As many of us are living longer than our forebears and enjoying more years of leisure after our working lives, getting the right pension provision for ourselves becomes ever more important. Yet few subjects are more complex than pensions, not only in themselves but also in respect of how they are taxed. Hardly surprising, then, that this is one of the main areas explored in the most recent report by the Office of Tax Simplification, ‘Taxation and Life Events: Simplifying tax for individuals’.
This substantial report from the government’s independent adviser on tax simplification, which examines a host of life events that cause individuals the greatest difficulty from the tax perspective, devotes a chapter and three annexes to the complexities of saving for a pension during one’s working life. It looks at three topics of particular difficulty:
- The difference that their employers’ choice of auto-enrolment scheme can make to workers on incomes below the income tax threshold.
- The high marginal tax rates suffered by higher-paid workers subject to an annual allowance charge.
- The disproportionate effects of the steep reduction in annual allowance that can sometimes be triggered when an individual withdraws sums under pension flexibility rules.
Each of those topics repays study by tax practitioners advising individuals at different income levels, and the first two are already very much in the news and the subject of well-organised campaigns. I shall consider the auto-enrolment problem here and the other two in a subsequent article.
Auto-enrolment: Net pay versus relief at source
Since its inception in 2012, the system of auto-enrolment, under which employers are obliged to enrol their employees into a workplace pension scheme if they earn more than £10,000 a year, has been highly successful in providing pensions for the majority of the workforce. However, for workers on earnings below the income tax personal allowance, there is a catch.
When providing pensions for their employees, employers can choose between two types of scheme: ‘net pay’ and ‘relief at source’ (RAS). Under ‘net pay’ schemes, pension contributions are deducted before tax on the employee’s earnings is calculated, so that income tax relief on the contribution is already taken into account, while under RAS schemes, contributions are deducted from pay after tax and the scheme claims back 20% relief from HMRC, with the individual claiming any higher rate relief.
Most employers choose the ‘net pay’ type because the administration is easier: tax relief is already given and doesn’t have to be claimed by the scheme or by the individual. However, there is an inherent unfairness for workers on earnings below the level of the personal allowance: those in net pay schemes get no tax relief, while those in RAS schemes get the benefit of the 20% tax claimed back from HMRC by the scheme trustees. Consequently, while both end up with the same amount in their pension pot, it costs workers in net pay schemes with earnings below the tax threshold 20% more to achieve that amount.
The OTS report cites an example of two workers, each earning £12,500 a year; one in a net pay scheme, the other in a RAS scheme. They both contribute 5% of their annual earnings above the lower earnings limit (£318.20) to their workplace pension. However, the RAS worker contributes 20% (£63.64) less than the net pay worker, because the RAS scheme recovers that amount from HMRC irrespective of the worker’s earnings. Thus, different workers pay different sums towards the same amount of pension savings, depending on the choice of scheme made by their employer and the interaction of those schemes with the income tax personal allowance. Over time, the differential can mount up to a considerable sum.
There are two ways of looking at this: either that for two workers on the same earnings to contribute unequal amounts to the same pension saving is anomalous; or rather, that it is anomalous for workers in RAS schemes to receive tax relief when their earnings are below the income tax threshold. In answer to the latter argument, one can compare the rule that anyone can contribute up to £2,880 to a stakeholder pension, whether or not out of earnings, and receive a £720 top-up from the State, amounting to a gross contribution of £3,600.
According to the latest figures, from 2016/17, some 1.1 million workers are affected by this issue, out of 2.4 million workplace pension savers with incomes below the personal allowance. The current numbers affected are likely to be more than 1.1 million, given the increases in the personal allowance over the last few years. A powerful campaign to close the differential for workers in net pay schemes has the support of several well-known institutions and two former government pensions ministers, but the cost of doing so is estimated at £100 million plus £10 million to administer (John Glen MP, then Economic Secretary to the Treasury, giving evidence to the Work and Pensions Select Committee Inquiry on Pension Costs and Transparency, 3 April 2019, Q333).
For its part, the OTS recommends that:
‘The government should consider the potential for reducing or removing the differences in outcomes between net pay and relief at source schemes for people whose income is below the personal allowance, without making it more complicated for those affected.’
Given that the difference in treatment can only become more marked in time, as the 1.1 million figure grows and the size of the gap increases with rises in auto-enrolment contributions, the OTS’ recommendation that the government at least should do something about it seems unanswerable.