Reform is needed to the so-called simplification of pension savings tax, introduced from April 2006. With an ageing population posing a greater financial burden on the taxpayer, taxing those who are saving for their later life is counterproductive to maintaining economic growth and a balanced budget in the long term. It creates intergenerational unfairness, with those born in the 1970s, latecomers to auto enrolment, fewer offered defined benefit (DB) schemes, now faced with a falling lifetime allowance (LTA) and annual allowance (AA).
The objective in 2004 was to simplify pension savings tax, replacing four earlier regimes, with one applied to defined contribution (DC) and DB schemes. It was argued that the plethora of rules governing pension savings limits, incurred costs, confused the saver and put people off making retirement provision. One set of simple rules would resolve this. The generous allowances of 2006 (LTA £1.5 million and AA £215,000 and unlimited in the year of retirement) were designed to encourage saving, not to restrict tax relief.
Subsequent cuts from 2010 onwards, at the behest of the Liberal Democrats in the coalition government and continued by the current government, have failed the simplification objective. The nine protection regimes in place, multiple benefit crystallisation events and the differing outcomes for DC and DB members creates confusion. Worse still they will exacerbate inter-generational unfairness unless they are reformed.
The LTA of £1.5 million in 2006, enabled a DB member to accrue £75,000 per annum of guaranteed income, including annual increases and a dependant’s pension, compared to the DC member who would have been able to secure £97,350 per annum via annuity purchase. The valuation of benefits for the LTA has always favoured DB members. The DC member had to pay for fund management and administration and take investment risk to achieve their £1.5 million, whereas the DB member would have all this taken care of by a sponsoring employer, with these costs excluded from the calculation of the LTA. Significant DB accrual in the private sector is concentrated among the baby boomer generation, with younger workers relying increasingly on DC funds. Since 2006 annuity rates have tumbled so that £1,055,000 today only buys £40,000 per annum for a healthy 65 year old.
The shift from DB to DC may be inevitable but the reductions made in the LTA and AA since 2010 exaggerate the impact on retirement prospects for today’s middle-aged workers. From 2019-20 the LTA is £1,055,000 and will continue to be updated annually with CPI. Over the last decade CPI has averaged 2.25%, should it continue at this pace, it will be April 2035 before the LTA exceeds £1.5 million again. So, 29 years after A Day, the value of £1.5 million LTA, assuming average CPI of 2.25%, would be worth £786,783 in real terms.
The intergenerational unfairness of this is manifest. Those now aged 49 will reach age 65 in 2035 (although their state pension age will by then be 67-68). In real terms a DB member retiring then, will be allowed to accrue a pension worth £39,339 pa compared to the £75,000 pa allowed to their parent retiring in 2006. A DC member will be able to accrue only 52 % in real terms, compared to 2006, before extra tax is charged.
Added to this the reduction in the AA to £40,000 for most savers, but restricted further for higher earners and those who access their pensions flexibly, to as little as £10,000 and £4,000, the AA regime is no longer fit for purpose. The British Medical Association has highlighted the plight of doctors in the NHS which rewards promotion and taking on extra work with an unexpected tax bill. Similar impacts in the police force and schools are familiar to thousands in the private sector, bewildered and angry to receive a five or six figure tax bill just for being a loyal employee who gains promotion.
The Institute of Fiscal Studies has recently highlighted the impact of fiscal drag on measures introduced in the wake of the financial crisis which have not been reformed. The taper relief is a classic example, originally introduced at a threshold income of £110,000 which in real terms should now be £120,230 adjusted for inflation. Similarly, the AA of £40,000, £10,000 and £4,000, which in real terms should now be £59,740, and £10,930 when adjusted for CPI to previous levels*
A pension savings tax regime which makes each subsequent generation poorer is not one which can sustain economic growth nor give retirees the dignity of achieving security through financial independence. A forward-looking policy would restore the LTA to £1.5 million in real terms, that would require an LTA of £2 million now, with CPI adjustment annually. Restoring the AA and money purchase annual allowance to 2015 levels in real terms and abolishing the tapered allowance would be a first step to addressing this intergenerational imbalance.
*Assumes CPI of 2.25%on average applied to £50,000 AA since 2011 and £10,000 tapered and MPAA allowance since 2015.
Kay Ingram is director of public policy at LEBC Group