allowance and lifetime allowance, rather than introducing additional limits for specific groups of individuals, the system would indeed be simple by now,” she says.

Many commentators would like the tapered annual allowance to be abolished. The calculation is based on ‘adjusted income’, which is complex and has caused problems for the self-employed and the public sector, most notably doctors working in the NHS who have retired early or reduced their working hours through fear of incurring tax charges.

Quilter adds ‘scheme pays’ to combat taper issues

“If the political agenda has swung around to limiting so-called perks for the rich, then there are other ways of doing this,” says Tait. “Lowering the main annual allowance and/or considering a flat rate of tax relief could have a similar effect, but within the original simplification framework.”

Similarly, the money purchase annual allowance is seen as too complicated to remain. It reduces the amount that people can pay into a pension and still get tax relief on it where they have started taking money from a DC scheme.

“The MPAA acts in complete contradiction of the mantra that people should save enough to fund an adequate and sustainable income throughout retirement,” says Tait. She points out that changing working patterns and pension freedoms have meant many people access some of their pension before they retire. It makes sense for those in this situation to continue saving, but the MPAA imposes a limit on this.

The introduction of pension freedoms in April 2015 enabled people to access their retirement savings from age 55 and opened up choices beyond buying an annuity or income drawdown.

However, with flexibility and the ability to make choices comes complexity.

“These days savers have to assess whether they should draw money using flexi-access drawdown, uncrystallised funds pension lump sum, full encashment or, where applicable, continue with capped drawdown (if drawing down pre-pension freedoms),” says Douglas. She adds that if a guaranteed income is required, they can search the open market for the most appropriate annuity.

Clifton Asset Management group financial planning director Anthony Carty thinks reining in some of the pension freedoms would probably not be a bad thing.

“How often do advisers get calls saying ‘I’m 55 next month and I want to access my tax-free cash,’ just because they can?” he says.

Long-term thinking

Gately Legal partner in pensions Michael Collins says government policy needs to be driven by the long-term aim of allowing and encouraging people to save for a reasonable level of retirement income, rather than seeing pensions as a short-term cash cow to help the chancellor balance the books.

“Pension freedom and choice was said to be about giving people more control over their pension savings, but I’m sure it’s no coincidence that it also resulted in an acceleration of the tax payable on those savings,” he says.

Foster Denovo financial adviser Jamie Smith thinks a system that is fair for all, politically acceptable, and which costs the Treasury less than the current regime, just doesn’t exist.

“The only way to achieve simplification is if the government chooses to spend significantly more on tax relief, which we know it cannot afford to do,” he says. “Trying to achieve pension simplification is just trying to achieve the impossible.”