Introduction
The UK pension scheme started as a non-contributory testing scheme which began in 1908 and established under the Old Age Pensions Act (Bozio 2010, p. 7). This system later developed into a contributory scheme and enforced under the Widows, Orphans and Old Age contributor pensions act of 1925 which majorly encompassed the lowly paid workers and excluded all other employees (Bozio 2010, p. 8). However, this scheme later developed from the 1942, Beveridge report that reformed the system into a universal social insurance coverage scheme which encompassed all employees.
The initial goal for establishing the pension scheme was not to provide a means for extra income for waged workers in the UK but to provide security against financial risks associated with old age. The Beveridge system did not however provide much security against this risk because it provided social security alleviation, just above the poverty level. The contributions to support the scheme were paid from monthly contributions during ones working life and calculations were to be done on actuarial grounds.
The National insurance act of 1946 was later developed to supplement the inconsistencies which the Belveridge system posed and its recommendations were later effected in 1948 (Bozio 2010, p. 8). This system was definitely an improvement from the Beveridge system but it failed to keep up with the pace of growth. In this regard, the Graduated retirement benefit fund was established but its inherent cost was too high, prompting the government to withdraw from it. Due to this reason, the state earnings related pension scheme was established in 1978, but in 2002, the state second pension scheme replaced the system (Bozio 2010, p. 8).
The new system meant that pensioners had varying interests on the scheme because new guidelines were implemented to grant different personal entitlements on the pensioners, depending on the amount of money they saved and at what point in their careers they started saving. These new provisions were a deviation from the previous pension schemes that majorly provided a flat benefit to all pensioners.
Nonetheless, this system did not have its fair share of troubles because the government was worried about its future costs. Upon proper calculations of the state’s obligation in the pension scheme, many of the expectations of the new scheme were watered down. This also tremendously eroded the expectations of the new pension scheme because it did not provide the expected income which is normally witnessed in a majority of European pension schemes (World Bank 2010, p. 13).
Due to the concerns about the existing pension scheme, many reforms have been made on the system. The most recent reform was made in 2007. The new recommendations proposed that: contributions were to be increased to support the long-term viability of the system, the number of pensioners was to be increased, pensioners’ contributions should increase with increased income and the entire pension scheme should in future provide a flat rate of benefit to all pensioners (Bozio 2010, p. 9).
Regardless of all these reforms, the state pension scheme was initially meant to achieve certain goals. Comparatively, across the globe, we can evidence a lot of pension schemes aimed at providing old age financial security (more or less). The same objectives are yet to be fully achieved in the UK as can be evidenced throughout the rampant change of pension tax systems in the past 60 years. However, the success of these schemes to a large extent depends on the commitment of the government in productively intervening to make the whole system a success.
With the development of the pension scheme in the UK, there came the need for the government to tax these schemes because of the investments made from the pension funds. However, primarily, these pension schemes were not meant to be taxed, but since the funds had to be hedged, there came a pressing need to invest the funds and this in turn attracted tax schemes.
More specifically, the changing manner in which pension schemes are invested today and the manner in which pension schemes generate income has been a potential ground for further taxation (OECD 1999, p. 143). For instance, the UK pension funds have been majorly invested in property, venture capital funds, hedge funds and the likes to safeguard against inflationary risks and to provide extra income to manage the funds. These developments have the potential of attracting more taxation especially if the structures for investment are not properly understood by the government.
Purpose
With regards to the goals of taxation on pension schemes, alleviation of poverty at an old age has been a primary objective. This primary goal has been advanced through various principles of the tax system which encompass the goal of the Pension funds tax regime. Firstly, the tax system is aimed at maintaining the burden of tax to the lowest possible levels. The burden of tax can be best understood through the percentage taxation takes of the overall accumulated pension funds. Secondly, the tax regime is aimed at increasing wealth through the pension schemes by providing incentives that encourage pensioners to contribute more towards their future financial security.
Thirdly, the tax regime is aimed at increasing expenditure on taxes rather than increasing the expenditure on income. This primarily elopes out of the belief that taxes on income have a potential effect of increasing the work incentive of pensioners. Fourth, the pension regime is aimed at providing an equitable system that taxes all pensioners equally. Lastly, the scheme is aimed at making the market work better because the UK government believes that if it has control of funds such as the pension scheme, it can improve the market in case of a market failure (Tutor2u 2010, p. 1).
Since the early 1920s, the taxation of pension schemes has been traditionally known to fall outside the taxation bracket until income is received as pension. However, this principle has not been practically true for decades now (Booth 2003, p. 1). This system has largely developed into the expenditure tax system which has also developed into the EET system which describes the taxation of pension as only applicable when the pension system starts to generate income.
This system of exempting taxes from pension contributions was largely thought to lead to the increase of efficiency of pension taxation and also make the system a lot simpler, but the system has turned out to be very complex contrary to previous expectations. A number of factors therefore underlie the pension taxation system which makes it incoherently economical because there is a tax discrimination between equity and debt which also distorts the entire system such that the balance expected of the pension scheme is totally unachievable. In the same regard, the taxation system has become very complex such that there are increasing implicit and explicit costs associated with compliance to the tax regime such that most pensioners can be easily discouraged from contributing to the scheme. In this respect, it is correct to note that the tax regime has to a far extent missed its goals of creating more wealth through existing tax regimes.
Evolution of the Tax Regime
The UK tax system on pension is one that undergoes frequent changes through the years and is termed as one of the most complex in Europe (Global Investors 2010). A universal lifetime allowance was launched in 2006 and was to be applied on all the benefits which the tax system was in favor of. Also, a universal accrual was also determined on an annual basis for all pensioners. The lifetime allowance described here is the maximum amount of money that can benefit from the tax regime and it was previously put at GBP 1.5 million but an annual limit of 215,000 was also set (Global Investors 2010, p. 12).
The new tax rules now stipulate that 55% of all amounts which exceed the annual allowance will constitute the taxed figure. This tax rate is however still subject to changes. Later, the value for individual pension assets can be put up for evaluation once the pensioner comes to collect the final lump sum payments; which also means that contribution plans will be more defined. The new scheme also outlines that applying a fixed multiplier of 20 will stipulate the value of the benefit provision in the coming years. The new provisions also eliminate the rigidity associated with collecting pensions and also outline that 25% of the lump sum due for collection can be collected as a tax-free lump sum (Global Investors 2010, p. 15).
Impact of a Change in the Tax System
The new changes outlined above were meant to streamline the inconsistencies evidenced in the tax system but the new challenges evidenced in implementing the tax regime prompted a change in the general objectives of the tax system. The objectives of the tax regime therefore changed to make the system more self-reliant and reduce the overall cost of implementing the tax system by reducing government involvement to sustain long-term viability of the pension scheme. All factors withstanding, the major implication of these tax changes rest on the pensioner (HM Treasury 2010, p. 11).
Implications of Investing in the Pension Scheme
Once every British citizen reaches the legal retirement age, he/she is entitled to a given sum under the State pension scheme (Jones 2007, p. 408). However, before an individual is entitled to this fund, he/she must have been a member of the state pension scheme. The decision to join the pension scheme is however influenced by the extent to which the pension scheme will be beneficial to the pensioner and the economy at large. The extent to which these benefits meet the pensioner’s need can be further analyzed through the PEST analysis. This means the analysis of the Political, Economic, Social and Technological factors.
Economic
Investing in pension schemes poses a number of economic advantages and disadvantages. Firstly, some pension schemes have a fixed rate of contribution thereby limiting the amount of money one can save in the scheme. Secondly, pension schemes are subject to inflationary pressures and since such schemes are normally on a long-term basis, such risks are normally compounded. Also, under the private pension scheme, there is an uncertainty to the amount of contributions one can make because the pensioner’s income may not be defined (Finney 2004, p. 291). The above factors outline the disadvantages of pension schemes but there are some derived benefits associated with the same schemes and they are outlined below:
Lifetime Allowance
When an individual invests in a pension scheme, he/she gets a tax relief on a fixed amount of money known as the Lifetime allowance. This figure has continuously risen to 1.8 million pounds in 2010 from 1.5 million pounds on 2005 (Money Engines 2010, p. 3). The set amount of standard allowance is usually predetermined by the amount of money needed to purchase pension that the HM revenues and customs would allow as the standard amount, considering the rules of the current tax regime. However, any excess amount of money under the tax regime is assumed to be improperly benefiting from the pension scheme and therefore attracts taxes.
The HM revenue and customs authority have been using a valuation factor under the ratio 20:1 for determining the cash equivalent of a given pension scheme; like say, a lifetime allowance of 1.5 million pounds would be equivalent to 75,000 pounds in gross income each year. However, funds which go beyond the predetermined lifetime allowance are taken as a lump sum and under current systems; the lifetime charge is stipulated at 55% (Money Engines 2010, p. 3). Nonetheless, there is a lifetime allowance charge stipulated at 25% of pensions an this ultimately constitutes the pension income but the income will still be subject to income tax at variable rates, depending on the pensioners income and therefore the overall taxation rate would be 55% (Money Engines 2010, p. 3).
Annual Allowance
Over the years, the annual allowance has been constantly increased from 215,000 pounds to 255,000 pounds from 2005-2010 (Money Engines 2010, p. 4). One great advantage with the annual allowance scheme is that it does not necessarily apply to the year of retirement and so one can strategically increase annual contributions a few years preceding retirement for increased income in future. Personal contributions have a limit of 17.5% while people contributing under an occupational money purchase scheme have a limit of 15% under the annual allowance scheme for individuals below the age of thirty six; thereby giving individuals more opportunity to contribute for their future financial plans (Money Engines 2010, p. 4).
However, the tax relief to be awarded under the annual allowance scheme is limited to a higher of 100% of the income to be earned and also in instances where the tax relief is done at the source (Money Engines, 2010, p. 4). Normally this is subject to a limit of 3,600 pounds (James 2008, p. 267).
When funds exceed the allowed limits, a tax charge of 40% is levied on such amounts of money. It should also be noted that any loss or growth on investments made on such money is never subject to annual allowance. In instances where a person does not receive any earnings, it is possible to contribute money to the tune of 3,600 pounds per annum in a personal pension scheme where tax relief enjoyable by other salaried pensioners can be advanced to the unsalaried pensioner under the personal pension scheme. It is therefore important to note that this scheme gives an opportunity for people without income and those with income to participate in the pension scheme (Money Engines 2010, p. 4)
Political
Pension Schemes
The UK pension scheme is specifically tailored to serve the needs of many types of pensioners. This means that every person can have an opportunity to take part in the pension scheme because it is flexible enough to accommodate everyone. The major types of pension schemes currently operational in the UK are the unit linked pension schemes and the profit driven pension schemes. Under the unit linked pension systems, there are similar sub categories that also suit the needs of the pensioners and they involve the managed funds, specialist funds, tracker funds, lifestyle funds while the pension schemes with a profit provide a bonus system whereby pensioners get extra money depending on how the money invested performs.
With regard to small businesses and businessmen taking part in the same, there are the small self-administered pension schemes that cater to the needs of small businessmen while the occupational pension scheme takes care of people taking part in large businesses (Roberts 2008, p. 133). Also, there is the group personal pension scheme for small groups, ethical pension schemes (for pensions which are not to be invested), unit and investment trusts, pension mortgages, and pension systems for overseas citizens (Pension Sorter 2010). The variable pension schemes mean that the UK pension scheme is flexible enough to accommodate the needs of all types of pensioners. However, pension schemes are subject to many legal changes that may be contrary to the pensioners’ wishes, like the change in retirement age, change in minimum contributions, change in taxation and the likes (Micocci 2010, p. 2).
Social
Pension schemes sometimes pose a lot of problems to both pensioners and institutions investing in pensions. Firstly, some pension lump sum payments can be lost in the event of job termination and the pensioner may lose all the money invested.
Also in as much as pension schemes offer future financial security, they also have specific limitations. First, funds are normally held until the retirement age is attained, meaning that it is not possible to access accumulated funds until one reaches the retirement age. This is usually very frustrating for those people who are faced with huge financial needs before they attain their retirement age. Secondly, the pension schemes sometimes have a very limited availability in that, it has become harder to find traditional pension schemes since many employers hesitate to pay guaranteed sums of money to pension schemes (Riley 2010, p. 4).
Technological
Technological advances have majorly been used in improving the accountability of pension schemes and the facilitation of online contributions especially for overseas pensioners. Technological advancements have also been used to improve payment methods, taxation procedures and record keeping, thereby guaranteeing pensioners that computations regarding their pension funds are properly managed.
Conclusion
From the above analysis, we can conclude that the UK pension taxation scheme is more complicated than previously thought. Moreover, it is economically incoherent and does not provide a favorable tax treatment, much to the disappointment of most pensioners. Nonetheless, the pension scheme has a number of advantages alongside various setbacks especially on taxation procedures and limits to the same but the bottom line is that pensioners should evaluate their needs to determine which type of pension scheme best suits their needs.
References
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