EET migration to ISA-style
TEE pensions looks attractive on the face of it but the devil is
in the back office detail
4 November 2015
The Government’s consultation document (HMT CM9102)
raises the possibility of substantial change in the
taxation of pensions. The starting gun on these changes
could be fired by George Osborne in his Autumn Statement
on 27 November in just one month’s time!
We all
know what this is about – reducing the country’s debt
burden and eventually balancing the books. And there is
a lot of money at stake: in 2013-2014 tax year alone tax
relief on individual contributions to pension schemes
from untaxed income added up to a £27bn tax relief loss
to the Treasury.
If you add the other incentives
to lock up our money for retirement including national
insurance contributions (NIC) relief for employer
contributions at £14bn; £7bn for not taxing investment
earnings during accumulation; and finally £4bn for the
tax free lump sum on withdrawal, there is a total of
£52bn put up by the Government each year. And this
figure is rising fast as Auto Enrolment hits its straps
and baby boomers retire at the rate of 700,000 or more
each year. It is understandable that the Treasury should
level its fire at the largest of these numbers by
thinking hard about taxing contributions on the way in
rather than at decumulation.
So this explains why
HMT is giving serious consideration to moving away from
the current UK pension tax regime Exempt-Exempt-Taxed -
abbreviated as EET – meaning that pension saving is
Exempt from income tax (and), returns on pension savings
are also Exempt from tax when they occur but pension
income is subject to income tax (but not NIC) at point
of decumulation.
Michael Johnson at the Centre of
Policy Studies (CPS) has been the most vocal supporter
of moving to Taxed-Exempt-Exempt, or TEE, which means
that pension savings will be taxed on the way in, Exempt
at point of saving or when asset returns rise as well
when pension income is drawn.
This would bring
pensions savings into line with the tax regimes of ISA
as well as mortgage contributions. It seems to suggest
simplicity and as ISA saving is currently going from
strength to strength, you could be forgiven for thinking
it will stimulate an uptick in saving for retirement.
Michael Johnson’s team has the ear of the Treasury and
providers are now beginning to look at what changes they
would need to make in order to accommodate a switch from
EET to TEE.
The economists’ verdict of this move
is almost universally negative. The
National Institute
of Economic and Social Research (NIESR) study on this
issue reports that it will negatively impact the level
pension savings, hit consumption, incomes, productivity
and GDP. It will also hit younger people’s pockets
harder than older ones (mainly to do with people
switching more assets from pensions into the more liquid
asset of housing - further increasing prices and
concentrating wealth into the hands of those that have
the funds to play this expensive game). They even
predict it will force increases of interest rates on the
Government’s indefatigable debt mountain - now that
really would be an own goal.
Macroeconomic
black-marks aside, let’s look at the administrative
challenges of moving to TEE. Like all changes of this
magnitude, the problem is not just about implementing
the new tax regime for future pension policies from
April 2016/17, but managing legacy pension pots
alongside the new ones. Firstly, taxing contributions in
TEE is not straightforward, especially for employer
contributions which are often pooled across groups of
employees with different marginal tax rates,
administration of which would become very complicated as
a result.
More significantly, in the transition
period (which for DB schemes may need to be as long as
60 years according to one provider I spoke with),
providers would have to segregate savings built up under
the current EET regime from those built up under the new
tax regime. This ‘duel-running’ administration, as it is
often called, could prove costly if not managed very
carefully.
In our view providers which operate
physical splits between asset types (uncrystallised
versus crystallised assets for example) in which they
literally migrate customers’ assets into different
underlying funds with different risk profiles for
example, may face considerable administrative upheaval.
They may be having to administer up to four separate
pots (2 governed by EET and a further 2 by TEE covering
uncrystallised and crystallised assets).
They
must also report meaningfully on this back to the
customer – giving him a consolidated view of all assets
and what income these funds are capable of delivering in
retirement. For some already dealing with numerous
legacy issues this will be an extra admin headache,
meaning additional costs they could do without.
Inevitably some of those costs will be passed back to
the policy holder over time.
We have looked at
how the changes could be applied in Imago. Providing
funds are split on Notional rather than Physical lines
it is relatively straight forward to create a new
pension ‘arrangement type’ with new rules being applied
thus accommodating TEE-governed funds when they take
effect for new payments. But pensions administration
does not begin and end in the back office. For example
HMRC now demands submission on non-taxable income so RTI
submissions will still have to be made at each
decumulation event, even when tax is not due as in
TEE-governed pots. Illustrations will need to be created
to support each arrangement and accurate consolidated
view provided annually -ideally delivered online going
forward.
The other question is around mitigating
tax at decumlation. It is entirely understandable that
those with both EET and TEE pots will want to take their
EET tax free cash lump sum first. Next they might cash
up their TEE pots as there is no tax to pay on exit
there either, while the bulk of EET pots will be kept
intact for longer – potentially reducing the
Government’s tax take substantially. It begs the
question will the Government have to insist that you
cash in your older EET pot first to help boost their
ailing coffers? For that matter will future governments
go further and introduce income tax on pension
withdrawals – creating the nightmare TET tax regime? The
existing government cannot prevent this change being
made by future governments whatever they say.
The other question is, will different annual and
lifetime allowances be instituted for EET and TEE pots?
Another potential administrative horror story could
surround pensions transfers and consolidation in a
post-TEE reform world. In a world where your smaller
pots do not follow you from employer to employer;
combined with the fact that Gen Yers aged under 30 today
are also unlikely to stay with one employer for more
than
four years; it is inevitable that people will want
to reduce administrative costs and resulting paperwork
by consolidating smaller pots into one or two larger
ones.
But the shiny new larger one could now be
governed by TEE. Will this mean that anyone
consolidating will suddenly find themselves with a tax
liability that they would not have incurred if they kept
it in a myriad of poorer performing legacy EET pension
policies? If so will the tax change actually discourage
optimisation of pension savings?
One further
consideration is that some life assurers are not geared
to running ISA books. Will they have to buy in
ready-to-go ISA admin systems to make sure they are
ready to trade in new TEE pensions? If so they have high
upfront implementation costs to contend with and then
the complexity of resourcing and managing administration
for two different systems for the same customer ongoing.
The ABI has proposed an interesting alternative
of flat tax relief at 25-33%. The ABI’s figures based on
this percentage range, and when applied to defined
contribution (DC) alone, could yield sustainable tax
relief savings to HM Treasury of around £1.3bn per annum
when coupled with reductions to the Annual Allowance. Is
that enough?
Finally, we are at the very point
where employers and employees desperately need
incentivisation to auto enrol and ideally pay more than
statutory contribution amounts to build up sufficient
pots to retire in comfort. Flat rate tax relief, perhaps
repositioned as a ‘saver’s bonus’, surely seems a more
sensible and sustainable approach - one that doesn’t
risk de-railing the AE success story as smaller firms
start to move towards their staging dates next year and
micro businesses in 2018?
The Government seem to
be running for cover on
tax credits following defeat in
the House of Lords this week jeopardising a potential
£4.4bn boost to the Treasury. Let’s hope that they won’t
press ahead with EET to TEE pension tax reform in their
increasingly desperate quest to reduce the deficit.
Natanje Holt, Managing Director
Dunstan Thomas Holdings Limited.