• Reports suggest the Treasury is eyeing cuts to pension tax incentives to help pay the cost of COVID
• Reforms said to be under consideration including introducing a flat rate of pension tax relief, cutting the lifetime allowance or taxing employer contributions
• AJ Bell analysis suggests a flat rate of pension tax relief set at 20% could cost a 35-year-old higher-rate taxpayer £50,000 in retirement income, while defined benefit (DB) members would also be hit
• Squeezing the lifetime allowance or raising employer pension costs also fraught with difficulties
Tom Selby, senior analyst at AJ Bell, comments:
“Beyond the political fire and brimstone a pensions tax raid would cause among Conservative backbenchers and voters, there would be significant practical implications for any of the proposals floated by the Treasury.
“Cutting tax relief for individuals risks undoing the groundwork laid by automatic enrolment and sowing mistrust in the stability of the retirement savings framework.
“Hitting employers, meanwhile, might raise a fast buck for the Chancellor but would risk strangling off the UK’s pandemic recovery.
“There were always going to be tough fiscal choices as the country slowly shifts away from dealing with the health emergency of Coronavirus and focuses on the financial hole blown in the Exchequer’s balance sheet.
“It is critical any proposals for pension tax reform consider both short and long-term priorities, and in particular the challenge of ensuring current and future generations’ retirement prospects are not fatally damaged.”
Introducing a flat rate of pension tax relief
Current system: pension tax relief granted at saver’s marginal rate of income tax.
Possible reform: flat rate of pension tax relief set at between 20% and 30%.
Impact: A 35-year-old higher-rate taxpayer earning £60,000 a year and paying 4% of salary into a pension until age 67 could miss out on £50,000 in retirement income (if flat rate is set at 20%).
Depending on where the flat rate of relief was set, thousands of defined benefit (DB) scheme members would also likely face a tax charge under this proposal.
Commentary: “Given the priority of the Government is to raise cash for the post-COVID economic recovery, a flat rate of pension tax relief would likely need to be set well below 30% to achieve this.
“In fact, analysis carried out by the respected Pensions Policy Institute1 suggested setting a flat rate of pension tax relief at 30% would actually cost the Government money, while a rate of 25% might save between £2-£3billion a year and 20% around £6-£8 billion a year.
“Such huge savings would clearly come at a cost to individuals. A 35-year-old higher-rate taxpayer earning £60,000 a year and paying 4% of salary into a pension until age 67 could miss out on £50,000 of retirement income if a flat rate of 20% was introduced. Those earning more or making larger contributions would face an even bigger hit to their plans.
“However, the big challenge in going down this road – both practically and politically – lies in the public sector, where workers continue to enjoy generous guaranteed defined benefit pensions.
“In order to apply a flat rate of relief to these pensions a tax charge would need to be calculated and applied directly to employees by HMRC.
“Doctors and senior NHS staff who have been on the front line dealing with the pandemic would likely end up with tax bills running into thousands of pounds as a result.”
Reduce the pensions lifetime allowance from £1,073,100 to £900,000 or £800,000
Current system: savers benefit from a lifetime allowance of £1,073,100 (frozen at the last Budget until 2025/26).
Possible reform: reduce the lifetime allowance to £900,000 or £800,000.
Impact: A healthy 66-year-old with a £900,000 pension pot could buy an inflation-linked annuity paying just over £26,000 a year (after 25% tax-free has been taken).
If the same person had an £800,000 fund, they could buy a similar annuity (after taking their 25% tax-free cash) worth just over £23,000 a year2.
Someone with a £900,000 fund who took their 25% tax-free cash, invested the remaining £675,000 in drawdown and enjoyed 4% investment growth after charges each year could take an inflation-adjusted income of around £29,000 annually and the fund should last 30 years.
If the same person had an £800,000 fund, took 25% tax-free cash, invested the remaining £600,000 in drawdown and enjoyed 4% investment growth, they could take an inflation-adjusted income of around £26,000 annually for 30 years.
Commentary: “The lifetime allowance has been tinkered with relentlessly by successive Governments, reducing from £1.8 million a decade ago to just £1 million by 2016/17. Two years later it was pegged to CPI inflation – but this link was removed for the rest of this Parliament by Rishi Sunak in March. This constant tinkering has led to huge complexity and uncertainty for retirement savers.
“If we were to get yet another cut to the lifetime allowance to £900,000 or even £800,000, as has been suggested, more diligent savers would be at risk of breaching the limit.
“To put this in context, reducing the lifetime allowance to £800,000 would mean after tax-free cash has been taken the retirement income someone could take at age 66 would be well below the average salary in the UK.
“This would feel like an extremely low bar to set for people’s retirement aspirations.”
Tax employer pension contributions
Current system: like employee pension contributions, employer contributions benefit from National Insurance relief.
Possible reform: apply National Insurance to employer pension contributions.
Impact: Unclear but any increase in pension costs would almost certainly lead to a levelling down of provision.
Commentary: “Of the pension tax proposals floated this was the one with the least amount of detail attached – which is saying something.
“At the moment employer pension contributions are exempt from National Insurance, so it is theoretically possible the Treasury could reverse this position – or perhaps apply a limited charge - in a bid to raise revenue.
“However, going down this road would cause uproar among businesses already struggling to deal with the fallout from the pandemic. It could also be counterproductive if landing these firms with extra costs forced them to hold off on investment.
“Over the long-term, any increase in the costs of providing pensions would likely see a damaging levelling down of provision.”
1 How pension reform would affect individuals, or (pensionspolicyinstitute.org.uk)
2 Quotes sourced from Money Advice Service annuity calculator on 22/06/21
