‘A number of workers, disproportionately women, who earn between £10,000 and £12,500 have been missing out on pension benefits because of a loophole affecting people with net pay pension schemes. We will conduct a comprehensive review to look at how to fix this issue.’
Such was one of the commitments in the 2019 Conservative manifesto. I described the loophole it refers to in my blog Auto-enrolment: caught in the net? To recap briefly, if an employer opts for a pension scheme which operates on a ‘relief at source’ (RAS) basis, workers’ pension contributions are deducted from pay after tax and the scheme claims back 20% relief from HMRC. However, if the employer goes for a ‘net pay’ scheme (as most do because it is administratively simpler), pension contributions are deducted before tax. As a result, workers in RAS schemes who earn between £10,000 (the auto-enrolment threshold) and £12,500 (the personal allowance) get tax relief even though they are not liable to tax on their pay, but those in net pay schemes do not get tax relief on their contributions. Consequently, net pay scheme members on that level of earnings have to contribute more towards the same amount of pension saving than RAS scheme members on the same earnings.
Much credit is due to the influential coalition that has been pressing for this change, which includes bodies such as the Pensions and Lifetime Savings Association and the Low Incomes Tax Reform Group alongside two former pensions ministers, Baroness Altmann and Sir Steve Webb. The loophole (perhaps better described as an anomaly) was also highlighted by the Office of Tax Simplification (OTS) in its report on Taxation and Life Events, which recommended 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.’
It is gratifying when governments take note of well-reasoned and persuasive arguments from external bodies. If the current government implements its manifesto commitment, potentially millions of low earners will benefit.
Money purchase annual allowance
While focusing on pension tax traps, the new government might usefully turn its attention to another pension anomaly that affects people on modest means. This too was highlighted in the OTS report mentioned above.
When pensions freedom was introduced by George Osborne in 2015, the so-called ‘money purchase annual allowance’ (MPAA) was brought in alongside it to prevent ‘recycling’, or withdrawing money from a defined contribution (DC) pension scheme and then saving some or all of it again in another DC scheme, thereby attracting tax relief twice over. The MPAA works by restricting the annual allowance of anyone who has taken money out of a DC scheme, subject to certain exceptions. Originally the annual allowance was reduced in such circumstances to £10,000 a year, but in 2017 it was further reduced to £4,000.
An everyday example will illustrate just what a beartrap the MPAA can be for those (i.e. most of us) who are unversed in the arcane disciplines of pensions and taxation.
Karen was made redundant at age 57 but finds another job a few months later. She hopes to keep working until she reaches state pension age at 67.
When she was made redundant, she withdrew £3,000 from one of her pension pots (one totalling £11,000) using a flexible access drawdown arrangement. As her new job pays well, she plans to put aside £650 a month for the next 10 years towards her pension. But because she has withdrawn £3,000 from her existing scheme, the MPAA means she will only get tax relief on contributions of £4,000 for each of those 10 years.
In fact, Karen would not have had to worry about MPAA if she had restricted her withdrawal to 25% of her total pot, or £2,750. Or she could have cashed up to three pots in their entirety, provided they each totalled no more than £10,000. A professional adviser might have pointed this out to her, but for such small sums she did not think it worthwhile paying for professional advice.
The example of Karen is taken from the OTS report and is based on an actual case. There are many similar situations where people withdraw modest lump sums from their DC pensions under flexible drawdown arrangements for such blameless uses as helping out children or elderly parents, or carrying out repairs or improvements to their houses, or paying off part of their mortgages. Then, quite unawares, they find that they have infringed this recondite and complex rule when they still have several years during which they had hoped to make further pension contributions.
The OTS recommends that the government should review the operation of the MPAA, considering in the light of the evidence whether it meets its policy objective, is set at the right level and is well enough understood, given the disproportionate effects it can have on individuals’ levels of pension provision. Whilst they are looking into the RAS/net pay loophole, the new government would do well to reflect on the MPAA too and consider some of the practical suggestions made in the OTS report.