Why the pensions industry gets tax relief wrong
The strong rumours that the Chancellor would limit pensions tax relief in the Autumn Statement have turned out to be true.
Predictably the pensions industry was up in arms about the prospect.
But by defending the indefensible they do not help pensions for the many. Instead they make it easier for the Chancellor.
The pensions world should look at ways that redistribute the current hand-outs instead. What now goes to the highest earners should instead go to more modest savers or current pensioners. Otherwise pensions tax relief will continue to be shaved away with no benefit to pensions.
In the jargon pensions tax relief is available at your marginal rate of tax . What this means is that your income tax contributions are assessed on your pay less your total pension contribution. That has the merit of simplicity, but is unfair.
To understand this let’s look at someone who contributes £1,000 a year to a pension.
If they took it as pay instead, a standard rate taxpayer would pay 20 per cent tax on this (£200). A higher rate tax payer would pay £400 and someone on the top rate of 45p (the one the Chancellor reduced from 50p in the last budget) would pay £450. This is progressive taxation in action.
But what this means is that it costs the standard rate taxpayer £800 to put £1,000 in their pension as their tax bill is reduced by £200 when tax relief is taken into account. The higher rate taxpayer gets £1,000 worth of pension for £600 and those on the highest rate are just short of bogof pension contributions as they only have to pay £550. Or to put it another way, it costs a standard rate taxpayer 80p to save a pensions pound but only 55p for the highest earners.
There are three caveats to this:
- there is a lifetime limit of £1.25 million -reduced today from £1.5 million – on the size of your pension pot. This is enough to fund a pension of about £62,000 a year.
- while you get tax relief as you pay into a pension, you do have to pay tax on the pension you draw when you retire. However six out of seven higher rate tax payers will drop to standard rate tax payers once they have retired. In other words they get 40p relief for each pound saved but pay 20p on what they take above their annual allowance on the way out.
- there is a limit on how much you can put into your pension in any one year and claim tax relief on it. Originally introduced by Alistair Darling it was £50,000 a year, and is now £40,000. This is easy to understand for DC (money-purchase) schemes as this is simply the limit on the cash you and your employer can put in with tax relief. For DB pension scheme members it is ferociously complicated as it includes not just the sum of employee and employer contributions but also a measure of the total increase in the value of your pension each year. This is not a measure of how much extra each year you will get when you retire, but an estimate of the cost of buying that income stream through an annuity. If you are in a final salary scheme and get a promotion with a significant pay rise this can hit the limit. However you can roll forward unused allowances from the previous three years.
Pensions tax relief is heavily skewed towards the better off – and I’m not going to argue it should be left untouched, even if today’s changes can have a big impact on some DB scheme members who are on good pay but fall well-short of being super-rich.
And it is not just those on the TUC’s side of arguments who see problems. A right of centre thinktank has just published this thoughtful paper from Michael Johnson who argues that current reliefs are not just unfair but ineffective.
The argument that any limit to tax relief discredits all pensions savings is particularly daft. As George Osborne notes,
98% of people currently approaching retirement have a pension pot worth less than £1.25 million. Indeed, the median pot for such people is just £55,000. 99% of pension savers make annual contributions to their pensions of less than £40,000. The average contribution to a pension is just £6,000 a year.
While the impact on DB schemes should not be dismissed, the pensions industry has made a strategic mistake in simply opposing all change. This positions them as simply champions of the super-rich, How many people can afford to put almost twice as much as the median household income into a DC pension each year?
Those attacking universal benefits always argue that the low paid should not pay tax to give wealthy pensioners a winter fuel allowance. But most are silent on pensions tax relief – even though winter fuel allowance is the same for everyone while pension tax relief gives no help to those too poor to afford a pension but can provide more than £20,000 a year to someone at the top of the income distribution.
Better would be to argue for a redistribution of relief. With auto-enrolment starting, why not put more into the pensions pot of standard rate taxpayers with extra relief on contributions up to the maximum required on the full earnings band under minimum contributions? Or use some of it to help current pensioners who will not benefit from the flat-rate pension reforms due to be announced in the not too distant future. Or to think a bit laterally, use it to help fund social care.
Let us start from first principles: the case for pensions tax relief is valid. Almost all can agree that we should help people to save enough to lift them above the poverty line in retirement (and thus clear of means-tested benefits).
There is also a strong argument that it is a valid part of public policy to use tax relief to encourage a reasonable rate of income replacement in retirement, (a key recommendation of the Pensions Commission) but how far up the income scale this should go is not obvious – and no-one much seems to want to talk about it.
I do not agree with Michael Johnson that we should treat ISA and pensions savings as essentially the same, but his critique joins the TUC’s and the Lib Dem call at the last election for higher rate relief to be limited to standard rate (since echoed by Labour’s Rachel Reeves.)
The Pensions Policy Institute is currently researching how pensions tax relief works and the TUC is part of a group of organisations funding that work. Let us hope that this can kick-start a debate on how best tax relief can boost pensions for the many, rather than the few.
It is also worth noting that the government is consulting on smoothing the measurement of deficits in DB pension schemes.
This makes sense. A measured pension deficit is really an accoutancy measure used as a proxy for the strength of the covenant between the scheme and the sponsoring employer. While it is hard to put numbers on that and therefore some measure of the future needs of a scheme makes sense, c hanges in deficit figures have far more to do with moves in the rest of the economy that changes in future liabilities. Smotting them therefore makes much sense.