Too much freedom and choice for Treasury’s comfort?

The Government’s Budget announcement of freedom and choice in pensions - essentially greater freedom in taking defined contribution (DC) benefits – may have inadvertently created a tax loophole. The Government has attempted to restrict the potential tax leakage, but further action is likely to be required.

The Treasury’s Autumn Statement appears not to have included any measures to further close the tax loophole.

The loophole relates to new tax advantages of employers paying their employees through pension contributions via a salary sacrifice arrangement rather than through salary.

Salary sacrifice is a legitimate method, accepted by the Treasury and used by many employers, whereby individuals agree to forego part of their earnings in return for employer pension contributions. There are normally both employer and employee National Insurance (NI) savings, as no NI is payable on the part of salary that is sacrificed. Salary may not be sacrificed entirely, as employees must be paid at least the minimum wage.

Payments made through salary attract employer NI of 13.8% on everything over a threshold of £7,956, whilst employees below state pensionable age pay NI of 12% on salary between £7,956 and £41,865 and 2% on everything over £41,865.

Under current rules, individuals can begin drawing their benefits from age 55. Tax-free cash can be taken upfront; the balance must be taken as income, so can normally only be drawn at a prescribed rate. The ability for individuals drawing benefits to make substantial further pension savings is limited, as they will need to have other cash to live off.

The forthcoming freedom from April 2015 for individuals age 55 or over to access their entire benefits in cash form whenever they want creates a loophole to reduce both employer and employee NI, as well as income tax. Employers could pay remuneration through a combination of salary (up to the minimum wage) and salary sacrificed pension contributions, both with immediate access for those over age 55. Remuneration paid through pension contributions would be free of employer and employee NI, and 25% available tax free.

The following simplified example illustrates the potential tax leakage/opportunity, based on:

• employee aged 55 or older and below state pensionable age
• 2014 income tax/NI rates and thresholds, and standard personal tax allowance
• remuneration of £35,000 p.a. paid either:

1. entirely through salary, i.e. for simplicity, assumes no pension saving
2. through salary up to the minimum wage (£11,484), with the balance through salary sacrificed pension contributions (£23,516), i.e. a scenario to illustrate the potential tax leakage

• no employer pension contribution, other than that financed by the employee via salary sacrifice

The following tables show the impacts on take home pay, employee’s total income, employer’s remuneration costs and tax to the Treasury.

The example illustrates a potential tax leakage to the Treasury for the employee through freedom and choice in pensions of over £7,000 (from Table 4). The potential tax leakage figure would be smaller but comparable where it is assumed that the employee is currently making pension contributions at a modest, common level (either from salary or via salary sacrifice).

Since the Budget, the Government has announced the following measure to restrict the tax advantages whilst retaining the flexibility of the new freedom – a reduction in the annual contribution allowance from £40,000 p.a. to £10,000 p.a. for anyone taking benefits. After first taking benefits, the reduced contribution allowance restricts the extent to which the tax leakage may be repeated. However, significant tax advantages remain and further action is likely if tax leakage becomes a reality.

Industry discussion suggests that removing or capping tax-free cash sums could also be one way to help restrict the tax leakage, despite the fact that this action would be deeply unpopular. A further reduction in the annual contribution allowance below £10,000 p.a. for anyone taking benefits could be another target, as could levying NI on employer pension contributions.

We understand there is appetite for employers to facilitate this, potentially for the whole workforce (those over age 55) rather than just senior employees. Although salary sacrifice is a legitimate method, employers designing processes specifically to take advantage of the loophole should consider reputational risk (should the Treasury name and shame) and the possibility of further action prior to April 2015 to address the loophole by making pension saving less attractive. The complexity of setting this up will undoubtedly have cost implications and providers may be reluctant to facilitate the processes if they are obviously set up for this purpose.