Workplace pensions have had an incredible impact on pension saving in the UK, resulting in millions of people putting cash away each month to help tide them over in retirement.
But a bizarre feature of the way that contributions are made means that low earners are being short-changed and end up having to pay significantly more for the same result as their higher-paid colleagues.
And it’s time for that to end.
The ‘net pay anomaly’
One of the perks of saving into a pension is that you receive tax relief on the money you pay in. In effect it means your contributions are bumped up the Treasury, making your money go a bit further.
But there can be issues based on how that tax relief is claimed by your pension provider.
Some schemes claim relief at source, which is where contributions are deducted from your pay after tax has been taken off, with HMRC then sending that tax relief back to the scheme at the 20% basic rate.
If you pay higher rates of Income Tax, then you can claim that directly from HMRC.
However, other schemes go for a net pay arrangement, where contributions are deducted from pay before tax is taken off, meaning savers get the tax relief automatically based on their marginal rate.
There is a problem though for people who earn below the £12,500 Personal Allowance threshold ‒ the point at which you start paying tax on your income ‒ as with the net pay arrangement they then don’t get the 20% tax relief they should on their pension contributions.
What difference does this make?
A vast number of workers find themselves in this position according to the UK Government itself.
In fact, according to HMRC, there are more than a million low earners who are seeing their pension contributions short-changed by not receiving the proper tax relief, with the majority being women.
And that missing money will make a real difference to the eventual pension pot of those savers.
Calculations from pension provider NOW: Pensions show that someone earning £12,500 a year, paying minimum contributions of 5%, would have missed out on up to £63.64 in the 2019/20 tax year.
Over time, and with the returns from the assets the pension is invested in, that would likely be worth far more. And that’s for each and every year that this anomaly remains in place.
So, for a low earner to get the same pension pot as a higher paid peer, they would have to pay in more to make up for that missing tax relief. And that’s a farcical situation all round.
Putting things right
The Government is well aware that this situation is indefensible and put forward a call for evidence from stakeholders which recently closed.
It outlined many possible options for fixing the net pay anomaly, but warned all options identified have drawbacks and would ‘introduce significant complexity’ in the pensions tax regime for employers and pension schemes, while also being tricky to explain to individual savers.
But to be honest, the fact they might make things a bit more complicated for pension schemes or be rather complicated to explain are simply nowhere near good enough reasons not to crack on and make things fairer for the lowest earners, for whom every penny in their pension pot really does count.
What are the options?
So, what are those possible solutions? Here’s a brief run through:
A popular suggestion is for HMRC to use the real time information (RTI) data it gets about employees through the Pay As You Earn system to identify those who are contributing into a workplace pension but not receiving the tax relief, and then correct it.
It’s an option that’s got the backing of the likes of the Association of British Insurers (ABI).
“The recent Coronavirus Job Retention Scheme has proved that HMRC’s systems can move quickly and effectively when needed,” said Yvonne Braun, director of long-term savings policy at ABI.
“A small HMRC administration change would make a big contribution to reducing the gender pensions gap and improving the retirement prospects for many in low paid or part-time work.”
Alternatively, HMRC could use that same information to apply a charge to those low earners whose contributions enjoy relief at source to remove that tax relief, so that neither group of low earners receive it.
Frankly, this is madness ‒ taking money away from some of the nation’s lowest earners in the name of fairness is absurd.
Multiple schemes from employers
A third option is for employers to provide both net pay and relief at source schemes.
Employers could then move their employee contributions between schemes depending on whether their earnings take them above the Personal Allowance threshold.
Again, this seems mad ‒ the admin involved means it would only really be an option for the largest businesses.
Mandate use of relief at source
Finally, the most radical option, which would be forcing all defined contribution schemes to operate relief at source. This would guarantee that all low earners still receive that top-up to their savings.
It’s certainly a dramatic option, and it would be a hassle for employers that don’t currently operate relief at source schemes, but it would at least only be a short-term issue.
The Government will now consider the responses it has received from the industry, and hopefully decide swiftly on how we can move forwards.
None of the proposed solutions so far are completely perfect, but there can be no question that they are all an improvement on the current injustice, which is effectively robbing the lowest earners of money that should be going into their pension pots.
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