Pre-Budget rumours that tax relief on pension savings would be reduced to a standard rate, rather than the more generous marginal income tax rate of 40p or 45p in the pound did not surface in Sunak’s second Budget instead, he chose to freeze the lifetime allowance (LTA) until 2026.
The LTA is the total value which an individual can take from all their private pensions with the benefit of tax -free growth.
Once the allowance is used up a lifetime allowance charge is levied at 25% if the excess is drawn as income (also subject to income tax) and at 55% if drawn as a lump sum.
Freezing the LTA at the current level of £1,073,100 will not make much difference to savers in the short term, as the CPI increase applied would have only increased it to £1,078,900. However, the long- term effects of this change, on top of earlier reductions in the LTA, make it more difficult for savers to accrue enough pension to support a comfortable retirement.
It is reasonable that the taxpayer subsidy should be contained. Limits on the amounts paid into pension savings, the annual allowance, restricts this to £40,000 a year or less, with tax penalties applying if it is exceeded. Imposing the LTA as well inhibits investment risk-taking which in other parts of his speech the Chancellor sought to encourage.
Private pension savers need to take investment risk to help their savings keep pace with inflation and the growing cost of securing a lifetime income.When success could be rewarded with a tax bill it creates a bizarre disincentive.
When introduced in 2006 the LTA was £1,5m and rose to £1,8m by 2012, before it was subject to a series of cuts down to £1m in 2016 and linked to CPI inflation since. Pension savers who had accrued higher levels than the prevailing LTA could apply for a higher protected LTA but with restrictions on what they could add to their pensions from then on.
Those in the private sector and the self-employed are hardest hit by this measure. The amount required to secure a guaranteed lifetime income (aka an annuity) from invested pension pots has grown at a much faster pace than the lifetime allowance has increased.
Since 2016, the CPI linking of the LTA has increased it by 7.31% but the cost of buying a lifetime income has increased by 22%. To keep pace with the true cost of securing a retirement income since 2016, the LTA would now need to be £ 1,293,100.
The rising cost of retirement is due to improving longevity, falling interest rates and gilt yields, whereas inflation, although affecting the ongoing cost of living, is not the main driver of the cost of converting £1 of pension fund into an annual lifetime income.
These factors affect the cost of providing defined benefit (DB) pensions too, but the scheme member is shielded from the immediate impact of lower gilt yields and increasing longevity as the scheme trustee must guarantee the benefit earned, regardless of cost. The way in which defined benefit schemes are measured against the LTA is more generous, based on the pension received, not the cost of providing it.
Based on the current cost of converting a fund to an income, £1,073,100 would buy a healthy 65-year-old around £29,000 a year of income, together with provision for a surviving partner and annual increases. Those in DB schemes (mostly public sector) do better because the way the LTA value is calculated (20 x annual pension) gives them an annual pension of £53,655 before any LTA charge is due.
That £1,073,100 pension pot also has to bear all the cost of investment services and administration, with additional advice costs required on top for the private pension saver, whereas DB scheme costs are accounted for separately by trustees and are disregarded in the LTA test.
It is true that private pension savers enjoy more flexibility in how and when they draw out their retirement income, giving opportunities to save tax, flex the income when transitioning into retirement and to leave a largely tax-free legacy.
Most DB pensions cease on the death of the member, or surviving spouse or partner, with little opportunity to control the amount or timing of the income they receive. Nevertheless, to allow one group of taxpayers to accrue almost £54,000 a year of income and others only £29,000, on a like for like basis, seems unfair.
This latest freezing of the LTA adds to the asymmetry of risk and reward. After 15 years of tinkering with the taxation of retirement savings now is the time for a review with simplification at its heart. Applying only the annual allowance to invested pension pots and only the LTA to DB pensions would be a good start.
Kay Ingram is director of public policy at LEBC