No easy solution to the freedom and choice conundrum

The industry has a number of suggestions for how the Chancellor can close the loophole opened by his freedom and choice in pensions policy. The big question is, which is the least unpalatable? John Greenwood reports

George Osborne’s barnstorming budget performance last March may have made everyone fall back in love with pensions, but now Treasury officials have the job of shaping a tax and regulatory structure that can make it work.

So how will the Treasury close the loophole opened by the Chancellor’s budget pension freedoms that, without significant changes, will allow billions of pounds of tax and National Insurance to be avoided through salary sacrifice?

If over-55s can access their pension without penalty, then why pay them any salary beyond what is legally required by minimum wage legislation? Without new rules, the numbers are staggering – if someone aged 55 earning £40,000 sacrifices all but the minimum wage of around £11,400 into pension, and draws on their pension as they would a current account, thus avoiding employer and employee NI and getting a quarter of their ‘pay’ tax-free, the Treasury loses 62 per cent of its revenue.

That is clearly not going to happen. Which is why Treasury officials are currently scratching their heads as to the best way to square the circle.

It is a debate that is going on largely behind closed doors – which provider or trade body wants to go down in history as the organisation that proposed restrictions to tax-free cash? But it is a crucial one for corporate advisers, providers and employers, as they are the ones that will have to implement whatever new anti-avoidance rules are introduced, before next April’s incredibly short implementation date.

Those close to the Treasury see perhaps four options – restricting the scope of tax-free cash, National Insurance on pension contributions, reducing the annual allowance, possibly to zero, or introducing complex anti-avoidance measures that require employees to prove pension contributions should be eligible for tax relief.

Aon Hewitt partner Paul McGlone says: “There is a massive issue around anti-avoidance. The idea that you can take out your DC fund is fantastic. But we can expect pages of rules on what you can and can’t do.

“The point with tax relief has been people don’t get to spend their money straight away. I do not thing that tax leakage will happen so the simplification we had hoped for could be watered down.”

None of the options are, on their own, particularly palatable. But in the context of the prize of the broadly welcomed new freedom to spend pension as individuals wish, the task for the government is to see which solution works best.

Hargreaves Lansdown head of pensions policy Tom McPhail says: “The Treasury is going to have to do something about this. Whether it leads to rapid change in the tax treatment of pensions or something less invasive remains to be seen.”

McPhail predicts some form of anti-avoidance measures will be introduced, using the same principles as those already in place for tax-free cash avoidance.

But AJ Bell head of platform marketing Mike Morrison Morrison believes the anti-avoidance route introduces unpalatable levels of complexity. “If you say that someone who goes from earning £35,000 salary to zero salary is avoiding tax in breach of the rules, it gets messy. It is subjective and takes us back to the old days of ‘was my pension contribution wholly and exclusively an expense of the business’.”

Even if the government opts for pages of anti-avoidance regulations, they will have to specify a level of contributions that is acceptable. And with DB schemes getting relief on up to 30 per cent of contributions, it would be unfair to prohibit a 55-year-old in an 8 per cent of band earnings auto-enrolment scheme from increasing that to, say, 15 per cent of earnings. The problem for the government is that even that could lead to big tax savings for employers and employees, if applied across the board for big organisations.

An alternative approach is to penalise those who draw benefits before they retire. Sources close to Corporate Adviser say this idea has traction with the Treasury, which is understood to be considering blocking tax-free cash on future contributions once benefits have been drawn, while allowing it to remain on investment growth.

That gets over the tax-free cash loss, but would still make salary sacrifice beneficial from an NI point of view. Morrison adds: “One suggestion is to apply National Insurance to contributions. If pension contributions are pay, which technically they are, then you could do away with salary sacrifice in this way.”

Aon Hewitt UK lead, global risk services Kevin Wesbroom says: ““The easiest option would be to follow the logic of the policy, which means if you access any pensions savings, your annual allowance goes to zero. But that would be unpopular.”

“Either the government upsets a lot of people it has told can have easy access to their money or it means guaranteed jobs for everyone over 55 because they will be that much cheaper to employ. That is what you get for not thinking things through before you come out with them.”