Budget 2014 contained some (sorry to be cliché) radical pension reforms, and the Telegraph has picked up on an obvious flaw in the plan, something spotted by me and everyone else on Budget Day. In fact, the only people not to spot it on Budget Day were those at HM Treasury as they would have been fully aware when they were putting together the plans.
Income tax filtering, as I call it, is a way of washing your income through the pension scheme to save two types of “tax” – National Insurance on the whole lot and income tax on the quarter that can be paid tax-free. Instead of being paid salary by your employer, a pension contribution is paid into a pension scheme for you and then you draw out that pension contribution. It’s not very practical at the moment given that the money you draw out has to be paid out over your lifetime, but from 6 April 2015 the proposed rules will allow you to draw it all out in one instalment.
So given that everyone knows about this, I doubt the actual fundamental principle of being able to access your pension at the speed you want will be compromised. All we have to remember is that “the devil is in the detail”.
There are a number of options available to counter against income tax filtering. I actually believe that those in the Government, without their prejudice views of what pensions should look like, will come up with a better solution than me. But the options that I see are as follows:
1. Use Flexible Drawdown provisions
Flexible Drawdown is already in play (for those with secure pension income of at least £12,000) and contains some anti-avoidance provisions. Essentially, you cannot start Flexible Drawdown if you’ve made pension contributions that year and once you’ve started any further contributions would be taxed (effectively at income tax rates).
An easy option would be to extend these rules to all people but that has two problems that I can see:
Problem 1. Flexible Drawdown is a choice. If you extend the rules to everyone, then you would be impeding almost everyone who would not be able to retire in the same tax year that they have their final contribution. This isn’t acceptable.
Problem 2. Following on from this theme, many people may want to use pension as a means of transitioning from full time work, through part time work, to full time retirement. Again, if future pension contributions are taxable, that isn’t generally going to be fair or workable for the masses.
Of course, one option is to retain capped drawdown whilst extending Flexible Drawdown so that it is available to all, subject to meeting the contribution rules.
This is actually consistent with the Budget 2014 papers which indicated that there could be room for new drawdown products, though the consensus is that capped drawdown will be no more and the new products will instead offer some sort of protection against old age whilst allowing more unusual shapes of benefit drawing (e.g. high drawings in early years with a guarantee of a lower minimum income for life).
2. Introduce a waiting period
Of course, one way to deter people from having a pension contribution paid for them only to have it paid straight out is to introduce a waiting period – i.e. you cannot draw upon contributions unless they have been invested for say, five complete tax years.
There are two problems I see with this method, but they aren’t deal breakers.
Problem 1. This is administratively awkward – though that would not stop it being introduced. It would be particularly difficult for SSASs and traditional SIPPs.
Problem 2. Having a time limit isn’t consistent with flexibility in retirement. People could quite legitimately make a contribution and then be made redundant and want to access their pensions savings. The argument against this of course is that in the grand scheme of things, they should have greater flexibility under this method than under capped drawdown.
3. As above, but the time limit only applies in relation to the tax-free lump sum.
Problem 1 still remains, but it helps a bit with problem 2. For example, for every complete tax year an extra 5 per cent of the fund can be drawn tax-free (up to the maximum 25 per cent after five complete tax years).
4. Restrict tax-free cash and apply NI to pension contributions
Income tax filtering relies on the NI saving and the ability to draw some funds out tax-free. Removing these benefits indiscriminately to deal with this issue is a rather blunt way of tackling the issue which would have far greater impact than the issue it is trying to resolve.
What would be my preferred method? All in all, keeping capped drawdown whilst extending Flexible Drawdown for everyone seems the simplest option. The existing controls for Flexible Drawdown would protect the Exchequer and everyone would have the choice of unrestricted pension once they have fully retired.
It would mean retaining the capped drawdown rules and so I should clarify that I a not in favour of doing that. Some readers may think that as I work for a pension provider, I would rather a system that retains this recurring income. Actually, I would rather people could obtain information on the right level of drawing for them rather than an artificial government limit.
As I said earlier though, I can imagine that people at Treasury not working in the pension industry may come up with some more out of the box thinking and so I am looking forward to seeing their proposals for a system that does away completely with capped drawdown limits.