By Dale Critchley, Technical Reform Manager, Corporate Benefits - Friends Life, part of the Aviva Group 
The current bill for pension tax relief is unaffordable according to the Chancellor, but can we collectively afford TEE?
One of the major stumbling blocks for this review is that the current system isn’t understood. A recent survey by Aviva showed that 65% of people didn’t know that government paid 20% into their pension through tax relief, but then 59% didn’t know how an ISA was taxed either. This low level financial literacy represents a barrier to incentivising any saving.
The force of the ISA brand is clearly strong as 41% of respondents said they would prefer a pension ISA, but this fell to 23% when told they would pay more in tax. This is something many people fail to appreciate. Tables produced showing that net in and gross out amounts to the same as gross in and net out lead commentators to conclude that this means TEE is fine as it costs the same.
However, if we look at what happens when we include employer contributions in these calculations it looks a lot more complicated.
Under TEE employees would be taxed and pay national insurance on employer contributions up front rather just tax in retirement. Employer contributions won’t feel like “free money” any more and cost increase will particularly impact members in defined benefit schemes. Even in defined contribution schemes costs will rise. If we look at a typical higher rate tax payer, they will face almost exactly double the net costs they do today, to achieve the same net retirement income, in a matching contribution pension scheme.
For basic rate tax payers it will be 40% more expensive. If we consider that the number one reason for not saving is lack of affordability, it seems a strange to make pension saving more expensive. The government will need an incentive to stop opt outs, or employers choosing to pay cash instead of pension contributions to reward workers.
We have to look at the current system to try to understand what level of incentive could be affordable under TEE. Without the ability to use a tax deferral as an incentive the Chancellor will have to find real money that is never repaid. Under the current system 20% of the tax relief for most higher-rate tax payers is never repaid, nor is NICs relief on employer contributions. Then there is the 25% tax free cash sum, which is worth 5% tax relief to most. If employers keep their incentive we think an incentive of around 10% could be affordable across the current population of savers, or it could be spread more thickly across a smaller group.
10% isn’t enough to offset the increase in the cost of TEE, but the incentive has another job to do - to offset the risk that once you have invested in a pension scheme, a future government won’t change the rules and tax your pension income. What level of incentive is required to overcome that barrier is not a question anyone can answer with authority. But if the Chancellor can’t find the right answer he could find people saving less, with the cost of tax relief replaced by unaffordable welfare costs in the future.
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