Pensions tax relief needs reform, but it should start from the top

The increasing cost of tax relief – for a variety of well-documented reasons – has led to increasing complexity and a system that is now, frankly, unworkable; just look at the trouble caused by the money purchase or tapered annual allowances.

It is arguable whether tax relief really acts as an incentive to save. It undoubtedly does for some, but are they really the target audience to get people saving more for their retirement? 

In a world of inertia and auto-enrolment, there is a strong case for redesigning the system to support saving of all types; a system that has less complexity, that has clear objectives and offers the exchequer a degree of control of the cost.

This last point is important to deliver a long-term sustainable and stable solution, otherwise tweaks and complexity will follow as sure as night follows day.

So how do we move ahead from here? 

Too often the debate is focused around potential solutions, and I, myself, have certainly been guilty of that. Some advocate ripping up the current exempt-exempt-taxed system and moving to a tax relief solution more closely aligned with Isas.

Others argue that the annual and lifetime allowances should be reduced, with the annual allowance only applying to defined contribution schemes and the lifetime allowance only applying to defined benefit schemes. Others advocate a flat rate tax relief of, say, between 25 and 33 per cent, which would apply to all savings.

There is no single right answer in any of these solutions and they all involve difficult trade-offs, with many winners and losers. This makes the politics particularly difficult to navigate – and it probably does not get much easier with a relatively large Conservative majority.

We need to go back to the drawing board and develop a consensus around a set of principles that can form a springboard for a reformed and sustainable system.

Importantly, we need to clearly identify and articulate the outcome of what, as a society, we are trying to achieve with our pensions tax relief system, and the outcomes that we want any new system to deliver. Only once we have that baseline consensus akin to what was delivered by the Pensions Commission, can we realistically have a sensible debate about the mechanics of delivery.

What would those principles be?

There will be much discussion about what these principles should be, but here is a starter for 10.

I would start by defining the outcome that we want to achieve. The new state pension provides a baseline income for individuals with a full contribution history of almost £8,800 a year. This is a reasonable starting point.

We should then work out how the level of private savings for retirement that we should reward, encourage or incentivise.

Perhaps this could be set with reference to median earnings (currently just above £30,000), but including the state pension. Alternatively, it could be defined as two-thirds of average earnings, in line with the Pension Commission’s replacement rate for a median earner?

The outcome could equally be set with reference to the Pensions and Lifetime Savings Association’s recently launched retirement income targets. Hence, the role of the state would be to ‘help’ people get up to this amount. The much-needed pensions dashboards would help people clearly see where they are against these targets.

Defined this way, any change to the system would require a clear policy choice by future governments, and would come under a high degree of scrutiny.

Once we have developed consensus about the outcomes society is trying to achieve, then we need to agree a set of principles for reform. I would suggest:

• The system should be clear to understand, and people should see the tax relief benefit they derive from saving for their future.

• There should be broad equivalence in terms of incentives or rewards, and outcomes, between DB and DC savings.

• The system should be straightforward to administer and run.

• The solution needs to be fiscally sustainable and stable, with an inbuilt bias against adding extra features or tinkering.

All of this is easy to say and a lot more difficult to do. There would be winners and losers, and it will be difficult to transition to a new regime.

While not underestimating the challenges, we need to start at the top, identify desirable outcomes, and principles against which we can design a system to achieve them.

Then, and only then, might we have a chance of  implementing a system that works for all savers.

Darren Philp is director of policy and communications at Smart Pension