Tom Selby: Covid-19 pension tax relief raid risks widening generational divide

With rumours once again swirling around the future of pensions tax relief in the run up to this year's budget, comments Tom Selby, any reduced incentive for long-term savers could risk further exacerbating the generational divide in retirement...

With rumours once again swirling around the future of pensions tax relief in the run up to this year’s budget, comments Tom Selby, any reduced incentive for long-term savers could risk further exacerbating the generational divide in retirement…

One of these days I’m going to run a sweepstake for when the annual ‘higher-rate pension tax relief is about to be axed’ rumour first gets aired. This year, if you’d backed the last weekend of August in my imaginary (and incredibly nerdy) gambling guessing-game you’d have been in the money.

Recent Sunday Times and Sunday Telegraph front pages, both speculated – thanks to help from the usual ‘Treasury sources’ – that pension tax relief could be in Rishi Sunak’s sights, with the prospect of introducing a flat-rate set at 20% or 30% floated.

Various other measures including aligning capital gains tax (CGT) with income tax, raising corporation tax from 19% to 24% and ditching the state pension triple-lock are also apparently being drawn up ahead of the Budget later this year.

While the Treasury has been guilty of crying wolf on countless occasions on pension tax relief reform, it was clear even before Covid-19 gouged a £300 billion hole in the nation’s finances that some within Number 11 were in favour of slashing and burning retirement saving incentives.

Generational problems

If the nuclear option of scrapping higher-rate pension tax relief altogether – and saving an estimated £10 billion in the process – was pursued, it would have a significant impact not only on the pension outcomes of over 4 million higher and additional-rate taxpayers, but of those who may become higher earners in later life.

A 30-year-old higher-rate taxpayer saving £500 a month in a pension could end up with a fund worth £140,000 less by the time they reach age 65 if tax relief is limited to the basic-rate. If the extra relief wasn’t invested in a pension they could be over £50,000 worse off over the course of 35 years.

This would leave the generation coming down the track hamstrung in their attempts to save for retirement.

Having already had the defined benefit rug pulled from under them (unless they work in the public sector, of course), millions of younger people would be stripped of a retirement saving incentive their parents enjoyed.

Given most people are already failing to put enough to one side for later life, stripping back the incentives provided by tax relief would inevitably see some higher earners reduce the amount they save.

This might save some money in the short-term but it would also risk exacerbating the pensions crisis automatic enrolment was put in place to address.

Defined benefit challenge

While younger people would be clear losers if higher-rate pension tax relief is abolished, perhaps the biggest challenge to the reforms exists at the Treasury’s own door.

A significant chunk of the pension tax and NI relief costs incurred by the Treasury each year goes to members of defined benefit schemes – most of whom now reside in the public sector.

For starters, it is entirely unclear how flat-rate relief would work for DB from a practical perspective – and it would have to work for the Government to achieve the savings it hopes for.

But even if this complexity could be overcome, ministers would be setting themselves up for a significant battle with representatives of public sector workers – including those in the NHS who the nation clapped for every Thursday during lockdown.

Tom Selby is a senior analyst at AJ Bell