Looking Ahead series: Autumn Budget 2024 - article four
Much pre-Budget speculation has focused on ending marginal rate tax relief on pension contributions. One newspaper article even suggested that there was a four-out-of-five chance of this happening[1], though that predated reports suggesting the idea was unlikely to proceed because of concerns about how public sector workers would be affected[2].
Rachel Reeves repeatedly advocated this, in various forms, before becoming responsible for Labour’s tax policy:
However, she never spelled out how equivalent treatment would be applied to employer contributions.
Asked about her prior views during the election campaign, Ms Reeves replied: “ What we’re seeking at this election is a mandate to grow the economy. Not a mandate to tinker around with tax rates, that’s not what I’m about…”[6]
Ending marginal rate tax relief means moving to a system where at least some income saved in a pension is taxed both when it is earned and when it is paid in retirement (other than for the tax-free 25%, if that does not change), but topped up in between.
Top-ups per pound saved from post-tax income could be the same for everyone, or could vary – for example, they could be bigger on the first £X that someone contributed each year or could be bigger for specific groups, e.g., those with the lowest incomes.
A standalone top-up could be made more or less valuable almost at the flick of a switch and would be a tempting lever for Chancellors to reach for at every Budget. Savers would have to guess whether the top-up would soon get bigger or smaller when deciding whether to save now or later.
Because withdrawals would remain largely taxable, some pros and cons of the existing system would be preserved:
Curiously, it is sometimes suggested that making tax relief flat rate would allow it to be rebranded as a bonus/reward. For example:
Presenting things this way would overstate the fiscal incentives to save through a pension. A condition for getting the top-up would be agreeing to pay tax on the same income twice (or one and three-quarter times if 25% of withdrawals remain tax-free) – something the saver would not have to do if they saved outside a pension. That is not how Help-To-Save or the Lifetime ISA work. The top-up would not be a simple gift; much of it would be paid back like a loan. Would pension providers subject to the FCA’s consumer duty be able to reconcile this presentation with the requirement for communications to be “clear, fair and not misleading”[10]?
For example, with a flat rate of relief at 25%, the Government would add one-third to contributions made from post-tax income, turning £75 contributed into £100. But if 20% tax applied to three quarters of a £100 withdrawal, the saver would be left with £85[11]. So, the true end-to-end top-up for a person who had been a basic rate taxpayer when the contribution was made would be £10/£75 = 13.3% rather than 33.3%.
Nor could the Government highlight the true number. This cannot be known when the contribution is paid:
Proposals to move to a flat rate of relief in other jurisdictions have been limited in scope or have not progressed.
The Irish Government is replacing marginal rate tax relief with a flat top-up for employee contributions to its new automatic enrolment scheme[12]. However: (a) this is not being extended to employees participating in existing occupational schemes[13], and (b) employer contributions are not going to be treated as a taxable benefit in kind and will not attract a government top-up – in effect, they will still qualify for marginal rate relief.
Ahead of the 2020 US Presidential election, President Biden’s campaign proposed a flat rate of relief for 401k contributions[14]. This has not come to fruition .
Currently:
A flat rate of relief would seek to change this principle so that basic rate and higher rate taxpayers give up the same amount of post-tax income for every pound credited to their pension pot.
If the flat rate of relief were set between the basic rate and the higher rate, savers currently receiving only basic rate relief would be net winners and savers currently receiving only higher rate relief would be net losers. This is not the same as saying that current basic rate taxpayers would always gain and only current higher rate taxpayers would lose: some basic rate taxpayers effectively receive higher rate relief – either because their own pension contributions reduce their taxable income below the higher rate threshold or because employer contributions would take them over this threshold if taxed as a benefit-in-kind.
Policymakers seriously considering this sort of change would need to consider detailed examples. That is partly to know the scale of gains and losses (especially losses, if they think these will be noticed more).
But it is also because the implementation method chosen would affect how gains and losses are experienced, pending adjustments to pay packages – through pension balances or through take-home pay. The table below shows this, for employees with gross salaries of £25,000 and £75,000, who both currently pay 2% of salary as an employee pension contribution and benefit from an 8% employer contribution. It assumes a 25% flat rate of relief.
Under the first approach, all gains and losses are experienced through the pension input. Under the second, the higher rate taxpayer suffers a reduction in take-home pay (but sees a bigger pension input than now). Under the third, pension inputs are unaffected; the basic rate taxpayer gains in take-home pay while the higher rate taxpayer loses.
| Employee contributes from post-tax income; employee contribution reduced to stop take-home pay falling; income tax siphoned off employer contribution; scheme claims top-up[17] | Contributions reach scheme untaxed but increase taxable income; employees receive a 20% tax credit to offset new tax; scheme claims a (smaller) top-up to turn this into 25% relief | Contributions reach scheme untaxed but increase taxable income; employees receive a 25% tax credit to offset new tax | ||
|---|---|---|---|---|
| £25k salary | Change to annual contribution reaching pension pot after all taxes/top-ups | +£166.67 | +£166.67 | £0 |
| Change to annual take home pay | £0 | £0 | +£125 | |
| £75k salary | Change to contribution reaching pension pot after all taxes/top-ups | -£1,500 | +£500 | £0 |
| Change to take home pay vs now | £0 | -£1,500 | -£1,125 |
Some people’s tax status can change during the year – they might get a pay rise or be out of work for part of the year or have overpaid tax if a new employer applied an emergency tax code. Where this means that the wrong tax/top-up was applied, correction mechanisms could be necessary.
More radically, employer contributions could be replaced with salary supplements used to finance higher employee contributions. In that case:
Currently, diverting pay into a pension can increase some people’s entitlement to means-tested benefits such as Universal Credit (which more than a quarter of working-age families are projected to receive when it is fully rolled out)[18]. The Government would need to be clear about how it wants employee and employer contributions to affect entitlement and to ensure that the new legislation achieves this, noting that changes here could sometimes make more difference than a change in the headline rate of relief.
Unlike with Universal Credit, the current rules for Child Benefit withdrawal (on incomes in the £60k-£80k range) count taxable benefits-in-kind as income. Making employer pension contributions taxable could reduce some families’ entitlements unless the legislation and/or thresholds were changed.
Taxable benefits also affect entitlement to various subsidised childcare initiatives, which stops once one parent’s income exceeds £100,000 (meaning that some people can significantly increase their family’s income net of childcare costs by working fewer hours); if not implemented carefully, pension tax changes could push this cliff-edge further down the income scale, potentially affecting labour supply in some public services.
Although active membership of private sector defined benefit schemes is around 700,000 and falling[19], DB provision remains a key part of remuneration for around five million public sector employees.
Recent attempts to reduce the cost of pensions tax relief have adversely affected public services: the Tapered Annual Allowance meant some doctors would effectively pay to work overtime (a problem that became particularly acute just before the pandemic). Ending higher rate relief would affect far more people, so the Government would want to tread carefully.
The central challenge with applying flat rate relief to DB is assigning employer contributions (which reflect the cost of providing benefits to the whole membership) to individuals, which is necessary to calculate tax liabilities.
The simplest approach would be to multiply the employer’s contribution rate by the member’s pensionable pay and say that this is the value of employer-financed accrual for that individual.
These contribution rates are high. In the main unfunded public sector schemes, the contributions covering current service cost are currently[20]:
(Headline contribution rates are higher than these – up to 73.5% in the case of the armed forces – because they because they include payments to address notional deficits.)
This might be thought an inappropriate way to calculate tax liabilities, because it assumes that the value of employer-financed accrual only varies with salary and not with other factors – for example, it can be more expensive to provide benefits for members closer to retirement, as there is less time to earn interest on the money paid in. Similarly, contributions will vary depending on the assumed investment returns (or projected economic growth in the case of unfunded public sector schemes). Changes to these assumptions (such as when employer contributions to public sector schemes rose in 2024 to reflect lower OBR growth projections) will feed through fed through to tax calculations. This objection also applies to some alternative ways of valuing accrual, discussed below.
It is implausible that employees would be taxed on their employer’s deficit contributions. Even if deficit contributions could be practically apportioned to individual members, that would mean pensioners being taxed many years after they accrued their benefits when the employer needs to top up funding. In this section therefore we focus on contributions in relation to further benefit accrual.
Alternatively, a value could be placed on the benefits accrued in a DB scheme. This involves an unavoidable trade-off between fairness and simplicity.
At the simpler / less fair end of the spectrum, the increase in an employee’s accrued annual pension over the year (after adjusting the opening amount for inflation) could be multiplied by the same factor regardless of the employee’s circumstances. This is what currently happens for the Annual Allowance (AA), where a factor of 16 is used.
The AA approach is deliberately crude. It takes no account of how an annual pension starting at 60 is worth more than the same annual pension starting at 65. Nor does it reflect the expectation that it will cost more to promise a given annual pension from 65 to a person now 60 than to a person now 30 (because there is less time for the contribution to earn investment returns).
Although some people incur AA charges (especially in the public sector where cash alternatives to pension are less common), the AA primarily works by deterring a relatively small number of high earners from contributing more in the first place. A simple but inaccurate approach is harder to justify when calculating actual tax bills, potentially for millions of people.
Indeed, when the last Labour Government proposed restricting tax relief to the basic rate for the highest earners not for everyone over the 40% tax threshold) via the High-Income Excess Relief Charge (HIERC), it concluded that a more sophisticated approach was needed. Its legislation paved the way for two-way factors, taking account of the member’s age and normal pension age[25], but the Coalition Government that replaced it in 2010 considered the HIERC too complicated and reduced the AA instead.
A two-way factor approach could be revived under flat rate relief. But even this would fail to capture elements relevant to a pension promise’s value. This is the case when thinking about how schemes differ (design features such as whether pension increases are capped, the size of a survivor’s pension, or the terms on which members can exercise options such as converting part of their pension to a lump sum; how secure benefit promises appear, based on the scheme’s funding level and employer covenant) and about differences between members (how long they might be expected to live, whether they are likely to have a partner who would qualify for a survivor’s pension when the member dies). Trying to capture much of that would be impossible; the point is that not everything relevant to a pension promise’s value could be included in a tax calculation and policymakers would have to decide what goes in and what stays out.
As with DC, it is possible to imagine ways of letting take-home pay and/or pension inputs take the strain.
One difficulty with collecting tax from members is that the increase in the pension value may not be clear until after the end of the tax year. But not all 40% taxpayers (still less those who would be 40% taxpayers if employer-financed pension accrual were a taxable benefit-in-kind) can easily settle large, unexpected bills.
It would also be possible to issue tax bills to members but force schemes to offer a “scheme pays” option; the scheme would pay the tax and reduce the individual member’s pension entitlement to recoup the cost at retirement. Take-up of such an option might be high: it can be more tax-efficient to pay from yet-to-be-taxed resources in the pension scheme than from already-taxed take-home pay.
For unfunded public sector schemes, a “scheme pays” approach reduces the short-term net fiscal gains from increased tax. This is because “scheme pays” diverts money from that the scheme that would otherwise be used to pay benefits. Therefore the Treasury will need to give the schemes the money back in order to meet the pension payments (unchanged in the short term). In the longer term, the pensions paid out for members who have used scheme pays would be smaller, but this fiscal gain would largely come beyond the time horizon used for the Chancellor’s fiscal rules.
If, instead of taxing each year’s savings in retrospect, contributions flowing into a scheme after taxes and top-ups were adjusted to be bigger/smaller than under the current regime, benefit design could be altered in response. If this were done through changes to the accrual rate for everyone, it would cancel out the redistributive effects. Theoretically, it would be possible to translate the extra value of Government top-ups for basic rate taxpayers into higher benefits or a DC balance on top of DB benefits – but this would be extremely unwieldy.
As the thorniest problems with flat-rate relief concern DB schemes, one option would be to make this change for DC only. It has been argued that the Government does not need to change tax relief for its own employees when it can adjust salaries and employee contribution rates.
But this is not an easy get-out :
In a single-employer CDC scheme, the aggregate increase/reduction in contributions might just affect future pension increases for all members; the change need not have the same redistributive effect as in individual DC. For multi-employer CDC schemes, the distribution of basic and higher rate taxpayers would vary by employer and employers would not want to cross-subsidise each other’s workforces.
