Pensions tax reform – how should employers react?

All the signs are that this year’s Budget on 16th March 2016 could bring seismic changes to pensions taxation. For companies that sponsor pension schemes this could lead to significant new challenges (and opportunities).

Over the past decade, previous pensions tax changes have been largely focussed at higher earners (for example the introduction of and subsequent changes to the “Annual” and “Lifetime” Allowances). This trend continued in last year’s Summer Budget for those earning over £150k from April 2016, who could see their Annual Allowance fall to as low as £10k. 

For affected employees, this latest change could significantly reduce the attractiveness of pension saving. Many employers have responded in turn by reviewing their reward strategy for these employees to ensure they remain efficient (for example providing cash alternatives).  

However, for the vast majority of employees who save below these levels, the current tax system has been a relative constant over the period, in theory offering significant incentives to save through full tax relief at employees’ marginal rate (either 20%, 40% or 45%). As a result, even as pension provision for current employees has shifted from defined benefit (“DB”) to predominantly defined contribution (“DC”) schemes, pensions have remained an efficient way for employers to reward staff -with many DC schemes offering generous matching contributions scales above minimum levels.

Last year’s government consultation “strengthening the incentive to save” raised serious concerns about this tax system, both in terms of its cost to the Exchequer (with some estimates of over £30bn p.a.) and how effective the current incentives to save truly are.   For example, a key problem is that the current incentives are not well understood – and PwC’s research found that 59% of people thought complexities in the tax system put them off saving more.

As a result, key alternatives being considered by government include:

  • a system of “flat rate” tax relief (potentially in the range of 25% to 33%) and
  • an “ISA” style system in which pensions are paid tax free, but contributions are paid from after tax income (possibly with a government top up)

New challenges (and opportunities)

For many individuals, these changes could be significant – potentially having a material (and unpredictable) impact on incentives to save. For example;

  • for basic rate tax payers, a flat 25% tax relief rate would increase incentives to save and individuals might respond by contributing more to their pensions;
  • higher rate tax payers would lose out from a 25% flat rate. However it is unclear whether they would seek to reduce contributions significantly, particularly if still benefitting from generous employer contributions.

For employers (particularly those with matching contribution scales), this could mean an immediate (and unpredictable) cost impact. Employers will need to quickly plan for, and model, this impact and potentially review contribution scales to make sure they remain efficiently targeted. 

Administrative impacts will also be important, with employers’ potentially needing time to meet new payroll challenges, and pension scheme administration becoming increasingly complex.

However, longer term, a more transparent tax system will help to underline the value to employees of good quality pension schemes.   In particular, as the war for talent continues, access to a generous, flexible scheme could move up employees’ wish list when making job decisions - potentially a boon to employers already offering paternalistic pension arrangements and encouraging others to review their schemes accordingly. 

With the position currently very uncertain, many employers will be monitoring Budget developments closely and pensions looks set to remain high on corporate agendas.

Steven Taylor 
PwC | Senior Manager
Office: 01895 522372
Email: [email protected]