Moving to a flat rate of pensions tax relief would not significantly improve the retirement incomes of lower earners according to a new report from the Pensions and Lifetime Savings Association.
This report comes after renewed speculation that the chancellor may look to reform pensions tax relief to raise additional revenue to help meet the costs of the pandemic.
The report ‘Pension Tax Reform: Implications for Savers’ looks at the potential impacts of reforming tax relief. It explores how a selection of workers with different levels of income and in different types of workplace pension scheme would be affected by four potential reform options.
These include flat rate relief set at 20 per cent, 25 per cent and 30 per cent, and TEE – whereby pension contributions are taxed at a person’s marginal rate of income tax but investment returns and pension income are exempt.
The report shows the effect on private pension income, total retirement income, retirement replacement rates and the PLSA’s Retirement Living Standards.
The analysis, based on modelling by the Pensions Policy Institute (PPI), finds that removal of the higher rate of pensions tax relief would be of no benefit to the majority of taxpayers who pay basic rate income tax and even the introduction of a new, more generous, single rate of 25 per cent would only result in a modest uplift in pension income for some savers.
In contrast the report finds that higher rate tax payers, would face higher tax bills, which could particularly hit those in DB schemes, including many doctors in the NHS.
Key finding for lower earners
The report gives cites a number of examples. If higher rate tax relief was removed and everyone received a single rate of relief at 20 per cent, a person on median earnings throughout their working life (i.e., at age 22 earning £19,000 per year and at age 68 earning £29,000 per year) would see no change to their pension contributions or tax bill.
The same person, however, would see an increase in their private pension income due to a rate of tax relief of 25 per cent. This would result in a higher pension of between 5 per cent and 8 per cent depending on the type of scheme they are in. For someone saving at the 8 per cent minimum AE level the additional annual income in retirement would be around £200 per year.
Key findings for higher earners
All higher rate taxpayers would pay more tax for every year that they remain a higher rate taxpayer. For some, particularly those in DB schemes, there would be very substantial tax bills to pay and, for their schemes, a decision to make as to whether to allow the tax bills to be paid by the scheme in return for lower benefits at retirement.
Under a reform where all the higher rate of tax relief is removed (a 20 per cent single rate), someone who remains a 90th percentile earner throughout their working life (i.e. at age 22 earning £29,000 per year and at age 68 earning £64,000 per year), would pay between £34,500 and £205,700 in extra tax over a working lifetime, depending on whether saving into a DC scheme at the 8 per cent minimum AE rate or in a typical DB CARE scheme such as that used in the NHS.
The resulting reduced pension contributions would lead to the high earner’s retirement income falling by between £900 per year and £7,500 per year, depending on the type of scheme. This amounts to a reduction in private pension income of over 20 per cent in all scheme types.
If a single rate of tax relief at 25 per cent is introduced, the same person would also lose out though not as significantly. At this rate, a 90th percentile earner would pay between £26,300 and £150,400 in additional tax, depending on whether the person is saving in a DC scheme at the minimum AE level or in a typical DB CARE scheme. This results in a reduction in private pension income of 16 per cent.
The PLSA found in its previous paper, ‘Five Principles for Pensions Taxation’ (first published in February 2021), that adopting a single rate of 25 per cent might be expected to raise £3.5bn-4.8bn per year for the Treasury.
Removal of all higher rate relief and the adoption of 20 per cent for pensions tax relief, would raise around £8bn to £10bn per year.
The modelling also demonstrates how few people are currently likely to achieve a ‘moderate’ or ‘comfortable’ living standard in retirement from pensions. All but high earners, 90th percentile earners in a generous DB scheme or some of those making very large DC contributions throughout large part of their career, get near the ‘comfortable’ level – according to PLSA definitions.
Under current minimum automatic enrolment savings levels of 8 per cent people on median earnings saving by themselves are only likely to achieve a retirement incomes that falls between ‘minimum’ and ‘moderate’.
PLSA director of policy and advocacy Nigel Peaple says: “Many commentators talk about the desirability of pensions tax relief reform, particularly the idea of removing higher rate pensions tax relief or introducing a new single rate of 25 per cent. However, our analysis shows that such reforms create few winners and many losers.
“Under the worst scenario assessed by the PLSA, a person who pays the higher rate of income tax for almost all of their working life could see a reduction of over 20 per cent in their private pension income before tax, irrespective of the type of scheme they belong to.
“While it might seem reasonable to reduce tax relief for the 13 per cent of the working population who pay higher rate income tax, it should be remembered that many more than 13 per cent of taxpayers will earn this amount at some time, and many only for a short number of years towards the end of their careers – when pension saving is often at its highest.
“The PLSA estimates that the removal of higher rate tax relief on pension contributions could result in around 3-4 million taxpayers each paying an average of £2,000 more tax each year; money that would otherwise have gone into their pensions.
“On balance, the PLSA believes the current system of pension taxation should be maintained to encourage an adequate level of saving for all. However, if the Government does choose to introduce a reform, we urge them to consider the ‘Five Principles for Pensions Taxation’ that we set out earlier this year, and to consult extensively to avoid unintended consequences.
“The difficulty in achieving adequate levels of income in retirement set out in our report, highlights the case for increasing the statutory minimum under automatic enrolment pension saving, not taking actions that result in less saving.”