UK
London, 23 August 2010

• Proposals ‘better’ than previous attempt but still risk ‘pulling rug’ from underneath UK occupational pension provision unless amended
• Mercer highlights four main areas where the government’s proposals need more consideration

Mercer believes that the coalition government’s revised proposals for restricting tax relief on pension savings are an improvement on those presented by the previous government, but it still has four main areas of concern. These areas need to be addressed to ensure a healthy environment for the UK’s retirement system, and it suggests how to achieve this in its response to HM Treasury’s consultation process. The consultation closes on 27 August.

“Certain elements of the current proposals will accelerate the demise of defined benefit (DB) occupational pension schemes unless changed – otherwise, employees on incomes just above the higher rate tax threshold could inadvertently become liable for tax charges greater than the amount of pension they have actually accrued,” commented Deborah Cooper, Head of Mercer’s Retirement Research Group. “The loss of more DB schemes will precipitate a reduction in the overall savings level and increase the degree of risk individuals have to bear, resulting in more pensioners with insufficient incomes. This is not in the long-term best interests of the UK economy and will pull the rug from underneath the UK’s occupational pension system.

“The proposals also incentivise the current generation of senior management to drop out of pension provision. Hit those in companies who make the decisions on pensions and you undermine enthusiasm for the whole regime, to the detriment of us all.”

Mercer believes the current proposals will inhibit employers’ ability to provide pension schemes that are strategically right for their business and that support the long-term wealth creation of their staff. The government risks introducing a penal tax law attacking the specific provision of long-term risk sharing / defined benefit provision, which will inhibit employers from doing what is right for their employees. It also believes that increasing the complexity and cost of DB pension provision will encourage employers to dumb down pension provision to the minimum acceptable level, which may not be in the best long-term interests of employers and employees, and the nation.

Mercer’s preferred regime would have the following four characteristics:

1. A reduced annual allowance with an annual allowance charge equal to the individual’s marginal rate of tax.
2. Age-related factors to convert defined benefit accrual into an equivalent ‘contribution’, which treats all employees fairly.
3. The annual allowance charge should be levied on current accrual only and should not be applied retrospectively.
4. Tax relief should continue to be granted at an individual’s marginal rate.

“Whilst there is a case for limiting the extent to which tax relief is available on pension savings, the tax system should encourage long-term savings plans, such as corporate pension provision, and not hinder them for short-term tax revenue purposes.

“This is not just a high earner issue – it will affect a wide range of employees. If the government’s proposals go through unamended, in some schemes the majority of members will find themselves exposed to an unpredictable and inequitable tax regime,” concluded Dr Cooper.

Notes for editors

1. Annual and life time allowances
Mercer believes it is reasonable for the government to reduce the Annual Allowance dramatically in order to restore integrity to the pension tax regime. However, other, longer-term, considerations should be taken into account, including who is likely to be affected by the limit. Mercer suggests an annual allowance of £40,000, indexed to earnings, to permit someone to build their funds in time for retirement. In the short term we recommend the Lifetime Allowance should remain frozen at £1.8m.

We see a trade off between the Annual Allowance and the Lifetime Allowance. It is more proportionate to set the Annual Allowance slightly higher and retain a Lifetime Allowance test, than to dispense with the Lifetime Allowance and set the Annual Allowance so low that it catches relatively modest earners.

Mercer also believes that measures should be put in place to avoid people being taxed just as a result of good investment performance.

2. Age-related factors
Mercer is also concerned over how the value of pension accrual in DB schemes, which will bear the brunt of this revenue-raising exercise, will be assessed. While the value of DC accrual is simply the amount of the contributions paid into the scheme during the year, calculating the value of someone’s DB accrual is more complicated: the amount accrued each year must be calculated and then multiplied by a factor to arrive at a value. Under the current regime, where the annual allowance affects very few people, the factor is currently 10 but, for the new regime, the government proposes to increase this to between 15 and 20.

If the value calculated exceeds the annual allowance, the individual will be liable for tax. Mercer’s view is that, if a flat rate factor is used to calculate the value, most DB members will be paying tax on a completely arbitrary basis with no consistency between defined contribution and defined benefit arrangements. Instead, Mercer believes age-related factors are the correct solution. This would be straightforward for trustees to implement, be fairer for members and ensure a level playing field between different forms of provision.

3. Past service
Mercer also believes that past service should not be included when calculating the value of accrual to test against the annual allowance. People are normally taxed on pay and other income accrued during the tax year. This principle should be applied, as far as possible, to pension savings. If this can be achieved, the new regime is less likely to hit those on lower salaries simply because they get promoted or have been in the same DB scheme for many years.

4. Marginal rate tax relief
Individuals should continue to get tax relief at their marginal rate, up to the annual allowance threshold. We believe this on principle, but also because restricting tax relief reintroduces much of the complexity criticised in relation to the previous government’s proposals.
When people receive tax relief on their savings at a higher rate than their marginal rate in retirement, this normally indicates that they were not such ‘higher earners’ after all. The obvious comparison is between someone whose earnings remain steady at just below a tax threshold, and a comparator whose earnings fluctuate above and below the threshold. If their earnings are the same on average, then the latter person would be more heavily taxed if pension tax relief was not provided at his or her marginal rate.