Pensions tax relief is a big cost to the UK economy. Recent statistics from HMRC showed £44.1bn was spent on income tax relief on pension contributions and investment income in 2020/21.
There are some who, in these straightened times, say the Treasury won’t be able to resist such a big carrot dangling in front of them. But these rumours are not helpful. They undermine confidence in the stability of pensions and encourage people to take unnecessary and, often, incorrect action.
Instead of altering pensions tax relief – for example to a single rate – the Treasury should be concentrating on how to make sure the pension tax rules work efficiently and robustly for everyone.
Complex pension rules
Since April 2006 the pension system has changed significantly and over this period, I have written several articles which are variations on this theme. Complexity has built on complexity, making it almost impossible for people to navigate the rules.
There are no less than three annual allowances. On top of this, the lifetime allowance has been sliced back from £1.8m to just over £1m, creating a web of seven protection regimes designed to provide transitional protection. To make things worse the lifetime allowance is now frozen until at least April 2026 – drawing more and more people into its net, with the charges raised for the Treasury coffers continuing to escalate.
The Treasury should be concentrating on how to make sure the pension tax rules work efficiently and robustly for everyone
There is broad consensus that the current system has become too unwieldy. There are contribution and benefit limits, or should I say allowances for tax relief, but either way it is one too many.
Time for government action
Now is the right time for government and the industry to recognise that a single legislative and tax relief framework does not work for all types of pensions.
Defined benefit (DB) and defined contribution (DC) schemes are simply too different, too diverse to fall under the same regime.
Instead, if we want to prevent complexity from cuddling pensions to death, we need to split DB and DC pensions.
We need a different set of pension tax rules for each. DC pensions should have only a check on contributions by way of a single annual allowance, and no lifetime allowance.
In contrast DB pensions should only have a check on benefits through the lifetime allowance, dispensing completely with all three annual allowances.
This would still keep a lid on that costly pension tax relief, but remove the burdensome extra limitations placed on both DC and DB savers.
This would create a simple set of pension tax rules, which providers can easily work with allowing them to enhance their offering. More importantly, savers could understand and navigate the system easily, removing the off-putting complexity that discourages people from investing for their future.
Large tax bills
It would also remove many of the problems that are leading to large tax bills landing on the doorsteps of higher paid public sector workers – such as doctors and consultants – and nudging them to leave their profession. That should be a considerable incentive for a government that wants to improve productivity, grow the economy and reinforce a stretched health service.
Of course, changes of this scale are not without their challenges. We have to be cognisant that some will want to ‘game the system’ so we need to be able to control transfers between the two regimes, possibly through a new benefit crystallisation event, as well as setting limits for those building up benefits under both regimes.
Savers could understand and navigate the system easily, removing the off-putting complexity
Policymakers may also be uncomfortable with the prospect of higher tax-free lump sums under DC and might want to limit these by a cap. And if the government believes the cost of abolishing superfluous allowances is prohibitive, it could explore options to lower the annual allowance to, say, £30,000 or even, dare I say it, bring pension schemes within the inheritance tax net!
Pension tax complexity is reaching a head, and we cannot carry on with the status quo. Public sector workers continually threatening strikes is not sustainable, nor can we tolerate tax rules being used as a political football every time the word ‘budget’ is mentioned.
It’s time to create a simpler pension tax framework that focuses on making life as easy as possible for people who do the right thing and save for their future. It’s time to split the rules for DB and DC.
Andy Bell is CEO of AJ Bell
Interesting article from Andy, and I can see much merit in it.
At the same time as making these changes there will need to be a very public promotion to give the general public some education on what pensions are, what they do and more importantly that DB & DC are different.
Finally the promotion needs to reinforce the message that people should chat with advisers to make sure they will have adequate income in retirement.
As usual, perfect common sense from Andy. The Lifetime Allowance for DC is an absurd tax, leading to poor decisions by many and penalising those who try to do the right thing.
This is all far too simple for the Treasury to grasp of course, so expect nothing to change.
Andy, This was actually the outcome of my masters research. There is clearly precedent given the old Occupational vs Personal rules, which are actually very similar to this proposal.
Something has to change and this helps but future HMRC policy also has to look at whether the factor of 20 for DB measurement under LTA is a) undervaluing the benefit and b) is perpetuating the inequality of benefits between DC and DB schemes.