Ask any financial planner or wealth manager about the piece of tax legislation most likely to send them into a tailspin and the chances are it will be the pensions taper.
Since rules were introduced in April 2016, the UK’s top earners have seen their annual allowance whittled down from £40,000 to £10,000. The rules are fiendishly complicated to apply, as individuals have to predict what their total income is likely to be, but the real sting is the huge tax bills that result if you get it wrong.
About 300,000 people are in the scope of the taper, but it disproportionately affects those paying into defined benefit pensions — a significant proportion of whom work in the public sector. While these pensions are more generous, they are also less flexible.
Within the NHS, one of the only ways that doctors, consultants and other highly paid senior staff have been able to manage the impact of tax charges on their pension contributions is by working less — reducing their hours, refusing to take on extra shifts or even retiring early. This has caused serious staffing issues at hospitals and the prospect of rising waiting lists, and the new government is painfully aware of the political consequences.
This week, chancellor Sajid Javid pledged to review the pensions taper, not just for NHS staff but for other highly paid public servants such as judges and senior police officers. However, experts argue that any review has to look beyond the public sector and take account of workers in the private sector too — all of whom have plenty of reasons to feel feverish about the taper’s impact, and would welcome its sudden demise.
Why does the taper cause tantrums?
When the taper was introduced in 2016 to reduce the tax relief claimed by higher earners on pensions, experts including a former pensions minister described it as “horrific” and “nightmarish” because of its complexity.
Unlike the annual or lifetime pension allowances, which are defined amounts for all workers, the taper is unique to each individual and relies on calculations involving a complex mix of threshold income, pension accrual, adjusted income and the other rules.
The taper works by gradually reducing the standard annual allowance from £40,000 to £10,000 for those with adjusted taxable income (including salary, other incomes and pension contributions) of £150,000 to £210,000 a year. However, those with earnings of £110,000 or more can also be caught by the taper, due to complex rules around how it works.
Any pension savings or benefits above the tapered level will be subject to tax charges, at an individual’s marginal rate.
“My view is that the introduction of the taper three years ago was ill-conceived and should never have been brought in,” says Malcolm McLean, senior consultant at Barnett Waddingham, an actuarial consultant.
“Among other things it added a layer of complexity to an already complicated and overlapping system of allowances — the annual allowance and lifetime allowance — and has never been fully understood by most employers and individuals potentially affected by it. It was, and is, perverse in the way it operates, acts as a disincentive to long-term saving and affects many other key relatively highly paid workers in addition to doctors.”
The measure is expected to raise £1.2bn this financial year, rising to £1.3bn next year. Although it is not possible to say how much of this tax is paid by NHS or public sector workers, economists point out that this is a relatively small sum in the context of government finances.
“It is not clear why someone getting total remuneration of £150,000 should be able to save £40,000 of it in a pension without incurring penal tax rates, while someone earning £210,000 should only be able to save £10,000,” says Stuart Adam, senior research economist at the Institute for Fiscal Studies.
“Some of the disincentives to work it creates are absurd,” he says. “In the most extreme cases, people can be made significantly worse off by doing extra work, and many more see little financial reward for working more.”
When it was first introduced in 2016, the taper’s impact could be managed by “carrying forward” unused tax relief from previous years.
“It’s taken until 2019 for the taper to become such a widespread issue, because the wealthy can’t carry forward any more,” says Michael Martin, relationship manager at Seven Investment Management.
“It’s far too complicated for people to predict a year in advance what the impact of the taper could be on their tax return. That said, reducing pension contributions or opting out may cost NHS workers more. I’ve encouraged consultants to weigh up the impact of a tax bill against the much bigger pension that they will receive for the next 30 years when they retire.”
There are further complexities for consultants who split their time between NHS work and private practice.
“For many people, it’s the level of private income that is putting them into the taper zone,” Mr Martin says, adding that many manage this by channelling private earnings through a limited company.
This, he accepts, is a “first world problem”. “But it’s also a problem affecting the whole country through increased waiting lists — and that’s why I think the taper will be scrapped.”
The likely scope of Javid’s review
The tapered annual allowance has hit high earners across the private and public sectors. But it has been particularly problematic for workers in the public sector, where the test for the allowance is based on pension accrual (growth) and not contributions. Promotions or pay increases will affect their accrual; a situation made more complex for members of more than one defined benefit scheme where rights are building at different rates.
In addition, public sector workers have little control over the level of their pension contributions, which are set according to their salary level — a position which has resulted in thousands of high-earning senior doctors, and others such as judges and police chiefs being landed with pension tax bills for breaching their annual allowance.
Currently, the only way to mitigate the risk of pension tax bills for most public sector workers is to reduce their hours, turn down promotions or quit their pension scheme. This is in contrast to the private sector, where most top earners have some flexibility over their pension contributions and can limit their exposure to the taper.
This week, the Treasury pledged to review how the tapered annual allowance “supports the delivery of public services” such as the NHS. In addition it proposes to make the NHS pension scheme more flexible for senior doctors to help them mitigate the risk of pension tax bills.
This could allow senior NHS staff to select their level of pension accrual at the start of the year, to give them “headroom” to take on additional work without breaching their annual allowance. To compensate them, doctors would receive a top-up to their annual salary, on which they would have to pay income tax and national insurance.
No terms of reference or a likely timetable were given for the review. However, the government said that it would report the findings in the usual manner in the Budget.
A government official added that any eventual reforms would be likely to apply across the whole public and private sectors as well, because discrimination in the tax system “doesn’t wash”.
The government could face a legal challenge if it failed to extend any pension flexibilities granted to the NHS to millions of other public sector workers. Yet while there is political desire to help high-earning doctors negotiate complex tax rules, voter sympathy is unlikely to extend to wealthy City workers.
Pension experts welcomed the taper review, but said it should have been much broader.
“The Treasury has suggested its review would focus just on the NHS and perhaps some other public sector defined benefit schemes, but this is not good enough,” says Baroness Altmann, a former pensions minister.
“The problem [with the taper] is that it is just not operating effectively or efficiently and is hitting many workers who it was not designed to impact, especially in defined benefit schemes where they have no control over their accrual rates and where the calculations are horribly complex.”
The Association of Consulting Actuaries said the review should also consider private as well as public sector workers.
“The tapered annual allowance is of course targeted at high-earning individuals’ pension benefits, but it is unutterably complicated, both for the individuals impacted and for pension schemes which carry much of the burden of trying to make the system work,” said the ACA.
“The complexity is exacerbated for defined benefit schemes, like the NHS scheme, [and] means that in many cases the wrong tax will be paid — which is not the right way to design a tax system.”
What could replace the taper?
If the Treasury were to abolish the taper, it is likely to look at putting other measures in place to ensure it does not lose out on tax revenue.
“A simple change would be to abolish the taper and claw back lost revenue through a lower annual allowance across the board,” says Sir Steve Webb, director of policy with Royal London and a former pensions minister.
Baroness Altmann says another proposal would be to operate the tapered annual allowance on a forward basis, so it would depend on your earnings in the past year, not in the current year.
“That way, if you have ended the tax year, you will know what you earned last year and what your annual allowance is for the year ahead and can then plan your pension contributions. This seems a much more sensible way to run policy than the current system, which makes it impossible to plan.”
Mr McLean believes the review could result in some tweaks to pension tax rules.
“I suspect that the scope of Javid’s review will be to consider whether the taper should continue to apply in its present form or whether its objectives — to limit the amount of pension tax relief a high earner can legitimately receive — can be achieved in other and better ways,” he says.
“I would expect the review to conclude that the taper should be scrapped with effect from the start of the next tax year 2020-21, with a smallish reduction in the annual allowance — say down from £40,000 a year to £35,000.”
However, Sir Steve does not think the review will result in the taper being scrapped.
“Although people other than hospital consultants will be affected by the taper, it will mainly be those whose income is variable and unpredictable, and that seems much less likely in education or the civil service,” he says.
“So if this turns out to be mainly an NHS issue and if the NHS pension changes take the sting out of the issue, the Treasury may conclude that the problem is largely solved and make no changes to the taper — except perhaps something cosmetic like raising the threshold from £110,000 to £120,000.”
While the review is under way, it is likely that high-earning workers in the private sector at risk of the taper tax will continue to appeal to employers to pay them cash in lieu of pension contributions, which they can direct into other tax-efficient vehicles such as stocks and shares Isas.
Any solution will have to balance the impact on the tax take against the need to simplify an unwieldy system for taxpayers saving for their retirement.
“The Treasury needs to stop playing whack-a-mole with pension tax policy,” says Tom McPhail, head of policy with Hargreaves Lansdown.
“They need to start from scratch, ask themselves how the pension system and its tax architecture could serve the needs of individuals, employers and wider society, then decide how much public money they can use to incentivise saving and the best way to deliver it. If you did that you’d end up with something looking very different from the system we’re battling with today.”
Additional reporting by Valentina Romei
How the pensions taper works
The annual allowance governs how much can be saved into a pension each year and benefit from tax relief — currently a maximum of £40,000 per person, which includes your own contributions and those from your employer.
Successive chancellors have sought to rein in the costs of pensions tax relief with cuts to the annual and lifetime savings allowances. While unwelcome for some, these were at least fairly straightforward and transparent in how they were applied.
Not so with the annual allowance taper. From April 2016, individuals who expected to have a total income of more than £150,000 in the tax year faced further reductions to that £40,000 annual allowance.
And total income doesn’t just include your salary — employer pensions contributions, plus any bonus, dividends from shares, savings interest and even income from a buy-to-let property are all included. Unlike an annual salary, many of these extra income items are hard to predict at the start of the tax year.
The taper works by reducing the annual allowance by £1 for every £2 of total, or “adjusted” income over £150,000. This means anyone with total income of more than £210,000 would see their annual allowance whittled down from £40,000 to just £10,000.
Not all high earners will be caught by the taper. If an individual’s “threshold” income — which excludes employer pension contributions — was less than £110,000 the rules do not apply.
— to www.ft.com