The tapered annual allowance is poorly designed and not fit for purpose.
Its impact on the NHS has recently been well documented in the press but the problems don’t stop there. The taper strangles the ability of higher earners to build provision for the retirement within pensions.
The cost of pensions tax relief, particularly that for higher earners, is clearly still on the Treasury’s radar. We all remember George Osborne attempting to introduce reforms but backtracking after realising the enormity of the task.
To understand why we need to abolish the taper (and perhaps the money purchase annual allowance too) lets go back to 2006 and simplification at A-day.
The new regime introduced the lifetime and annual allowances (LTA and AA).
The LTA was designed to limit the value of funds savers could build up before tax charges kicked in. The charges were designed to recoup the tax relief and tax free growth on funds over the LTA.
The original AA, at a level of £215,000, was intended as a light touch to stop one off contributions up to the lifetime allowance. Given the existence of the LTA, arguably it wasn’t needed at all. However you could see how it may have been introduced to prevent sizeable up-front tax relief costs.
In 2010 George Osborne (who was in opposition at the time of pension simplification) took a look at the books, grabbed the levers of the LTA and AA and pulled hard. He fiddled year on year with his last pension hurrahs being to give us the tapered AA and the money purchase AA.
As a result we have a LTA of just over a million and an AA of £40,000. Even if you chose the worst times to invest you could reach the LTA with 20 years’ contributions. If you’re fully affected by the tapered AA the number of years increases nearly four-fold.
If you leave university with your student loan debt, look at the state of the housing market and the cost of raising children and just accept the auto-enrolment contributions into a pension scheme you might easily get to 40 without seriously considering your pension. You now have a bit of spare money and a growing sense of your impending retirement needs and you decide to save. However your income could mean you face restrictions in how much extra you can actually save.
To illustrate the effect of the taper today, let’s consider a 50 year old whose annual salary after bonuses means they’re affected by the taper. Their children are graduating, they’ve purchased their dream home but those other financial priorities mean they’ve only managed to build a pension pot of £150,000. Sounds reasonable until you consider the amount they can now save into a pension each year without a tax charge has been limited to £10,000 each year. This is just when they are looking to start increasing their own contributions.
Take a £150,000 fund value, a £10,000 yearly contribution and project forward at 5% per annum after charges until they are 70. At that point, they could have a fund value of just over £790,000. Even mopping up any carry forward at the start is unlikely to get them near the lifetime allowance within 20 years.
Taking the current LTA of £1,055,000 and projecting forward 20 years with CPI at 2% gives us a potential LTA in 20 years of c £1,570,000. So our high earner has a fund value of half the LTA limit thanks to the taper.
These numbers all assume our saver knows their earnings and bonuses for the tax year. Thanks to the fiendishly difficult rules, many clients and advisers won’t actually know what the level of the tapered AA is until after the end of the tax year due to variable earnings.
One option is to simply let the LTA do its job and wait for the tax take in the future.
Since the LTA was cut right back to £1 million in 2016, it has risen with CPI inflation and is currently £1,055,000. If that continues each year and policy makers resist the urge to tinker then that would leave the LTA to do its original job whilst allowing higher earners to build a pension pot that will provide for them during retirement.
Although retirement planning is a long term exercise, this option is unlikely to prevail as the question will still be asked as to how the cost to the Treasury of higher and additional rate pensions tax relief should be controlled each fiscal year if the taper is abolished. That though is the wrong question. We should not be looking to penalise savings and there are ways to tax high earners other than complicating the pensions system with unnecessary bureaucracy. A modest increase in rates of income tax for the highest earners being an obvious option.
Tax relief on pensions needs to be controlled, but the taper is not the right way to achieve this.
Charlene Young is senior technical consultant at AJ Bell