The proposals set out in the HM Treasury discussion paper of 27th July regarding tax relief for future pension savings could have significant consequences for the group risk market. The proposals appear very bad news for any employee currently eligible for an ill health retirement (IHER) pension but good news for the income protection market.
The paper suggests that tax relief on future pension accrual could be controlled by an annual allowance of £30,000 to £45,000, testing the increases in the nominal value of DB pension benefit, where value is determined by applying a factor of possibly 15x to 20x, and contributions to a DC scheme. Where the notional value of pension increase is more than the allowance, the employee will be subject to immediate tax on the excess, at the employee’s marginal income tax rate. As the benefit payments are also subject to income tax, the benefit could become very tax inefficient for the member.
The paper states that there would be “some exemptions in the event of death” or for individuals who receive lump sums on serious (terminal) illness. So it appears death benefits and some payments on incapacity would be unaffected, but the Treasury has stated that it is minded not to grant an exemption for IHER pension benefits.
Without an exemption the new rule could be very significant for employees who qualify for IHER. In a DB scheme it is common for the calculation of the IHER pension to extend beyond already-accrued service to include some or all of the lost future service between actual retirement and the scheme’s normal retirement age. And the IHER pension is typically not subject to the reduction factors that apply if the pension is taken early in good health.
Both of these enhancements could be considered increases when triggered, and large increases at that, of which all or part attract the new tax. Take a member aged 50, on a salary of £30,000, with 10 year’s scheme service. IHER pension is calculated using 1/60th of salary for each year of accrued service plus each year of lost potential service to age 65. The potential pension before IHER is £5,000 a year. The IHER pension increases to £12,500 a year. If the increase is converted by a factor of 15x to 20x the increase in nominal value would be deemed to be £112,500 to £150,000. Amounts in excess of the annual allowance of £30,000 to £45,000 would be subject to income tax. DC schemes can also be affected where large lump sums are paid.
The Treasury may be clamping down on ordinary IHER as it sees it as an opportunity for employers to use the area of incapacity potentially to bypass taxes aimed at high paid employees. But the proposed rules could catch many lower paid employees.
The discussion paper suggests IHER pensions could be replaced with IP – which is subject to normal rather than double tax. This is great news for the IP industry, which has long been pushing the virtues of IP over IHER and it is good to see the Treasury is aware of the availability of alternative group risk solutions.
But it is unclear how much the Treasury understands IP and the fact that, partly due to previous governments’ actions, there has been a drift away from traditional solutions providing benefits to retirement age towards short-term solutions.
If the Treasury is happy to suggest that IP is the reasonable alternative to IHER then it needs to ensure that other government legislation does not stifle the prospect of employer-provided IP arrangements. For instance, in future IP termination ages must be exempt from age discrimination regulations so the removal of a default retirement age of 65 does not leave employers offering IP with an open ended liability to continue benefits payments.
The political difficulties of trying to introduce a new tax that will fall on the sick and injured mean it is quite possible that the final legislation may be significantly different. However, it seems likely that to reduce the opportunities for senior staff to avoid tax, stricter conditions for the payment of IHER pension will be imposed. For employers who are looking to cut back or replace IHER with a more effective solution, any changes to the tax rules may give them the opportunity to pursue alternative solutions.
Any tightening of the rules for IHER will further enhance the attraction of IP insurance as an alternative benefit solution. The key will be for the industry to ensure that the solutions available meet employers’ needs and for the government to ensure that it, at least, does not discourage employers from providing long-term financial protection for their staff.
